Performance Measurement II;

Differential Analysis: The Key to

Decision Making – Part I

Chapters 10 & 11

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 Learning Objective 1

Understand how to construct

and use a balanced scorecard.

9-2
The Balanced Scorecard
Management translates its strategy into
performance measures that employees
understand and influence.

Financial Customer

Performance
measures
Internal Learning
business and growth
processes
9-3
 The Balanced Scorecard - From
Strategy to Performance Measures
Performance Measures
Financial What are our
Has our financial financial goals?
performance improved?

Customer What customers do Vision

we want to serve and
Do customers recognize that how are we going to and
we are delivering more value? win and retain them? Strategy

Internal Business Processes What internal busi-

Have we improved key business ness processes are
processes so that we can deliver critical to providing
more value to customers? value to customers?

Learning and Growth

Are we maintaining our ability
to change and improve? 9-4
 The Balanced Scorecard –
Non-financial Measures

The balanced scorecard relies on non-financial measures

in addition to financial measures for two reasons:

 Financial measures are lag indicators that summarize

the results of past actions. Non-financial measures are
leading indicators of future financial performance.

 Top managers are ordinarily responsible for financial

performance measures – not lower level managers.
Non-financial measures are more likely to be
understood and controlled by lower level managers.
9-5
 The Balanced Scorecard – Important Links

A balanced scorecard should have measures

that are linked together on a cause-and-effect basis.

If we improve Another desired

Then
one performance performance measure
measure . . . will improve.

The balanced scorecard lays out concrete

actions to attain desired outcomes.
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The Balanced Scorecard and Compensation

Incentive compensation should be

linked to balanced scorecard
performance measures.

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 The Balanced Scorecard ─ Jaguar Example –
Part 1
Profit
Financial
Contribution per car

Number of cars sold

Customer
Customer satisfaction
with options

Internal
Business Number of Time to
options available install option
Processes

Learning Employee skills in

and Growth installing options
9-8
 The Balanced Scorecard ─ Jaguar Example –
Part 2
Profit

Contribution per car

Number of cars sold

Customer satisfaction Results

with options Satisfaction
Increases
Strategies
Increase Number of Time to
Options options available install option Time
Decreases

Increase Employee skills in

Skills installing options
9-9
The Balanced Scorecard ─ Jaguar Example –
Part 3
Profit

Contribution per car

Results
Cars sold
Number of cars sold Increase

Customer satisfaction
with options Satisfaction
Increases

Number of Time to
options available install option

Employee skills in
installing options
9-10
The Balanced Scorecard ─ Jaguar Example –
Part 4
Profit
Results
Contribution per car Contribution
Increases

Number of cars sold

Customer satisfaction
with options Satisfaction
Increases

Number of Time to
options available install option Time
Decreases

Employee skills in
installing options
9-11
 The Balanced Scorecard ─ Jaguar Example –
Part 5
Results
Profit Profits
Increase
If number
Contribution per car Contribution
of cars sold Increases
and contribution
Cars Sold
per car increase, Number of cars sold Increases
profit should
increase. Customer satisfaction
with options

Number of Time to
options available install option

Employee skills in
installing options
9-12
Differential Analysis: The Key to
Decision Making – Part I

Chapter 11

9-13
Learning Objective 2

Identify relevant and

irrelevant costs and benefits
in a decision.

9-14
Decision Making – Six Key Concepts

Key Concept #1
Every decision involves choosing from among at least two
alternatives. Therefore, the first step in decision making is
to define the alternatives being considered.

9-15
Decision Making – Six Key Concepts

Key Concept #2
Identify the criteria for choosing among alternatives
• Relevant costs and relevant benefits should be considered
when making decisions.
• Irrelevant costs and irrelevant benefits should be ignored
when making decisions.

9-16
Decision Making – Six Key Concepts

Key Concept #3
Differential analysis - ONLY those costs and benefits that differ
between alternatives are relevant in decision.
• A future cost that differs between any two alternatives is
known as a differential cost.
• A future revenue that differs between any two
alternatives is known as differential revenue.
• An incremental cost is an increase in cost between two
alternatives.
• An avoidable cost is a cost that can be eliminated by
choosing one alternative over another.

