Differential Analysis

Differential Analysis

• Differential analysis, or incremental analysis, involves using relevant information to assess different options.
• It can help management in making decisions on one-off special orders, discontinuation of products/services and manufacturing parts.

Relevant Costs

• Relevant costs are future costs that differ among alternatives
• The difference between relevant costs of two options is called a differential cost
• For example, if labor costs differ based on the machine used, it is a relevant cost, but if they are the same, it is not

Opportunity Costs

• Opportunity cost refers to the potential benefit that is lost by choosing one alternative over another
• For instance, if a student chooses to study instead of working a $40,000 job, the true cost of studying is their expenses plus the $40,000 opportunity cost

Irrelevant Costs

• All costs are relevant in decision making except irrelevant costs

Unavoidable Costs

• Unavoidable costs are future costs that do not differ between alternatives
• For example, the direct labor cost needed for both machines is an unavoidable cost as it doesn't differ

Sunk Costs

• Sunk costs are irrelevant as they cannot be changed
• The carrying amount of depreciable equipment is a sunk cost when deciding whether to replace it

Relevant Income

• Relevant income is income that differs between alternatives and is used in decision making
• Differential income is the difference between the relevant incomes of two or more alternatives

Qualitative Factors

• Inclusion or exclusion of a product or changes in quality/service affects demand and customer loyalty
• Employee acceptance is crucial when making changes in work procedures
• Decisions to enhance competitive advantage may result in retaliation by competitors
• Legal requirements can influence opportunities
• Maintaining relationships with suppliers is important for prompt delivery

Capital Investment Decision-Making

• Capital investment decisions are long-term business commitments.
• These decisions involve large sums of money, usually for non-current assets
• Examples include establishing a new store, purchasing machinery, acquire technology, start production of a new product

Characteristics of Capital Investment Decisions

• They involve large sums of money

Payback Period

• This is the time it takes for cash flows to recover the initial investment cost
• Shorter periods are preferred
• An acceptable period is determined to judge an investment
• The project with the smallest acceptable payback period is chosen

Cash Flows

• Cash inflows and outflows determine the success of a project
• Inflows: increased sales/fees, increased receipts from accounts receivable, sale of an old asset
• Outflows: investment cost, overhaul of asset and operational costs
• Note: Depreciation is not a cash outflow

Net Cash Flows

• Net cash flows are expected cash inflows minus the expected cash outflows from investment

Advantages of Payback Period

• Simple to understand
• Appreciated, as cash outlays are recouped
• Provides some appraisal of financial risk attached to a project

Disadvantages of Payback Period

• It does not consider the time value of money from inflows
• Cash received after the payback period is not factored

Time Value of Money

• Money today does not have the same future value due to inflation impacts

Discounted Cash Flows

• Cash flows over time all have different values
• Converting future cash flow to their present value is called discounted cash flow

Cost of Capital

• It represents the cost of an investment

Risk and Return

• Higher risk leads to interest rate (or rate of return) and a higher discount rate
• Financially riskier investments need higher return, equity finance has higher risk than borrowed funds because it lacks security.

Quantitative vs Qualitative Factors

• Quantitative: Payback Period (lower is better), Net Present Value (+ve if YES, -ve if NO) and use net present value if they contradict each other
• Qualitative: Employee morale, effect on business, environmental impact for society as a whole, future business opportunities, business' image and product quality

Main Qualitative Factors

• These are factors that affect investment decisions
• Customer preferences relate how people perceive a business
• Competition is intense and a business must consider its marketing, productivity, technology, etc.
• Government must follow government policy and regulations