This research involves the study of variations in prices of commodities and their effects on the profitability of companies. Differential Analysis is the study of changes in prices and organizational actions, which affect relevant profitability and revenues. This study uses the case study of Herrestad Company. Some of the relevant items that are essential for this study are Differential revenue, Differential cost and Differential profit or loss. Differential revenue is the growth or decline in revenues that a company expects for a particular product as compared to its substitute products. Differential cost on the other hand, is the rise or decline in the production costs which a company projects for a particular product as compared to other substitute products. Differential income is the result of subtracting differential cost from differential revenue if the revenue is greater than the costs. Differential loss is the result of subtracting differential revenue from the differential costs if the cost is greater than the revenue.
Herrestad Company receives an order to produce a new product C. Product B is already in existence but there are variations between the two products B and C. The relevant amounts and expenses that are vital for this decision are:
- The expected cost per unit of the new product C (The cost will reduce by $12 per unit because of a decrease in direct material cost).
- The present cost per unit of alternative B
- The expected income from the new product C
- The present revenue from the alternative B
Assuming the cost per unit of product B is $X, the cost of 1000 units will be $1000X. For product C, the cost per unit will be $(X-12), therefore, 1000 units will cost $1000(X-12).
The next step here is to compare the production costs for product C and its alternative B to determine the product with the lower cost.
Product C costs 1000(X-12) and B costs 1000X.
Product C costs 1000X-12000 while B costs 1000X, so product C is cheaper to produce than product B. This means there is rationale when the company decides to produce the new product C as opposed to using its alternative B. However, this is process is not complete until this company considers the revenues it expects from the two products. If the new customer only pays $150 per Unit, then for both products B and C, the company will receive 1000*150 = $150000.
The profit for B = $(150000-1000X)
The differential profit for C = $(150000-(1000X-12000))
The differential profit for C = $(150000-1000X+12000)
The differential profit for C = $(162000-1000X)
If the company decides to produce product C, its profitability will go up by
$(162000-1000X)-(150000-1000X) = $(162000-150000-1000X+1000X) = $12000.
If instead of $150, the company gives the customer an offer to pay $140 per Unit, the profitability of Herrestad Company is bound to fall. The cost of production for product C remains the same while the income becomes $(1000*140) = $140000.
The profit from C becomes (140000-(1000X-12000)) = 140000+12000-1000X
The profit from C becomes 152000 -1000X
The profit from B remains 150000-1000X.
As a manager, even though this profit falls, it remains higher than that of product B. It is advisable to accept the order considering that there will be no additional expenses to facilitate administration and sales. Other than financial considerations, it will be advisable to consider building a long-term relationship with the customer. This will be possible if the management of Herrestad Company practices ethical activities, which have the potential of satisfying the customer rather than just concentrating on maximizing the profits. This builds the reputation of Herrestad Company. That is why it is better to accept the new offer notwithstanding the fact that it will require an additional operational workforce.