9-17
Decision Making – Six Key Concepts

Key Concept #4
Sunk costs are always irrelevant when choosing among
alternatives.
 A sunk cost is a cost that has already been incurred and
cannot be changed regardless of what a manager
decides to do.

Key Concept #5
Future costs and benefits that do not differ between alternatives
are irrelevant to the decision-making process.

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Decision Making – Six Key Concepts

Key Concept #6
Opportunity costs also need to be considered and relevant when
making decisions.
• An opportunity cost is the potential benefit that is given up
when one alternative is selected over another.

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Relevant Costs and Benefits
AC2 Canteen

Irrelevant Price $35 $ 35

Cost

Relevant
Cost
Cost of walking $10 $0

Relevant Satisfaction of
Benefits $60 $40
the taste

9-20
 Relevant Costs and Benefits
AC2 Canteen

Price $35 $ 35
Avoidable Cost /
Incremental Cost
Cost of walking $10 $0

Satisfaction of
$60 $40
the taste

9-21
Keys to Successful Decision-Making

1. Focus only on relevant costs (also called avoidable

costs, differential costs, or incremental costs) and
relevant benefits (also called differential benefits or
incremental benefits).

2. Ignore everything else including sunk costs and future

costs and benefits that do not differ between the
alternatives.

9-22
Different Costs for Different Purposes

Costs that are

relevant in one
decision situation
may not be relevant
in another context.
Thus, in each
decision situation,
the manager must
examine the data at
hand and isolate the
relevant costs.
9-23
Identifying Relevant Costs

Cynthia, a Boston student, is considering visiting her friend in New York.

She can drive or take the train. By car, it is 230 miles to her friend’s
apartment. She is trying to decide which alternative is less expensive
and has gathered the following information:
Automobile Costs (based on 10,000 miles driven per year)
Annual Cost Cost per
of Fixed Items Mile
1 Annual straight-line depreciation on car $ 2,800 $ 0.280
2 Cost of gasoline 0.100
3 Annual cost of auto insurance and license 1,380 0.138
4 Maintenance and repairs 0.065
5 Parking fees at school 360 0.036
6 Total average cost $ 0.619

$45 per month × 8 months $2.70 per gallon ÷ 27 MPG

($24,000 cost – $10,000 salvage value) ÷ 5 years

9-24
 Identifying Relevant Costs
Automobile Costs (based on 10,000 miles driven per year)
Annual Cost per
Cost of Mile
1 Annual straight-line depreciation on car $ 2,800 $ 0.280
2 Cost of gasoline 0.100
3 Annual cost of auto insurance and license 1,380 0.138
4 Maintenance and repairs 0.065
5 Parking fees at school 360 0.036
6 Total average cost $ 0.619

Some Additional Information

7 Reduction in resale value of car per mile of wear $ 0.026
8 Round-trip train fare $ 104
9 Benefits of relaxing on train trip ????
10 Cost of putting dog in kennel while gone $ 40
11 Benefit of having car in New York ????
12 Hassle of parking car in New York ????
13 Per day cost of parking car in New York $ 25
9-25
Identifying Relevant Costs

Which costs and benefits are relevant in Cynthia’s

decision?

The cost of the The annual cost of

car is a sunk cost insurance is not
and is not relevant. It will remain
relevant to the the same if she drives
current decision. or takes the train.

However, the cost of gasoline is clearly relevant if she decides to

drive. If she takes the train, the cost would not be incurred, so it
varies depending on the decision.
9-26
Identifying Relevant Costs

Which costs and benefits are relevant in Cynthia’s

decision?

The cost of The monthly school

maintenance and parking fee is not
repairs is relevant. In relevant because it
the long-run these must be paid if Cynthia
costs depend upon drives or takes the
miles driven. train.

