Please respond to the following 3 discussions.
1. I had chosen 3M company and will discuss the financial data to be included and excluded in differential analysis, in which sunk and opportunity costs will also be considered. I will propose the specific revenues and costs that should be considered in an evaluation to drop or keep a customer and a product line.
Differential analysis refers to a tool that helps companies make decisions on whether to keep or drop customers/product lines. It calculates the costs and revenues for alternatives based on assumptions, such as assuming if the product line were to be kept and if it were dropped. (Heisinger & Hoyle, n.d.) For 3M, data required include sales revenue, variable costs, contribution margin, fixed costs and profit for each alternative. These are forecast data that vary when customers/product lines are dropped or kept. Data that stay constant, such as rental and salaries of security officers, will be excluded since the decision has no impact on such data. (Berman, n.d.)
If 3M were to do differential analysis for whether to keep their “Clinpro 5000 Anti-Cavity Toothpaste” (3M, 2021a), data required to calculate outcomes of each alternative include cost of raw materials such as packaging and ingredients, direct labour costs, cost of utilities, advertising costs, revenue earned from sales of the toothpaste. Excluded data would be one-time costs such as laboratory testing, which should be part of their research and development process. This belongs to sunk costs, which were incurred in the past and cannot be recovered. Overall corresponding data which assumes the product line is kept will also be required.
If 3M were to do differential analysis for whether to keep their medical industry clients, they need to gather data of all products sold to these clients. For example, the abovementioned data such as sales revenue, cost of raw materials, cost of utilities etc need to be gathered for their products such as sanitizers, stethoscopes, wound dressings etc. (3M, 2021b) Also, they would have to add in overhead costs of rental and salaries of security officers etc since whole factories may be closed if many product lines are dropped.
Opportunity costs refer to hidden costs incurred when an opportunity is forgone. (Tayari, 2020) In this case it refers to the additional profit forgone when an alternative is not chosen. Since these costs are apparent when profit is calculated, they do not have to be specially included. It is also more suitable when making a choice between 2 product lines, instead of when considering dropping or keeping a product line.
In conclusion, data required in differential analysis may vary according to the scope of products being evaluated. Financial analysts must be conscientious in determining which data to include to give companies the best advice on whether to keep certain product lines or customers.
2. Introduction
A “differential analysis” examines the disparities in current costs and revenues and relevant/incremental costs and revenues as a result of multiple alternatives (Heisinger & Hoyle, 2012). Differential analysis can be done in a variety of ways, but it’s critical for managers to understand them and use them to aid their decision-making. In this paper, I’ll go over how to use differential analysis to make business decisions. I’ll analyze a hypothetical scenario for Migros Hypermarket bakery. I ‘ll also talk about sunk and opportunity costs, and why managers should consider them.
What does differential analysis contain and exclude?
The following costs and revenues should be considered before deciding whether or not to keep a product line or customer:
1-Revenue increase as a result of an alternative/order: Extra sales as a result of accepting the order
2-Variable Costs: Since variable costs differ with the amount of production, they are always essential.
3-Avoidable Fixed Costs: Where there are any fixed costs that do not differ with the level of production but could be eliminated entirely if a particular product line or customer is eliminated, or could be avoided by not accepting a special order, it is essential to our decision-making.
4-Semi-Fixed Costs: They are also important since orders from new customers may cause production to increase above a certain amount, resulting in increased costs.
Is it necessary to consider sunk and opportunity costs?
1-Sunk Cost: The term “sunk cost” refers to a cost that has already been incurred and cannot be reversed. It is not relevant for decision-making and therefore cannot be used in the differential analysis since it is a past cost that is unaffected by the acceptance of a new order or product line (FERNANDO, 2020).
2-Opportunity Cost: The cost of choosing between alternatives is referred to as the opportunity cost. It is very important to our decision-making and is used in the differential analysis since it reflects the profit/money that might have been gained with the resources available if they had been invested in a different tactic. That is to say, by selecting this alternative, we are foregoing that profit, and hence it is important to us (FERNANDO, 2020).
Let’s pretend Migros Hypermarket is thinking of taking in a new client who wants to buy 200 units at $500 each. However, it will cost about 5,000 $ to expand the bakery’s space. As a result, we can draw the following conclusions:
1-If we do not accept the order, this expansion cost becomes an avoidable fixed cost. Thus, this expense would not be incurred. It’s applicable to our differential analysis.
2-The additional revenue generated by the above order is calculated as follows: 200 unit’s x $500 each = 10,000 $.
3-Additional profit generated from special order = $10,000 X 60% (Contribution margin ratio) = 6,000 $.
4-Actual profit from new order = Incremental Profit Minus Avoidable Fixed Costs = 6,000$ – 5,000$ = 1,000$
5-As a result, Migros hypermarket should accept this order because it generates a profit of $1,000 for the bakery.
6-Finally, since the company’s fixed expenses of $13,000 are sunk costs, they were not used in the differential analysis.
Conclusion
As previously stated, differential analysis is a tool that aids in making the best decision by comparing costs, efficiency, and benefits to discover the best solution. Management should be familiar with each approach and apply it appropriately to the condition at hand (Delgado, 2016).
3. In this discussion assignment, from the company selected in unit 2 of Unilever Indonesia, I will determine the type of financial data that would be include and excluded in the differential analysis, propose which specific revenue and costs should be considered in evaluation to drop or keep whether a customer or the product line. Later on, I will explain the sunk and opportunity costs related to the selected company, whether or not the cost be considered in the different analyses, and the reason to support this statement.
Differential cost analysis is the course of action to analyze the difference in costs between two alternative decisions and the level output changes, and the decision must be made to select the best option and drop the others (Heisinger & Hoyle, n.d.). Differential costs can be fixed or variable costs or a combination of the two.
Example of alternative decision: The wine factory will decide to utilize a fully automated packaging machine to produce 500,000 bottles of wine per year at $450,000, or continue using the direct labor for manual packaging and produce the same numbers with a cost of $600,000 per year, then $150,000 is the differential cost between the two alternatives.
Example of change in output. A wine factory above can produce 500,000 bottles of wine per year for $450,000 or 600,000 bottles of wine with $575,000. The differential cost of the additional 100,000 bottles is $125,000.
Based on the annual report year of 2020 from Unilever Indonesia are using the mixed type of differential cost where were includes the fixed and variable cost. The case study of the financial data below is included in the differential analysis to determine whether the management wants to keep or drop the customer to increase their profits. Since customer A has a very high variable cost and resulting negative impact on profit, hence the management has to drop customer A to sustain the company profits.
Furthermore, the impact of the product line from the beauty products harms the company profits hence the management decided to drop the beauty products line to boost the profit of the company.
To conclude, a sunk cost is a cost incurred in the past that cannot be changed by future decisions (Heisinger & Hoyle, n.d.). The cost had invested in manufacturing the beauty product has been sunk and can not be changed.
Opportunity costs—the benefits foregone when one alternative is selected over another—are differential costs, and must be included when performing the differential analysis (Heisinger & Hoyle, n.d.). Hence, the opportunity cost from eliminating customer A resulting in a profit loss of 1,161,346.
