SYNTHESIS 1 3rd Trinal, 1st Semester AY 2022-2023

Mae Alma C. Pedrosa, CPA, MBA Accountancy Department, Notre Dame University

DIFFERENTIAL COST ANALYSIS (Relevant Costing; Short-Term, Non-Routine Decisions)

Differential Analysis involves the process of analyzing the difference that will result from alternative
decisions, from potential solutions to a particular problem. It is a management accounting technique of
examining and analyzing only the changes in revenues, costs, and profits resulting from choosing one
alternative over the other course/s of decisions. A change could either be an increase (incremental) or a
decrease (decremental).

When a revenue or a cost differs from one alternative to the other, or from one assumption to another
assumption, it is considered relevant in the decision-making. For a revenue or cost to be relevant, it
must be both differential and future-oriented. Therefore, past revenue and costs (the sunk costs) are
considered irrelevant. Other than the differential costs, other relevant costs for a decision include:

Avoidable costs are costs can be avoided or eliminated in whole or in part, when one alternative is chosen
over the other alternative.

Opportunity costs are actually benefits foregone by choosing one alternative rather than the other
alternative. Though they are not reported in the financial statements, they are considered relevant in
decision-making.

When in making a decision involves quantitative information, like accounting data, there should be a
system or procedure used to measure and evaluate those data. As previously mentioned, differential
analysis analyzes only the ‘changes’, as distinguish to the Total Approach – which analyzes the total
amounts whether there’s a change or none. Consider the illustration that follow:

ILLUSTRATION 4: Total Approach and Differential Approach

Aling Nena sells kagikit – a topping for a pastil, made with strands and strips of chicken meat cooked
with herbs. Aside from providing the kagikit needs of some pastil vendors in her area, she also sells
them in bottles. Her store records showed the following average sales and costs in a month:
Sales from bottled kagikit ₱50,000
Cost of sales 22,500
Rent expense 8,000
Salaries expense 10,000
Utilities expense 5,000
Marketing expense 1,500
Other expenses 1,000

Recently, Aling Nena is considering to sell her bottled kagikit online. Online selling will increase her
sales by 40%, as well as her cost of sales. No change is expected on the store rent, but additional worker
will be hired on a part-time work only for a ₱2,500 pay per month. Internet cost will add ₱500 per month
to utilities; marketing expense will double because of the delivery of orders; but will reduce other
expenses by ₱200 per month.

Required: Help Aling Nena to decide whether to push through the online selling, or not.

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Solutions:
▪ Using the Total Approach
Current With Online
Store Selling Selling
Sales ₱ 50,000 ₱ 70,000
Cost of sales ( 22,500 ) ( 31,500 )
Rent ( 8,000 ) ( 8,000 )
Salaries ( 10,000 ) ( 12,500 )
Utilities ( 5,000 ) ( 5,500 )
Marketing ( 1,500 ) ( 3,000 )
Other expenses ( 1,000 ) ( 800 )
net change in profit
Profit ₱ 2,000 ₱ 8,700 = ₱6,700 increase
▪ Using the Differential Approach
Increase in sales (₱50,000 x 40%) ₱ 20,000
Increase in cost of sales (₱22,500 x 40%) ( 9,000 )
Increase in salaries ( 2,500 )
Increase in utilities ( 500 )
Increase in marketing expense ( 1,500 )
Decrease in other expenses 200
Net increase in profit per month ₱ 6,700

Therefore, it is better for Aling Nena to also sell her bottled kagikit online because it will increase her profit by
₱6,700 per month.

In the illustration above, the rent is irrelevant because it will not change whether Aling Nena will continue
the online selling or not. The ₱200 of her Other Expenses is an example of avoidable cost because it will
be eliminated if she chooses to sell online. While the ₱20,000 possible increase in sales will be
considered an opportunity cost if she’ll choose not to sell online.

