Short-Term Decision-Making

Managers often use differential analysis as a short-term decision-making tool to evaluate options like make-or-buy decisions or special order acceptance.

Alex, Pixel Corporation's CFO, faces such a make-or-buy decision. The company manufactures a component in-house, which costs ten dollars per unit, including two dollars of fixed overhead.

Since the fixed overhead is unavoidable and does not change between alternatives, it’s not relevant to this decision.

Alex uses differential analysis to focus on the variable cost of eight dollars per unit, which becomes the maximum acceptable purchase price.

If a supplier offers the part at nine dollars, Alex recommends continuing in-house production, since outsourcing would increase costs.

Later, Alex considers a special order for one thousand units at nine dollars each. If there’s spare capacity and no impact on regular sales, accepting the order makes sense as the price exceeds the variable cost and generates a positive contribution margin.

Differential analysis enables managers to focus on the costs and revenues that change between alternatives, leading to more informed and effective short-term decisions.