At this point, we can see that some of the average cost

of $0.619 per mile are relevant and others are not.
9-27
Identifying Relevant Costs

Which costs and benefits are relevant in Cynthia’s

decision?

The decline in resale The round-trip train

value due to additional fare is clearly relevant.
miles is a relevant If she drives the cost
cost. can be avoided.

Relaxing on the train is The kennel cost is not

relevant even though it relevant because
is difficult to assign a Cynthia will incur the
dollar value to the cost if she drives or
benefit. takes the train.
9-28
Identifying Relevant Costs

Which costs and benefits are relevant in Cynthia’s

decision?

The cost of parking in New

York is relevant because it
can be avoided if she takes
the train.

The benefits of having a car in New York and

the problems of finding a parking space are
both relevant but are difficult to assign a
dollar amount.
9-29
Identifying Relevant Costs
From a financial standpoint, Cynthia would be better
off taking the train to visit her friend. Some of the
nonfinancial factors may influence her final decision.
Relevant Financial Cost of Driving
Gasoline (460 @ $0.100 per mile) $ 46.00
Maintenance (460 @ $0.065 per mile) 29.90
Reduction in resale (460 @ $0.026 per mile) 11.96
Parking in New York (2 days @ $25 per day) 50.00
Total $ 137.86

Relevant Financial Cost of Taking the Train

Round-trip ticket $ 104.00

9-30
 Total and Differential Cost Approaches
The management of a company is considering a new labor-saving
machine that rents for $3,000 per year. Data about the company’s
annual sales and costs with and without the new machine are:
Situation Differential
Current With New Costs and
Situation Machine Benefits
Sales (5,000 units @ $40 per unit) $ 200,000 $ 200,000 -
Less variable expenses:
Direct materials (5,000 units @ $14 per unit) 70,000 70,000 -
Direct labor (5,000 units @ $8 and $5 per unit) 40,000 25,000 15,000
Variable overhead (5,000 units @ $2 per unit) 10,000 10,000 -
Total variable expenses 120,000 105,000 -
Contribution margin 80,000 95,000 15,000
Less fixed expense:
Other 62,000 62,000 -
Rent on new machine - 3,000 (3,000)
Total fixed expenses 62,000 65,000 (3,000)
Net operating income $ 18,000 $ 30,000 12,000

9-31
 Total and Differential Cost Approaches
As you can see, the only costs that differ between the
alternatives are the direct labor costs savings and the
increase in fixed rental costs.
Situation Differential
Current With New Costs and
Situation Machine Benefits
Sales (5,000 units @ $40 per unit) $ 200,000 $ 200,000 -
Less variable expenses:
We
Direct materials canunits
(5,000 efficiently analyze the
@ $14 per unit) decision 70,000
70,000 by -
Direct labor looking
(5,000 units at
@ $8 anddifferent
the $5 per unit) costs 40,000
and revenues 25,000 15,000
Variable overhead (5,000 units @ $2 per unit) 10,000 10,000 -
Total variable expenses and arrive at the same 120,000 .
solution 105,000 -
Contribution margin 80,000 95,000 15,000
Less fixed expense: Net Advantage to Renting the New Machine
Decrease in direct labor costs (5,000 units @ $3 per unit) $ 15,000
Other 62,000 62,000 -
Increase in fixed rental expenses (3,000)
Rent on newNet machine
annual cost saving from renting the new machine
- $
3,000
12,000
(3,000)
Total fixed expenses 62,000 65,000 (3,000)
Net operating income $ 18,000 $ 30,000 12,000

9-32
Total and Differential Cost Approaches

Why is
differential
approach Reason 1 Reason 2
desirable ?
• Ignoring irrelevant • Mingling irrelevant costs
data can save with relevant costs may
decision makers cause confusion and
tremendous amounts distract attention away
of time and effort. from the information that
is really critical.

9-33
Learning Objective 3

Prepare an analysis showing

whether a product line or other
business segment should be
added or dropped.