In actual, qualitative factors surrounding a decision should also be considered. Like in the case of Aling
Nena, what and how will the online selling affect her transactions with her main customers – the pastil
vendors. How about the capacity of her supplier to provide her more chicken meat to support her increase
in sales?
From the preceding illustration, the total approach is a long and detailed procedure. While the differential
analysis uses only the increase or decrease in relevant costs. Relevant costs are future costs that differ
from one alternative to the other. So, if a cost will not change (like the rent of Aling Nena), it is no longer
included in the analysis.

Differential analysis is used when there are more than one alternative courses of actions for a problem.
There is no decision to make when there is only one solution to a problem. Decision-making could
involve short-term, non-routine, or long-term (strategic) decisions. The basic rule is to take the action
that will give the business the highest income or the lowest loss. This section focuses only on the short-
term, non-routine cases. Examples are:

o Accept or Reject a Special Order

Typically, special orders are for goods or services at a reduced price. They are usually one-time (non-
routine) orders which do not affect regular sales in the short-run. Before accepting a special order,
management must consider its capacity to fulfill the special order, the price offered by the customer over
the associated costs. While before rejecting a special order, opportunity cost from the foregone income
must also be taken into consideration.

ILLUSTRATION 5: Accept or Reject a Special Order

Wigan Company produces and sells 12,000 units of its product per month. The regular selling price is
₱200 per unit. Its production, selling and administrative costs follow:
Direct materials, ₱40 per unit
Direct labor, ₱48 per unit
Variable overhead, ₱30 per unit
Fixed overhead, ₱60,000 per month
Variable selling and administrative expenses, ₱25 per unit
Fixed selling and administrative expenses, ₱45,000 per month

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The current operations represent only 80% of its normal capacity. Wigan Company received an order
for 3,000 units at a discounted price of ₱150. No additional selling and administrative expenses will be
incurred.

Questions:
a) Should Wigan Company accept or reject the special order?
b) Assuming instead that Wigan Company is already working at its full capacity. Should the special
order be accepted?

Answers:
a) Accept the special order, because there is still an available capacity enough to accommodate the special order.
And accepting the special order will generate additional profit of ₱96,000.
Increase in sales (3,000 units x ₱150) ₱450,000
Increase in variable production cost
(3,000 units x ₱118) (354,000)
Incremental profit ₱ 96,000 OR, [ (₱150 - ₱118) x 3,000 units

b) No, primarily because the company is already at full capacity, and accepting the special order would mean
losing some of its regular sales. Secondly, and for the special order to be acceptable, its selling price should
be at least enough to cover as well the lost sales, thus, should not be less than the regular price of ₱200 per
unit.

o Sell Now or Process Further

The concept here is similar to a decision to sell at split-off point or after further processing a joint product
(discussed in Chapter 4). The choice of selling now or after further processing is based on analyzing
whether the incremental revenue will be greater than the incremental cost of further processing.

ILLUSTRATION 6: Sell Now or Process Further

In the production of its Product M5, Bibao Company uses raw materials purchased from different
suppliers at ₱25 per unit. In the conversion of the raw material, each unit of Product M5 requires 1.5
hours to make for a labor cost of ₱60 per hour, and overhead cost of ₱8 per unit. Product M5 is sold in
the market at ₱150 per unit.

Bibao Company’s product may be sold as Product M5, or after further processing as another product
called Sede. It was already proven that Sede is highly salable at a price of ₱210 per unit after incurring
additional processing cost of ₱65 per unit. The company is now contemplating to focus on selling Sede
only.

Question: Should Bibao Company stop selling Product M5, instead focus on selling Sede?

Answer:
No, because Bibao Company will incur a loss of ₱5 per unit on Sede.
Incremental revenue per unit (₱210 - ₱150) ₱ 60
Incremental cost 65
Net disadvantage of selling Sede (₱ 5) per unit

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o Make or Buy Decision
This involves a decision of making the product (or part of a product) in-house or purchasing it from an
outside supplier. The comparison is between the cost of producing it, and the cost of outsourcing it from
others.

