Differential analysis

Scenario 1 :Variable Costs (40 ,000 x 250 10 ,000 ,000

Fixed Costs 1 ,500 ,000 Most Optimal Alternative

Increase fixed costs and reduce variable costs

Profit Statement '000

Sales Revenue (40 ,000 x 430 ) 17 ,200

Variable Costs (40 ,000 x 250- 80 ) 6 ,800

Contribution 10 ,400

Fixed Costs 1 ,500 250 ) 1 ,750

Net Profit 8 ,650 Diminish fixed costs and increase variable costs

Profit Statement '000

Sales Revenue (40 ,000 x 430 ) 17 ,200

Variable Costs (40 ,000 x 250 120 ) 14 ,800 p

Contribution 2 ,400

Fixed Costs 1 ,500- 400 ) 1 ,100

Net Profit 1 ,300 Reduce selling price

Profit Statement '000

Sales Revenue ([40 ,000 5 ,000] x 430- 50 ) 17 ,100

Variable Costs ([40 ,000 5 ,000] x 250 ) 11 ,250

Contribution 5 ,850

Fixed Costs 1 ,500

Net Profit 4 ,350 The profit statements prepared above reveal that the first option , being increasing fixed costs and diminishing variable costs show attainment of the highest profit during the period analyzed

Riskiest alternative

The option that presents the highest risk is the first one , because additional fixed expenditure frequently entails higher capital costs Such expenses are long-term in nature and are sometimes difficult to dispose . Thus if an error is made the consequences are much more significant than the other two options . For example , in to diminish the variable cost more elaborate machinery will be purchased and installed in the factory . These machines if attained through a finance lease will comprise periodic lease payments that can be considered as fixed costs . It will be more productive and efficient but if management no longer needs such machines , the lease commitments will still be applicable irrelevant of its use . Thus before deciding on the best option management should also consider qualitative characteristics like the one mentioned above and do not rely solely on quantitative features

Scenario 2

Sunk Costs

In the decision-making process , the manager is concerned with future events affected by this decision . Therefore he will focus on future costs and revues that will be influenced by the decision taken . This implies that post costs that cannot be altered by the decision are irrelevant sunk costs that should not be taken into consideration (Lucey T . 2003 ,

325

Consideration of Subjective Values

Costs and revenues are considered as relevant in project evaluations and other related business decisions when such variables are influenced by the decision taken . When these factors are common for all the decision choices , then they are considered as irrelevant and not taken into reflection (Lucey T . 2003 ,

325 . However it is important that elements necessitating subjective valuation like employee morale are valued appropriately by utilizing proper valuation techniques . We have to keep in mind the consequences that can arise from incorrect information for business decisions

When differential analysis is an effective method

Differential analysis can be adopted both for short-term and long-term decisions . This technique is particularly useful to evaluate different capital projects , especially mutually exclusive ones (Lucey T . 2003...