9-34
Adding/Dropping Segments

One of the most important

decisions managers make is
whether to add or drop a
business segment. Ultimately, a
decision to drop an old
segment or add a new one is
going to hinge primarily on the
impact the decision will have on
To assess this impact, it
net operating income.
is necessary to
carefully analyze the
costs.

9-35
Adding/Dropping Segments

Due to the declining popularity of digital

watches, Lovell Company’s digital watch line
has not reported a profit for several years.
Lovell is considering discontinuing this
product line.

9-36
Adding/Dropping Segments

DECISION RULE
Lovell should drop the digital watch segment
only if its profit would increase.

Lovell will compare the contribution margin

that would be lost to the costs that would be
avoided if the line was to be dropped.

9-37
Adding/Dropping Segments

Segment Income Statement

Digital Watches
Sales $ 500,000
Less: variable expenses
Variable manufacturing costs $ 120,000
Variable shipping costs 5,000
Commissions 75,000 200,000
Contribution margin $ 300,000
Less: fixed expenses
General factory overhead $ 60,000
Salary of line manager 90,000
Depreciation of equipment 30,000
Advertising - direct 100,000
Rent - factory space 70,000
General admin. expenses 30,000 380,000
Net operating loss $ (80,000)
9-38
Adding/Dropping Segments

An investigation has revealed that the fixed general

factory overhead and fixed general administrative
expenses will not be affected by dropping the digital
watch line. The fixed general factory overhead and
general administrative expenses assigned to this
product would be reallocated to other product lines.

The equipment used to manufacture digital watches

has no resale value or alternative use.

Should Lovell retain or drop

the digital watch segment?
9-39
A Contribution Margin Approach

Contribution Margin
Solution
Contribution margin lost if digital
  watches are dropped $ (300,000)
Less fixed costs that can be avoided
Salary of the line manager $ 90,000
Advertising - direct 100,000
Rent - factory space 70,000 260,000
Net disadvantage $ (40,000)

9-40
Comparative Income Approach

The Lovell solution can also be obtained by preparing

comparative income statements showing results with
and without the digital watch segment.

Let’s look at this second approach.

9-41
Comparative Income Approach
Comparative Income Approach
Solution
Keep Drop
Digital Digital
Watches Watches Difference
Sales $ 500,000 $ - $ (500,000)
Less variable expenses: -
Manufacturing expenses 120,000 - 120,000
Shipping 5,000 - 5,000
Commissions 75,000 - 75,000
Total variable expenses 200,000 - 200,000
Contribution margin 300,000 - (300,000)
Less fixed expenses:
General factory overhead 60,000
Salary of line manager 90,000If the digital watch line
Depreciation
Advertising - direct
30,000
100,000
is dropped, the
Rent - factory space 70,000 company loses
General admin. expenses
Total fixed expenses
30,000
380,000
$300,000 in
Net operating loss $ (80,000) contribution margin.
9-42
Comparative Income Approach
Comparative Income Approach
Solution
Keep Drop
Digital Digital
Watches Watches Difference
Sales $ 500,000 $ - $ (500,000)
Less variable expenses: -
Manufacturing expenses 120,000 - 120,000
Shipping 5,000 - 5,000
Commissions 75,000 - 75,000
Total variable expenses 200,000 - 200,000
Contribution margin 300,000 - (300,000)
Less fixed expenses:
General factory overhead 60,000 60,000 -
Salary of line manager 90,000
Depreciation
Advertising - direct
On the other hand, the general
50,000
100,000
Rent - factory space factory overhead would be the
70,000
General admin. expenses
Total fixed expenses
same under both alternatives, so it
30,000
400,000
Net operating loss is irrelevant.
$ (100,000)
9-43
Comparative Income Approach
Comparative Income Approach
Solution
Keep Drop
Digital Digital
Watches Watches Difference
Sales $ 500,000 $ - $ (500,000)

The salary of the product line

Less variable expenses: -
Manufacturing expenses 120,000 - 120,000
Shipping manager would disappear, so it is
5,000 - 5,000

relevant to the decision.

