What is the purpose of differential analysis?

Variance analysis, because of its focus on past performance, mostly supports three management accounting functions: attention directing, organizational learning, and performance evaluation. Differential analysis, which is fundamentally oriented towards the future, supports the other three: problem-solving, alternative evaluation, and decision-making. Many tools serve similar functions, so it is important to highlight what distinguishes differential analysis.

Differential analysis is a method to compute quickly the short-term economic impact of a decision to make the best possible use of available resources. It consists in focusing on the short-term costs and benefits differentiating the decision alternatives considered from the perspective of the decision maker.

Differential analysis focuses managers’ attention on what they can do now, with the resources at their disposal, to improve financial performance on the short term. It considerably increases computation speed and thus timeliness without damaging relevance or accuracy through four simplifications, which are also key limitations: it only pays attention to 1) the financial consequences 2) of a limited set of decision alternatives 3) on the short-term and 4) from a single perspective. In other words, it is fundamentally an extremely focused cost-benefit analysis.

Focus on financial performance

Differential analysis focuses on the impact of decision on Operating Income. This is an important piece of information for decision making; but this is neither the only nor necessarily the most important piece of information. The point of differential analysis is therefore not to dictate a decision, but to provide one of the premises informing a decision.

Focus on a limited set of alternatives

As you will see later through the examples we will address, differential analysis typically confronts two well-defined decision alternatives: “keep or drop a segment”, “make or buy a component”, “sell or process an output”, “take or leave a special order”, etc. The whole point of the method is indeed to simplify computations by focusing on what differentiates the alternatives considered. If alternative courses of action are not well defined or if too many alternatives are considered, it becomes increasingly difficult to compare them.

Focus on the short-term

Unlike the cost of flexible resources (e.g. consumption of raw materials, external services, etc.), capacity costs (asset depreciation, capital leases, permanent employees) depend on how much resources is acquired, not how much is used. Moreover, the acquisition of these resources typically takes time and requires long-term commitments which cannot be easily broken. Therefore, on the short-term, capacity and related costs are given: they cannot be altered cost-effectively. They can thus be ignored for the most part.

While capacity is fixed, demand is fluctuating and whether the demand is lower or higher than available capacity determines what is relevant or not. The problem of short-term decision-making is to make the best possible use of available resources at any given point in time, taking into account the level of the demand relative to the capacity.

Besides a fixed capacity, the second condition to apply differential analysis is that the time value of money can be ignored as well. This means that the decision at hand should not significantly alter the distribution of cash flows over several years. If either one of those conditions is not met, the decision must rely on other techniques like capital budgeting.

Some of the decisions we will consider later have long-term financial consequences, especially when it comes to value chain management. Therefore, they fall theoretically within the scope of capital budgeting. However, when cash flows are constant enough across time, the same short-term decision will be made at any point in time. In other words, if the following years are very similar to the current year, the decision made for the current year would be repeated the following years as well. The short-term decision is then strictly equivalent to the long-term decision and it is easier to apply differential analysis than capital budgeting.

Focus on one perspective

A last very important characteristic of differential analysis is that it focuses on the costs and benefits from the perspective of the decision maker. In other words, what is relevant or not to the decision is what the decision maker acknowledges as a cost or benefit. This precision is important as it introduces some subjectivity in the selection of what will be taken into account when making a decision.

For a decision maker, being socially responsible typically means taking into account costs and benefits for other stakeholders. Unfortunately, some decision makers are not socially responsible and they may, intentionally or unintentionally, ignore what economists call positive or negative externalities.

An externality is a cost suffered (negative externality) or a benefit obtained (positive externality) by a third party as a consequence of the actions of the economic agent.

Many debates around the question of Corporate Social and Environmental Responsibility are about how to promote socially and environmentally responsible choices. One approach is to internalize externalities: if economic agents bear all the costs and reap all the benefits of their decisions, they will take them all into account and make the right choices out of pure self-interest. This is however difficult to implement. Another approach is through awareness and the diffusion and enactment of collective values. These are alternative control mechanisms you will study in management control.

Therefore, differential analysis provides an estimation of the short-term financial consequences for the decision-maker of choosing one course of action over another. When a broader perspective is appropriate, i.e. when alternatives are fuzzy and malleable, have non-financial and long-term consequences, and affect a greater number of stakeholders, this approach looses either in simplicity or in relevance and other approaches and methods are deemed preferable.

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