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Chapter Chapter 2424Differential Analysis and Differential Analysis and
Product PricingProduct PricingAccounting, 21st Edition
Warren Reeve Fess
PowerPoint Presentation by Douglas CloudProfessor Emeritus of AccountingPepperdine University
© Copyright 2004 South-Western, a division of Thomson Learning. All rights reserved.
Task Force Image Gallery clip art included in this electronic presentation is used with the permission of NVTech Inc.
Some of the action has been automated, so click the mouse when you see this lightning bolt in the lower right-hand
corner of the screen. You can point and click anywhere on the screen.
Some of the action has been automated, so click the mouse when you see this lightning bolt in the lower right-hand
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1. Prepare a differential analysis report for decisions involving leasing or selling equipment, discontinuing an unprofitable segment, manufacturing or purchasing a needed part, replacing usable fixed assets, processing further or selling an intermediate product, or accepting additional business at a special price.
ObjectivesObjectivesObjectivesObjectives
After studying this After studying this chapter, you should chapter, you should
be able to:be able to:
After studying this After studying this chapter, you should chapter, you should
be able to:be able to:
2. Determine the selling price of a product, using the total cost, product cost, and variable cost concepts.
ObjectivesObjectivesObjectivesObjectives
3. Calculate the relative profitability of products in bottleneck production environments.
Differential AnalysisDifferential AnalysisDifferential AnalysisDifferential Analysis
Leasing or selling equipment. Discontinuing an unprofitable segment. Manufacturing or purchasing a needed part. Replacing usable fixed assets. Processing further or selling an intermediate
product. Accepting additional business at a special price.
Differential analysis is used for analyzing:
Differential AnalysisDifferential AnalysisDifferential AnalysisDifferential Analysis
DecisionsDecisionsDifferential Differential
AnalysisAnalysis
Alternative AAlternative A
oror
Alternative BAlternative B
Differential revenueDifferential revenue
–– Differential costs Differential costs
Differential income or lossDifferential income or loss
Lease or Sell Equipment
Marcus Company
Marcus Company is considering disposing of equipment that cost
$200,000 and that has $120,000 of accumulated depreciation.
Lease or Sell Equipment
Marcus Company
Sell equipment Sell equipment toto
Sell equipment Sell equipment toto
Broker
The equipment can be sold through a broker for $100,000, less a 6%
commission.
Lease or Sell Equipment
Marcus Company
Lease Lease equipment toequipment to
Lease Lease equipment toequipment to
Potamkin Company
ORPotamkin Company, the lessee, has offered to lease the equipment
for five years for a total consideration of
$160,000.
Lease or Sell Equipment
Marcus Company
At the end of the fifth year, the equipment is expected to have no residual value. During the period of the lease, Marcus Company
expects to incur repair, insurance, and property taxes estimated at $35,000.
Proposal to Lease or Sell EquipmentJune 22, 2006
Differential revenue from alternatives:Revenue from lease $160,000Revenue from sales 100,000 Differential revenue from lease $60,000
Lease the equipment!
Differential cost of alternatives:Repairs, insurance, taxes $ 35,000Commission expense on sale 6,000 Differential cost of lease 29,000
Net differential income from the leasealternative $31,000
OR
Proposal to Lease or Sell EquipmentJune 22, 2006
Lease alternative:Revenue from lease $160,000Depreciation expense for remaining 5 years $80,000Repairs, insurance, and property tax expense 35,000 115,000
Net gain $45,000
This is the traditional analysis. The differential income is the same.
This is the traditional analysis. The differential income is the same.
Sell alternative:Sales price $100,000Book value of equipment $80,000Commission expense 6,000 86,000
Net gain 14,000
Net differential income from the lease alternative $31,000
Discontinue a Segment or Product
Sales $100,000 $900,000 $1,000,000Cost of goods sold:
Variable costs $ 60,000 $420,000 $ 480,000Fixed costs 20,000 200,000 220,000 Total cost of goods sold $ 80,000 $620,000 $ 700,000
Gross profit $ 20,000 $280,000 $ 300,000Operating expenses:
Variable expenses $ 25,000 $155,000 $ 180,000Fixed expenses 6,000 45,000 51,000 Total operating expenses $ 31,000 $200,000 $ 231,000
Income (loss) from operations $ (11,000) $ 80,000 $ 69,000
Battle Creek Cereal Co.Condensed Income Statement
For the Year Ended August 31, 2006
Should Bran Flakes be discontinued?Should Bran Flakes be discontinued?