Commissions 75,000 - 75,000
Total variable expenses 200,000 - 200,000
Contribution margin 300,000 - (300,000)
Less fixed expenses:
General factory overhead 60,000 60,000 -
Salary of line manager 90,000 - 90,000
Depreciation 50,000
Advertising - direct 100,000
Rent - factory space 70,000
General admin. expenses 30,000
Total fixed expenses 400,000
Net operating loss $ (100,000)
9-44
Comparative Income Approach
Comparative Income Approach
Solution
Keep Drop
Digital Digital
Watches Watches Difference
The depreciation is a sunk cost. Also, remember that the
Sales
Less variable expenses:
$ 500,000 $ -
-
$ (500,000)

equipment has no resale value or alternative use, so the120,000

Manufacturing expenses 120,000 -
equipment and the depreciation expense associated with it are
Shipping 5,000 - 5,000
Commissions 75,000 - 75,000
irrelevant to the decision.
Total variable expenses 200,000 - 200,000
Contribution margin 300,000 - (300,000)
Less fixed expenses:
General factory overhead 60,000 60,000 -
Salary of line manager 90,000 - 90,000
Depreciation 50,000 50,000 -
Advertising - direct 100,000
Rent - factory space 70,000
General admin. expenses 30,000
Total fixed expenses 400,000
Net operating loss $ (100,000)
9-45
Comparative Income Approach
Comparative Income Approach
Solution
Keep Drop
Digital Digital
Watches Watches Difference
Sales $ 500,000 $ - $ (500,000)
Less variable expenses: -
Manufacturing expenses 120,000 - 120,000
Shipping 5,000 - 5,000
Commissions 75,000 - 75,000
Total variable expenses 200,000 - 200,000
Contribution margin 300,000 - (300,000)
Less fixed expenses:
General factory overhead 60,000 60,000 -
Salary of line manager 90,000 - 90,000
Depreciation 30,000 30,000 -
Advertising - direct 100,000 - 100,000
Rent - factory space 70,000 - 70,000
General admin. expenses 30,000 30,000 -
Total fixed expenses 380,000 120,000 260,000
Net operating loss $ (80,000) $ (120,000) $ (40,000)
9-46
Beware of Allocated Fixed Costs

Why should we keep the

digital watch segment
when it’s showing a
$80,000 loss?

9-47
Beware of Allocated Fixed Costs

The answer lies in the

way we allocate
common fixed costs
to our products.

9-48
Beware of Allocated Fixed Costs

Including unavoidable Our allocations can

common fixed costs makes the make a segment
product line appear to be look less profitable
unprofitable. than it really is.

9-49
In Business

• IBM sold the personal computing business to Lenovo in 2004. This

caused fervent internal debate mainly because its PC division was still
profitable at the time.

• IBM got out of the PC manufacturing business because it saw greater

profits in the services market. Since 2002, IBM has spent about $9
billion to acquire over 30 companies including Price Waterhouse
Coopers Consulting.

9-50
Quick Check 1
Consider the following statements:
I. A division's net operating income, after deducting both traceable and
allocated common fixed costs, is negative.
II. The division's avoidable fixed costs exceed its contribution margin.
III. The division's traceable fixed costs plus its allocated common
corporate costs exceed its contribution margin.

Which of the above statements is a valid reason for eliminating the

division?
A) Only I B) Only II
C) Only III D) Only I and II

9-51
Quick Check 2
A study has been conducted to determine if one of the departments in
Barry Corporation should be discontinued. The contribution margin in the
department is $60,000 per year. Fixed expenses charged to the
department are $75,000 per year. It is estimated that $34,000 of these
fixed expenses could be eliminated if the department is discontinued.
These data indicate that if the department is discontinued, the
company's overall net operating income would:
A) decrease by $26,000 per year
B) increase by $26,000 per year
C) decrease by $15,000 per year
D) increase by $15,000 per year

9-52
End of Chapter 11 (Part I)

9-53