Managerial Accounting 7.1: Using Differential Analysis to Make Decisions - YouTube

This is Kurt Heisinger, accounting professor  at Sierra College and author of Managerial  

Accounting. This video describes how to  use differential analysis to make important  

decisions within companies. It, differential  analysis, and it's often by the way called  

incremental analysis, differential or incremental  revenues and costs represent the difference in  

revenues and costs between two different courses  of action. And I'm going to show you on the next  

slide what this typically looks like. But we're  looking at alternatives and trying to figure  

out which alternative is best for the company. It is often used to make the following types of  

decisions that you see here. For example, we  might want to decide on whether to make a  

product internally or to buy it from the outside.  That is often called outsourcing. Maybe we want  

to have somebody outsource the production of our  products, or perhaps we would prefer to make them  

internally. We want to assess the costs that are  differential to each of those alternatives. Some  

companies also want to take a look at whether to  keep product lines or to drop product lines. So  

for example, we could be a hardware store and we  carry an outdoor furniture product line, and we  

carry a plumbing product line. And we can look at  those product lines to see if it makes sense to  

keep both of them or perhaps to drop one of those  product lines. Thirdly, we might want to decide  

on keeping or dropping customers. It may be that we  have some customers that we're not sure if they're  

profitable or not and we want to assess that. And  there might be some customers that we determined  

to be unprofitable in which case we may choose to  drop that customer. So that is another way to use  

differential analysis. And then lastly, we may get  some special orders from customers and we have to  

decide does it make sense to take those special  orders on or to reject those special orders.

Each of these types of decisions is discussed much  more thoroughly in separate YouTube lectures that  

I've created. So if you want to see the details  of what this analysis looks like, take a look at  

those separate videos. Here we are just looking  at in general what differential analysis is all  

about. So what does the format look like in  performing differential analysis. This is a  

fairly good generic example of the format that  is often used by companies that are performing  

differential analysis. So this example here,  relates to a decision about whether to keep  

or drop unprofitable customers. And we essentially  have two different alternatives. Here is alternative  

one. And alternative one is to keep all our current  customers. And then the second alternative is to  

drop any unprofitable customers that we might  have. And we are not sure if you know it says that  

it's unprofitable here but we are not certain that  dropping what we think are unprofitable customers  

is actually the best approach for us. And again  I talked about this in much more detail in a  

separate video. But this is the general format of  differential analysis. And then the third column  

shows the actual differential amount between  each of these two alternatives. And the last  

column shows us whether alternative 1 in  this example, keeping all customers, whether  

alternative 1 is higher in terms of sales  revenue, over here, higher in terms of variable  

costs, and contribution margin, and fixed cost. And  actually what we'll see here is alternative 1

is lower in profit. So this is the format that  we typically use and you'll notice that we're  

looking at a contribution margin income statement  format here. And I have a separate video on what  

that is all about. So you can take a look at  that video if you're not sure about it what we 

mean by contribution margin income statement.  In any case, we're looking at each of these  

alternatives, alternative 1 and alternative  2, and the profit associated with each.

And you will notice that alternative 1 has profit  of $1,300,000 and alternative 2 has profit  

of $1,320,000. And therefore alternative 2 is the  best. It has, alternative 1 has lower profit  

by $20,000. So we prefer alternative 2. Again, take  a look at the videos that show this type of an  

analysis in detail. This is just to give you a  sense of what differential analysis looks like.