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Differential vs. financial analysis

A frequent activity in managerial accounting is differential analysis. Differential analysis is about relevant costs for decision-making in management accounting. Only those costs and benefits that "differ" between alternatives are relevant in a decision. All other costs and benefits are irrelevant and should be ignored. Differential analysis, for example, can be applied to capital budgeting, since capital expenditures analysis involves selecting among alternatives, such as Intel building a plant in Costa Rica, or Ireland, or not at all to make special computer chips.

Managerial accounting has three main topical areas: cost accounting, management control (Plan/budget/review), and differential analysis. The accountant uses the term differential analysis, while finance person would use financial analysis.

Question:

Can you explain the difference between differential analysis and financial analysis?

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Differential analysis has also been called incremental or marginal analysis. It is used almost exclusively for managerial accounting, and not financial accounting. Differential analysis (DA) is based on specifically identifying relevant costs, and relevant revenues, of each alternative. The company then analyzes to what degree each alternative will impact the company's expected future revenues. It can be seen in part as trying to decide what the opportunity cost is, as in economics. What is the opportunity cost of one alternative, if the other alternative is chosen? It's the same basic concept, here.

Three different factors are generally involved in a thorough DA, including:
- Identifying the relevant cost, based on the revenues and costs that differ among available alternatives. You could think of it as identifying relevant costs based on revenues that differ among the alternatives, as opposed to the revenues and associated costs that don't change. The costs that do not change are irrelevant to DA.

- Identifying sunk costs, which is a cost that has ...

Solution Summary

The solution provides a detailed discussion of the difference between differential analysis and financial analysis.

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