Differential itemsDifferential items
Variable cost $ 60,000Variable cost $ 60,000
Sales $100,000Sales $100,000
Variable expenses $ 25,000Variable expenses $ 25,000
Bran Flakes
Other Cereals Total
Battle Creek Cereal Co.Condensed Income Statement
For the Year Ended August 31, 2006
Differential itemsDifferential items
Sales $100,000 $900,000 $1,000,000Cost of goods sold:
Variable costs $ 60,000 $420,000 $ 480,000Fixed costs 20,000 200,000 220,000 Total cost of goods sold $ 80,000 $620,000 $ 700,000
Gross profit $ 20,000 $280,000 $ 300,000Operating expenses:
Variable expenses $ 25,000 $155,000 $ 180,000Fixed expenses 6,000 45,000 51,000 Total operating expenses $ 31,000 $200,000 $ 231,000
Income (loss) from operations $ (11,000) $ 80,000 $ 69,000
Variable cost $ 60,000Variable cost $ 60,000
Sales $100,000Sales $100,000
Variable expenses $ 25,000Variable expenses $ 25,000
Bran Flakes
Other Cereals Total
If Bran Flakes is discontinued, net income will decrease by $15,000.
If Bran Flakes is discontinued, net income will decrease by $15,000.
Proposal to Discontinue Bran FlakesSeptember 29, 2006
Differential revenue from annual sales of Bran Flakes:
Revenue from sales $100,000Differential cost of annual sales of Brian Flakes:
Variable cost goods sold $60,000Variable operating expenses 25,000 85,000
Annual differential income from sales ofBran Flakes $15,000
Don’t discontinue!
or
Currently, a firm manufactures the dashboards that it uses in making automobiles. The cost of
manufacturing this part is summarized below. An outside supplier has offered to provide the part for
$240. Should the car manufacturer accept the offer?
Direct materialsDirect materials $ 80$ 80Direct laborDirect labor 8080Variable factory overheadVariable factory overhead 5252Fixed factory overheadFixed factory overhead 68 68Total cost per unitTotal cost per unit $280$280
INITIAL REACTION—DON’T MAKE INTERNALLY
Proposal to Manufacture Automobile PartFebruary 15, 2006
Purchase price of part $240.00Differential cost to manufacture:
Direct materials $80.00Direct labor 80.00Variable factory overhead 52.00 212.00
Cost savings from manufacturing part $ 28.00
The fixed factory overhead is excluded because it is not relevant—so continue
making the part.
The fixed factory overhead is excluded because it is not relevant—so continue
making the part.
Replace Equipment
Assume that a business is considering the disposal of several identical machines having a total book value of $100,000 and an estimated remaining life of five years. The old machines can be sold for $25,000.
They can be replaced by a single high-speed machine at a cost $250,000. The new machine has a n
estimated useful life of five years and no residual value. Analyses indicate an estimated annual
reduction in variable manufacturing costs from $225,000 with the old machine to $150,000 with the
new machine. No other changes in the manufacturing costs or the operating expenses are expected. Should
the new machine be purchased?
Annual variable costs—present equipment $225,000Annual variable costs—new equipment 150,000Annual differential decrease in cost $ 75,000Number of years applicable x 5Total differential decrease in cost $375,000Proceeds from sale of present equipment 5,000 $400,000Cost of new equipment 250,000Net differential decrease in cost, 5-years $150,000
Annual net differential—new equipment $ 30,000
Proposal to Replace EquipmentNovember 28, 2006
Buy the new equipment!Buy the new equipment!Buy the new equipment!Buy the new equipment!
Process or SellProcess or SellProcess or SellProcess or Sell
A refinery produces kerosene in batches of 4,000 gallons at a
processing cost of $0.60 per gallon. Kerosene can be sold without further processing for
$0.80 per gallon or further processed to yield gasoline, which can be sold for $1.25 per gallon. The additional processing cost $650 per
batch, and 20% of the gallons of kerosene will evaporate
during production.
Differential revenue from further processingper batch:
Revenue from sale of gasoline [(4,000 gallons –800 gallons evaporation) x $1.25] $4,000
Revenue from sale of kerosene (4,000 gallons x $0.80) 3,200 Differential revenue $800
Differential cost per batch:Additional cost of producing gasoline 650
Differential income from further processinggasoline per batch $150
Proposal to Process Kerosene FurtherOctober 1, 2006
Process further!Process further!
Accept Business at a Special Price
The monthly capacity of a sporting goods business is
12,500 basketballs. Current sales and production are
averaging 10,000 basketballs per month. The current
manufacturing cost is $20 (variable, $12.50; fixed,
$7.50). The domestic selling price is $30.
