Summary what is differential analysis

What is differential analysis ?
Differential analysis shows how different future courses of actions would result in different
economic outcomes. Variance analysis takes the budget as the benchmark and compares actual
performance to this benchmark. By contrast, differential analysis takes an initial future course of
action as a benchmark and compares it to a hypothetical scenario called alternative course of action.

Differential analysis builds on the technique of variance analysis and adds a layer of complexity.
Differential analysis will not only design and compare several possible alternative courses of action,
but also try to account for the uncertainty about both the implementation and outcome of any
particular course of action

What are the purposes and principles of differential analysis ?
Variance analysis, because it analyses past performance, mostly support three management
accounting functions: it directs attention, helps with organizational learning, and supports
performance evaluation and reward. Differential analysis, which is fundamentally oriented towards
the future, complements variance analysis by supporting the other three functions of management
accounting: formulating problems, designing solutions, evaluating and selecting these solution.
Capital budgeting serves similar functions, so it’s important to highlight what distinguishes them.

 Differential analysis is a method to compute quickly the short-term net economic impact of
alternative courses of actions so that decision-makers can make the best possible use of
available resources

This approach considerably increases computation speed and thus timeliness without damaging
relevance or accuracy through four simplifications

- The definition of outcomes of interest from the perspective of the sole decision-maker
- A focus on short-term decisions
- A well-defined problem
- The computation of an expected net economic impact before considering other, more
complex, criteria

A crucial and yet often implicit simplification of differential analysis is that it limits the scope of the
costs, benefits, and qualitative factors considered to those which are relevant to the decision maker.
This simplification can create negative (positive) externalities explaining why a course of action which
is beneficial and rational (harmful and irrational) for a decision-maker can be bad (good) for the
society or the planet

 Externalities are costs suffered (negative externality) or benefit obtained (positive
externality) by third parties as a consequence of the decisions and actions of an economic
agent

The focus of differential analysis on decisions having only short-term consequences does not only
imply a mostly constant capacity, but also the irrelevance of the time-value of money. Since
differential analysis both assumes a constant capacity and ignores the time value of money, it is
inadequate to make decisions affecting capacity or having long-term financial consequences. In these
situations, capital budgeting should be used instead.

, Differential analysis does not only simplify decision by assuming most capacity costs and time-value
of money constant and therefore irrelevant. There are typically two other ways to make additional
simplifications and accordingly two approaches to problem formulation:

- Optimization based on linear programming
- Choice between a limited set of alternative courses of action

Linear programming indicates optimal values for all the variables included in the model, but it does
not indicate how to achieve these optimal values. The problem is not formulated as a system of
equations solved mathematically, but as a set of alternative courses of action among which the
decision-maker must choose. This approach consists in asking ‘what happens if we do this instead of
that?’ and comparing alternatives based on their impact of various outcomes of interest. This
approach has several advantages over linear optimization

- It clearly identifies concrete actions which can be implemented
- It does not require agreeing ex ante on a hierarchy of goals and constraints
- It limits the list of variables taken into account to what differs across the alternatives
considered
- It is fast, flexible, and allows for continuous incremental improvement through multiple
iterations

Once alternative courses of action have been designed in enough details, their respective net
economic impact is relatively easy to compute and helps eliminating quickly many candidates on a
relatively objective basis. The remaining alternatives can then be compared based on more
qualitative factors

 The net economic impact of a decision is the sum of all the actual or potential differences in
future cash flows resulting from the chosen course of action

Non-financial, qualitative consequences of a differences typically fall in three families:

- Impact on business strategy
- Impact on operating risks
- Impact on Corporate Social and Environmental Responsibility

What are the steps of the short-term decision making process ?
Formulate a problem  classify costs and benefits based on relevance  identify the most
profitable course of action  review non-financial and qualitative impacts  make a
decision
Formulating problems is difficult because of a multitude of competing goals to achieve and
constraints to satisfy in a highly political context. Short-term decision making is about
making the best possible use of available resources and is fundamentally shaped by two
factors: demand and available capacity. They affect 9 generic kinds of decisions:
- Launch an advertising campaign or not
- Increase or decrease temporarily selling prices
- Improve productivity
- Maintain or replace an old equipment
- Take or leave special orders
- Allocate productivity capacity