ILLUSTRATION 7: Make or Buy

Alagaca Co. has estimated the costs of producing 5,000 units of a component of its product as follows:
Direct material ₱ 57,500
Direct labor 60,000
Variable factory overhead 62,500
Fixed factory overhead 70,000
Total ₱250,000

Other manufacturing companies are also producing and selling the same component at a market price of
₱48 per unit. If Alagaca Co. will purchase the component from an external supplier, it will save 30% of
its fixed factory overhead.

Question: Should the component be purchased from an external supplier or should be produced
internally?

Answer:
Alagaca Co. should purchase the component from an external supplier for a net advantage of ₱6.20 per unit over
producing it internally.
Cost to produce (₱250,000/5,000 units) ₱50.00
Cost to purchase ₱48.00
Less: Savings from fixed overhead ( 4.20 ) 43.80
Net advantage of purchasing the component ₱ 6.20 per unit

o Continue or Discontinue a Business Segment or Product

This problem arises when a business has multiple business segments or branches, or multiple products,
and these segments or products are incurring losses or showing unsatisfactory performance. Assuming
there are no other factors, when a segment will continue to operate or a product is continually
manufactured and sold, the same unsatisfactory result will be expected. But it will be discontinued,
naturally, incurrence of some costs will be avoided (avoidable costs), and revenues from that business
segment or product will also be eliminated.

In deciding whether to continue or discontinue a business segment or product, its own profitability should
be evaluated. Basically, if the income from continuing a segment operation or from selling a product, is
greater than its costs, then, it should be continued. Yet, if the net cost of continuing it is greater than the
cost of its discontinuance, then, it is better to discontinue the operation of such segment or the selling of
such product.

ILLUSTRATION 8: Continue or Discontinue a Business Segment or Product

One of the businesses owned and managed by Hyu We Group of Companies is a food chain store with
three branches in the Mindanao region. A summary of the average monthly operating results of these
three branches for the 2022 operations are shown below:
Koronadal Davao Cagayan Total
Sales ₱ 500,000 ₱ 465,500 ₱ 630,000 ₱1,595,500
Costs and expenses:
Variable ₱ 200,000 ₱ 150,000 ₱ 260,000 ₱ 610,000
Direct fixed costs 175,000 62,500 91,000 328,500
Allocated administrative costs 160,000 160,000 160,000 480,000
Total costs and expenses ₱ 535,000 ₱ 372,500 ₱ 511,000 ₱1,418,500
Operating profit (loss) ₱(35,000) ₱ 93,000 ₱ 119,000 ₱ 177,000

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Based on the monitoring of the management of Hyu We Group of Companies, they observed that the
Koronadal branch has been operating at a loss for the past few months already. Because of this, the
management is now contemplating to close the Koronadal branch to rule out the effect of its loss to the
overall profitability of the company.

Question: Should Hyu We Group of Companies close the Koronadal branch of its food chain store?
Why or why not?

Answer:
Based on the computation discontinuing the Koronadal branch will only increase the loss of the whole company
because the allocated administrative costs will still be incurred by the company. Looking at its own
performance, Koronadal branch actually is earning its own segment income which contributes to the absorption
of the company’s allocated cost. Thus, if Koronadal branch will be closed, this contribution will also be
eliminated, and so the overall loss to the company will increase evenmore.

Sales ₱500,000 Continue Discontinue

Variable costs (200,000) OR, Sales ₱500,000 -
Direct fixed costs (175,000) Variable costs (200,000) -
Segment contribution which ₱125,000 Direct fixed costs (175,000) -
will be eliminated if closed Allocated AC (160,000) (160,000)
(opportunity cost) Profit (loss) ₱(35,000) ₱(160,000)

increase in company’s loss, ₱125,000

o Temporary Shutdown
This decision scenario is somehow similar to continue or discontinue a business segment decision, except
that, this involves not only a segment of the business but the whole business to temporarily shutdown
due to internal or external factors which could adversely affect the business. In the analysis, whether to
continue the operations, or to temporarily shutdown, losses will still be incurred. But if income from
continuing the operations will be greater than the shutdown point, then, it would be better-off continuing.

