Methods in Corporate Finance: Differential Analysis
Author: Clayton Nesslein
What is Differential Analysis?
Differential Analysis gives us a practical way to incorporate relevant revenues and costs to simplify decision making, even when working in a complex and fluid environment. It provides a framework for identifying which types information are useful, and which should be ignored.
Why is it useful?
Managers should have a clear vision of how to analyze prospective projects and investment opportunities, with the end goal of maximizing long term profits. Differential Analysis can provide a framework that can apply to many common business scenarios, such as to accept or reject a special order, to outsource, and how to best use limited capacity.
What factors are considered as relevant costs, and what are irrelevant?
The basis for making appropriate business decisions relies on properly identifying relevant and irrelevant costs and benefits. Relevant costs and benefits are any future items that differ between two alternatives, whereas irrelevant items are ignored because they do not differ between competing alternatives. It is important to emphasize that any sunk costs must be ignored despite the emotional weight that a manager might place on them. Sunk Costs are irrelevant because they have already been incurred, and do not differ between two competing alternatives.
An Illustrative Case in Differential Analysis
To perform the differential analysis, the following items are considered for two alternatives, and clearly organized to show how they differ.
Click here for the TechCo. spreadsheet.
TechCo. sells B2B subscription software. The company’s leading platform is priced as $25,000 for an annual contract, and is utilized across many industries. It calculates the variable cost as $3,750 per client, and the average total cost per client is $5,500. An industry vertical co-op has offered to sign up 1,000 clients all at one time on TechCo.’s platform. In exchange for signing up all clients simultaneously, they are asking for a price per client of $20,000, along with exclusivity within the industry. This would bar some of the co-op’s competitors from utilizing the software. TechCo. must consider the lost revenue to other potential clients, in exchange for exclusivity.
What course of action is recommended? What is the opportunity cost of the lost orders? Is the opportunity cost greater than the benefit derived from the discounted co-op deal?
A financial analysis of the problem determines that the company will derive a net gain of $312,500 from accepting the special order, despite each special order unit having a significantly lower contribution margin. The net gain can also be referred to as opportunity cost. The opportunity cost of the estimated 750 lost clients does not exceed the contribution derived from the special order; therefore, management would be inclined to accept the order based on quantitative factors.
When considering a 5-year modified scenario, the outcome of the quantitative analysis is quite different. Variable cost per unit is omitted. In its place, average cost is used, which considers all costs of the business as variable in the long term. The modified scenario leads to lost margin of $625,000 over 5 years, and therefore the deal should be rejected.
I have provided an alternative scenario which shows the sales price per special client must be at least $20,125 for 5 years to provide a viable alternative to servicing the co-op agreement without a net decrease in profits. A premium beyond that amount should be negotiated to account for qualitative factors and long term uncertainty.
The purely quantitative analysis needs be considered in tandem with many qualitative factors. Differential analyses cannot assess the psychological impact and subsequent behavior that business decisions have on customers and other stakeholders. Additionally, the legal and regulatory environment may pose hazards that are outside the scope of differential analysis.
I hope this overview and example of differential decision analysis has been helpful.
For a template to analyze the cost and benefits of special orders, click here.
Glossary of Terms Commonly Used in Differential Analysis
Opportunity Cost
Opportunity costs do not show up on financial statements, but are the foundational concept underlying economic decision models. It is the cost of forgoing the best option if compared to the benefit of the chosen option.
Opportunity Cost=Return on best foregone option−Return of chosen option
Future Revenues
Revenues are inflows from the sale of goods or services, and should be considered if they differ between competing alternatives.
Outlay Costs
Outlay costs are any future expenditures required to deliver goods or services. They are relevant to the analysis if they differ between competing alternatives. Examples of outlay costs can include, but are not limited to conversion costs, new machine costs, and direct materials.
Sunk Costs
Sunk costs are past investments and expenses that cannot be changed. They are irrelevant to differential analysis because they do not differ between competing alternatives. Despite the omission of sunk costs in a differential analysis, sunk costs may show as an accounting loss. This may pose an ethical dilemma for business decision makers.
Disposal and Salvage Values
The cost of disposing or the cash inflow from salvage should be considered if it differs between two competing alternatives.
References:
Easton, Halsey, McAnally, Hartgraves, Morse. Financial & Managerial Accounting for MBA’s. Fifth Edition. Cambridge Business Publishers. 2018.
