10 Differential Decision Making
Learning Objectives LO
LO1 Define differential decision making
LO2 Identify relevant and irrelevant costs of differential decision making
LO3 Prepare the analysis for an add or drop a segment decision
LO4 Prepare the analysis for a make or buy decision
LO5 Prepare the analysis for a special order decision
LO6 Prepare the analysis for a sell or process further decision
Differential decision making LO1
Informed decision making is required to effectively run an organization. Managers must decide what products or services to sell, what prices to charge, what assets to purchase, and how to maximize profits. In most cases, managers are choosing between at least two competing alternatives. Therefore, effective managerial decision making aims to compare the costs and benefits of the alternatives and select the alternative that yields the most benefit to the organization.
When a manager is comparing the costs and benefits of competing alternatives, they only need to consider relevant financial data. Generally, managerial decisions are based on relevant costs or benefits. Relevant costs or benefits are defined as costs or benefits that differ between one or more alternatives. Differential decision making is the process of analyzing relevant costs and benefits to make managerial decisions.
This chapter focuses on using relevant costs to make specific managerial decisions. Identifying relevant costs and benefits for differential decision making is covered in the next section. Differential decision making tools for four common managerial decisions are covered in the remaining sections. Specifically, tools used to inform the following decisions are illustrated: adding or dropping a segment; making or buying (outsourcing); accepting or rejecting a special order; and selling or further processing a joint product.
Check your understanding LO1
Relevant and irrelevant costs of differential decision making LO2
Relevant costs or benefits are defined as costs or benefits that differ between alternatives. If a cost or benefit does not differ between alternatives, it is not considered relevant to the decision. If a cost or benefit differs between alternatives, it is considered relevant to the decision.
The theory underlying the use of relevant data is that costs or benefits that do not differ would not change regardless of which decision is made, so they are irrelevant. Since the costs are the same regardless, it is unnecessary to consider them when deciding between two or more alternatives. Irrelevant costs or benefits are considered unavoidable, whereas relevant costs or benefits are considered avoidable.
To illustrate the concept of relevant costs, assume that Kendra is deciding if she wants to make dinner at home or go out to dinner. Kendra does not need to compile all of her personal financial information, e.g., income, rent, and other expense data, to make this decision. Her income and monthly rent payment are the same regardless of