Shutdown point is when the loss from continuing the operations is equal to the loss from shutting down
the operations. The concept of its computation is also similar to the breakeven point, as follows:

Shutdown point = Fixed cost under continued operations – Shutdown costs

in units Contribution margin per unit

Shutdown point = Fixed cost under continued operations – Shutdown costs

in pesos Contribution margin ratio

Shutdown costs = unavoidable fixed costs + additional shutdown costs

= are costs which will still be incurred even if operations are temporarily
stopped

Decision guide:
if: then:
Expected sales > Shutdown point continue the operations
Expected sales < Shutdown point shutdown the operations

ILLUSTRATION 9: Temporary Shutdown

Travel and lockdown restrictions due to a pandemic has slowed down some business operations. The
tourism industry is one of the sectors that have been greatly affected. The management of Sicabai
Garden Resort is considering to shutdown operations for two months with the hopes that normal
operations will resume after that. The accounting records of the business showed the following data
of a normal operation for a month:

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 Revenues (₱150 per guest) ₱45,000
Total variable costs 18,000
Monthly fixed costs 15,000

If the business will temporarily shut down for two months, regular garden maintenance will still be
done, but some workers will be forced to take a leave without pay. This will reduce fixed costs by
₱5,400 per month.

However, if Sicabai Garden Resort will continue its operations, only 40% of the regular number of
guests is expected during these two months.

Required: Make a recommendation to the management of Sicabai Garden Resort as to what option
will be better for the business, to continue operations or to temporarily shut down for two months by
determining the following:
a) result of operations if the business will continue
b) loss if it will be temporarily shutdown for two months
c) shutdown point, in number of guests and in pesos

Solutions:
a) Revenues (120* guests x ₱150) ₱18,000
Total variable costs (120 guests x ₱60) 7,200
Contribution margin ₱10,800
Monthly fixed costs (15,000)
Loss under continued operations ₱ 4,200 per month

b) Contribution margin ₱ -
Fixed costs 9,600
Loss if operations will be shutdown ₱ 9,600 per month
c) Shutdown point in number of guests = ₱15,000 - ₱9,600 = 60 guests
₱90 per guest

Shutdown point in pesos = ₱15,000 - ₱9,600 = ₱9,000

₱90/₱150

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₱45,000 / ₱150 = 300 guests x 40% = 120 expected guests

At the shutdown point of 60 guests, the loss to be incurred is the same with the loss if operations
will be shutdown. If the number of guests is assured at 60 per month, the decision to continue or to
shutdown temporarily will incur the same amount of loss. If this will be the case, the 60 guests is called
the indifference point – the point where the alternative courses of action will yield the same result. To
check:
if shutdown at shutdown point
Contribution margin ₱ - ₱ 5,400 60 guests x ₱90
Fixed costs (9,600) (15,000)
Loss ( ₱9,600) (₱ 9,600)

o Product Combination / Optimization of Scarce Resources

When a business is engaged in the production and sale of more than one product (multi-products), the
need to determine the best combination of the quantities of those products arises when there are resource
constraints (like raw materials, direct labor hours, machine times, working spaces, etc.), and market
limitations (like product demand, market prices, market share, etc.). The best combination of the
products is the one which will yield the highest possible contribution margin per limited resource, or with
the largest cost savings considering a given constraint or resource limitation.