The manufacturer receives an offer from an exporter for
5,000 basketballs at $18 each. Production can be spread
over three months, so these basketballs can be
manufactured using normal capacity. Domestic sales would not be affected.
Should the offer be accepted or Should the offer be accepted or rejected?rejected?
Should the offer be accepted or Should the offer be accepted or rejected?rejected?
Differential revenue from accepting offer:Revenue from sale of 5,000 additional units at $18 $90,000
Differential cost of accepting offer:Variable cost of 5,000 additional units at $12.50 62,500
Differential income from accepting offer $27,500
Proposal to Sell Basketballs to ExporterMarch 10, 2006
Accept the offer!Accept the offer!
Setting Normal Product Selling Prices
Setting Normal Product Setting Normal Product Selling PricesSelling Prices
Setting Normal Product Setting Normal Product Selling PricesSelling Prices
1. Demand-based methods2. Competition-based methods
Cost-Plus MethodsCost-Plus Methods
Market MethodsMarket Methods
1. Total cost concept
2. Product cost concept
3. Variable cost concept
Market MethodsMarket MethodsMarket MethodsMarket Methods
Demand-based methods set the price according to the demand for the product.
Demand-based methods set the price according to the demand for the product.
Market MethodsMarket MethodsMarket MethodsMarket Methods
Competition-based methods set the price according to the price
offered by the competitors.
Competition-based methods set the price according to the price
offered by the competitors.
Using the Total cost concept, all cost of
manufacturing a product...
Using the Total cost concept, all cost of
manufacturing a product...
Manufacturing Manufacturing CostCost
Total Cost ConceptTotal Cost Concept
…plus the selling and administrative
expenses...
…plus the selling and administrative
expenses...
Manufacturing Manufacturing CostCost
Selling ExpensesSelling Expenses
Administrative Administrative ExpensesExpenses
Total Cost ConceptTotal Cost Concept
…are included in the cost to which the markup is added.
…are included in the cost to which the markup is added.
Manufacturing Manufacturing CostCost
Selling ExpensesSelling Expenses
Administrative Administrative ExpensesExpenses
Total cost
Desired ProfitDesired Profit
Total Cost ConceptTotal Cost Concept
The company’s desired profit is
$160,000.
The company’s desired profit is
$160,000.
Manufacturing Manufacturing CostCost
Selling ExpensesSelling Expenses
Administrative Administrative ExpensesExpenses
Desired ProfitDesired Profit
Desired selling price
Total Cost ConceptTotal Cost Concept
Per Unit TotalCost Cost
Cost Structure Example (100,000 units)
Variable Costs (per unit):Direct materials $ 3.00 $ 300,000Direct labor 10.00 1,000,000Factory overhead 1.50 150,000Selling and administrative 1.50 150,000 Total variable costs $16.00 $1,600,000
Fixed Costs:Factory overhead .50 50,000Selling and administrative .20 20,000 Total fixed costs . 70 70,000
Total costs $16.70 $1,670,000
Total Cost ConceptTotal Cost Concept
Only the desired profit is covered in the markup.
Only the desired profit is covered in the markup.
Markup Percentage:Desired profit $160,000 Total costs $1,670,000
= 9.6%=
Total cost per calculator $16.70Markup ($16.70 x 9.6%) 1.60Selling price $18.30
Total Cost ConceptTotal Cost Concept
Proof that a sale of 100,000 computers at $18.30 each will generate a desired profit of $160,000.
Proof that a sale of 100,000 computers at $18.30 each will generate a desired profit of $160,000.
Sales (100,000 units x $18.30) $1,830,000Expenses:Variable (100,000 units x $16.00) $1,600,000
Fixed ($50,000 + $20,000) 70,000 1,670,000Income from operations $ 160,000
Digital Solutions Inc.Income Statement
For the Year Ended December 31, 2006
Total Cost ConceptTotal Cost Concept
Product Cost ConceptProduct Cost ConceptProduct Cost ConceptProduct Cost Concept
Using the product cost concept only the manufacturing costs are included in the amount to which
the markup is applied.
Using the product cost concept only the manufacturing costs are included in the amount to which
the markup is applied.