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ILLUSTRATION 10: Product Combination / Optimization of Scarce Resources
Sappia Company manufactures and sells three products called Merah, Shiroh, and Luse. Some
production information about these products are provided below:
Merah Shiroh Luse
Contribution margin per unit ₱ 180 ₱ 75 ₱ 120
Required machine hours per unit 10 hours 2.5 hours 5 hours
Market limit 5,000 units 20,000 units 10,000 units
Total available machine time, 140,000 hours

Required: Determine the best combination of the three products under each of the assumptions that
follow:
a) if there is no market limitations
b) with the given market limits
c) if only Product Shiroh has a market limit

Answers:
Merah Shiroh Luse
Contribution margin per unit ₱ 180 ₱ 75 ₱ 120
Required machine hours per unit  10 hours  2.5 hours  5 hours
Contribution margin per machine ₱ 18 ₱ 30 ₱ 24
hour

a) If there is no market limitations, the company should use all available machine hours to produce product Shiroh
because it has the highest profitability per machine hour – the limited resource.

b) The given market limits are the maximum units that the customers will buy, thus, the company should not
produce more than those limits. In terms of profitability, product Shiroh has the highest contribution margin
per machine hour, followed by product Luse, and product Merah as the least profitable. Therefore, the available
machine hours should be allocated on that order of profitability, and maximizing also the market limit, as
follows:

Total available machine hours 140,000 hours

Production requirements:
Shiroh (20,000 units x 2.5 hours) ( 50,000 )
Luse (10,000 units x 5 hours) ( 50,000 )
Available machine hours for Merah 40,000 hours
Required machine hour per unit of Merah  10 hours
Maximum production of Merah 4,000 units

Therefore, the best product combination is to produce 20,000 units of Shiroh, 10,000 units of Luse, and 4,000
units of Merah.

c) If only product Shiroh has a market limit, then, the best product combination is to produce only 20,000 units
of Shiroh (with 50,000 machine hours), and 18,000 units of Luse (for the remaining 90,000 machine hours).

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ASSIGNMENT
(for 11/23 submission 11:59PM; by pair of your choice – not your previous pair)

Give what are asked. Show your computations. Label and properly identify (encircle or box) your final answer. Each essay
should be supported by a computation, if applicable.

1) Sawili Company’s production facility has the capacity to produce 20,000 units at the following
budgeted costs and expenses:
Variable production cost ₱108 per unit
Variable operating expenses 42 per unit
Annual fixed production overhead 210,000
Annual fixed operating expenses 340,000

The product is sold at ₱195 per unit. Last year, Sawili Company produced and sold 17,000 units of the
product.

Linamin Merchandisers has offered to buy 3,000 units of the product for ₱165 per unit next year. The
management of Sawili Company has set that all costs next year will be at the same levels and rates as
last year.

Required: For each of the independent assumption that follow, advise Sawili Company’s management
if the special order be accepted or rejected.
Assumption 1 – The company has no alternative use of the idle capacity
Assumption 2 – The idle facility can be used to manufacture a new product which could earn a
₱70,000 contribution margin.
Assumption 3 – The company has an opportunity to rent out the idle facility for ₱50,000.
Assumption 4 – If the special order is accepted, 600 units of regular sales are expected to be lost.
Assumption 5 – The special order is for 5,000 units, and Sawili Company has to sacrifice some of
its regular sales to accommodate the special order.

2) The management of Balangaw Corporation is studying the options of making its own Part CP-3, or
outsourcing it from an outside producer. A total of 15,000 units are needed by the company next year.
Option 1: If Part CP-3 is made in-house, total production cost is estimated at ₱38 per unit.

Option 2: An outside supplier has offered Balangaw Corporation to sell 15,000 units of Part CP-3 for
₱35 per unit. If the offer is accepted, ₱2 of the fixed overhead per unit will be eliminated.
The released production facility of Balangaw Corporation can be used to make a new product
called Yanze, which is expected to generate an annual contribution margin of ₱80,000. A
₱50,000 marketing cost will be incurred to sell the new product.

Questions: Which option is better, to make or buy part CP-3? How much is the advantage of that option?

3) You gathered the following financial results of the three products of Makapangwa Co. for the
previous year’s operations:
Product AA Product BB Product CC
Units sold 6,000 units 3,750 units 5,250 units
Sales ₱ 312,000 ₱ 103,500 ₱ 131,250
Variable costs ( 150,000) ( 67,500 ) ( 52,500)
Contribution margin ₱ 162,000 ₱ 36,000 ₱ 78,750
Fixed costs:
Avoidable ( 50,000 ) ( 30,000 ) ( 28,000 )
Unavoidable ( 40,000 ) ( 25,000 ) ( 35,000 )
Profit (loss) ₱ 72,000 ₱( 19,000) ₱ 15,750

The unavoidable fixed cost is a company-wide fixed cost allocated based on the units sold.

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Required: Answer the following independent questions
a) How will the profit of Makapangwa Co. change if Product BB is dropped?
b) If Product BB is dropped and the unit sales of Product CC will increase by 20%, how much will
be the company’s profit?
c) Suppose Product BB can be upgraded at an additional cost of ₱25 per unit, it will then be sold
for ₱65 per unit, how much will the company’s profit be?
d) If Product BB will be dropped, the facility used to produce it will be utilized to make 2,500 units
of a new product called EF. Product EF will be sold for ₱50, requires a variable cost of ₱35 per
unit, and will reduce avoidable fixed cost by ₱5,000. How much will be Makapangwa co.’s profit
if Product BB is replaced by EF?
e) In a decision to continue or drop Product BB, how should the unavoidable fixed cost be treated?
f) If scenarios in a, b, c, and d are available alternatives for Makapangwa Co., which alternative
will you recommend? Why so?

4) Bai Maniuantiuan operates a stall in a university’s food court. She sells packed meals with a drink
to the university’s students, faculty, staff and visitors. Variable cost of each meal pack amounts to ₱25,
and sells at ₱45. Monthly fixed costs incurred during normal operations include:
Salaries of stall workers ₱ 8,000
Space rent 5,000
Allocated costs:
Utilities 1,850
Safety and security 3,500
Janitorial services 2,000
Transportation expense 850

Due to the outbreak of a pandemic which started last month, classes were shifted to online instructions.
The government-mandated safety protocols which limit the travel movements of people, mass gathering,
required social distancing, etc. are expected to last for another three months. These have caused a
dramatic decrease in Bai Maniuantiuan’s sales from the monthly regular sales of 2,000 to 600 meal packs.
Her customers now include only few of the university’s faculty, staff and visitors.

Bai Maniuantiuan is considering to shutdown her stall’s operations for three months to avoid incurrence
of losses, but will restart the business once social protocols are lifted and face-to-face classes resume. If
she shuts down her business for three months,
o a ₱2,000 of the rent will still be paid each month to keep her stall’s place;
o her total allocated costs will be reduced to 20%;
o two out of her three stall workers will be forced to take a leave without pay, thus, ₱2,800 of the
salaries will still be paid;
o transportation expense will be reduced by ₱350; and
o she will have to incur ₱5,000 in restarting her operations after three months.

Required:
a) Calculate the shutdown costs.
b) Compute for the shutdown point, in meal packs and in pesos.
c) Should the stall be shut down for three months? Why or why not?

5) Dimangan Industries, Inc. is in the process of preparing its production budget for its two products –
Product AB and product BC, for next year’s operations. These two products require the same labor skills,
however, the company’s available direct labor hours in a month is at 8,000 hours only. Some information
about these two products follow:
Product AB Product BC
Unit selling price ₱ 80 ₱ 100
Unit variable cost 38 45
Monthly fixed cost ₱ 31,000 ₱ 45,000
Sales or market limit per month 3,000 units 2,000 units
Direct labor hours required per unit 1.5 hrs. 2.5 hrs.

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Required:
a) Determine the best product combination with the limited available direct labor hours.
b) Assume instead that Dimangan Industries, Inc. has to produce only one product,
b1. which product – AB or BC, will you recommend?
b2. at what level of production will the profit of the two products equal? (indifference point)

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