Per Unit TotalCost Cost
Cost Structure Example (100,000 units)
Variable Costs:Direct materials $ 3.00 $ 300,000Direct labor 10.00 1,000,000Factory overhead 1.50 150,000Selling and administrative 1.50 150,000 Total variable costs $16.00 $1,600,000
Fixed Costs:Factory overhead .50 50,000Selling and administrative .20 20,000 Total fixed costs .70 70,000
Total costs $16.70 $1,670,000
Product Cost = $15 per unitProduct Cost = $15 per unit
Product Cost ConceptProduct Cost ConceptProduct Cost ConceptProduct Cost Concept
Manufacturing Manufacturing CostCost
Product Cost
Markup
Product Cost ConceptProduct Cost ConceptProduct Cost ConceptProduct Cost Concept
Administrative Administrative ExpenseExpense
++
Selling ExpenseSelling Expense
++
Desired ProfitDesired Profit
Desired Selling
Price
Product Cost ConceptProduct Cost ConceptProduct Cost ConceptProduct Cost Concept
Markup percentage
Desired profit +
Total manufacturing costs=
Total selling and administrative expenses
Markup percentage
= 22%
Markup percentage
=$160,000 + $170,000
$1,500,000
Product Cost ConceptProduct Cost ConceptProduct Cost ConceptProduct Cost Concept
DM ($3 x 100,000) $ 300,000DL ($10 x 100,000) 1,000,000Factory overhead:
Variable ($1.50 x 100,000) 150,000Fixed 50,000
Total manufacturing costs $1,500,000
DM ($3 x 100,000) $ 300,000DL ($10 x 100,000) 1,000,000Factory overhead:
Variable ($1.50 x 100,000) 150,000Fixed 50,000
Total manufacturing costs $1,500,000
Manufacturing cost per calculator Manufacturing cost per calculator $15.00 $15.00Markup ($15 x 22%) Markup ($15 x 22%) 3.30 3.30Selling priceSelling price $18.30 $18.30
Manufacturing cost per calculator Manufacturing cost per calculator $15.00 $15.00Markup ($15 x 22%) Markup ($15 x 22%) 3.30 3.30Selling priceSelling price $18.30 $18.30
Product Cost ConceptProduct Cost ConceptProduct Cost ConceptProduct Cost Concept
Variable Cost ConceptVariable Cost ConceptVariable Cost ConceptVariable Cost Concept
The variable cost concept uses total of the variable manufacturing costs and the variable selling and administrative
expenses as the amount to apply a markup.
The variable cost concept uses total of the variable manufacturing costs and the variable selling and administrative
expenses as the amount to apply a markup.
Product Cost
Markup
Variable Cost ConceptVariable Cost ConceptVariable Cost ConceptVariable Cost Concept
Variable Manufacturing
Cost
+Variable
Administrative and Selling Expenses
Total Fixed Total Fixed Costs + Costs + Desired Desired ProfitProfit
Desired Selling
Price
Variable Cost ConceptVariable Cost ConceptVariable Cost ConceptVariable Cost Concept
Markup percentage
Desired profit +
Total variable costs=
Total fixed costs
Markup percentage =
$160,000 + $50,000 + $20,000
$1,600,000
Markup percentage
= 14.4%
Direct materials ($3 x 100,000) $ 300,000Direct labor ($10 x 100,000) 1,000,000Variable factory overhead
($1.50 x 100,000) 150,000Variable selling and administrative
expenses ($1.50 x 100,000) 150,000Total variable costs $1,600,000
Direct materials ($3 x 100,000) $ 300,000Direct labor ($10 x 100,000) 1,000,000Variable factory overhead
($1.50 x 100,000) 150,000Variable selling and administrative
expenses ($1.50 x 100,000) 150,000Total variable costs $1,600,000
Variable Cost ConceptVariable Cost ConceptVariable Cost ConceptVariable Cost Concept
Variable cost per calculatorVariable cost per calculator $16.00$16.00Markup ($16 x 14.4%) Markup ($16 x 14.4%) 2.30 2.30Selling priceSelling price $18.30$18.30
Variable cost per calculatorVariable cost per calculator $16.00$16.00Markup ($16 x 14.4%) Markup ($16 x 14.4%) 2.30 2.30Selling priceSelling price $18.30$18.30
Variable Cost ConceptVariable Cost ConceptVariable Cost ConceptVariable Cost Concept
Target CostingTarget CostingTarget CostingTarget Costing
Using target costing the cost is determined by subtracting a desired profit from the selling price.
Using target costing the cost is determined by subtracting a desired profit from the selling price.
Present Future
Actual Cost
Target Cost
ProfitProfit
Present Market Price
Required cost
reduction
Expected Market PriceDrift
Drift
BottlenecksBottlenecks
Sales price $130 $140 $160
Variable cost 40 40 40
Contribution margin $ 90 $100 $120
Bottleneck hours 1 4 8
Small Medium LargeWrench Wrench Wrench
Product Profitability Under Production BottlenecksProduct Profitability Under Production BottlenecksProduct Profitability Under Production BottlenecksProduct Profitability Under Production Bottlenecks
The number of heat treatment The number of heat treatment hours per unit for each product.hours per unit for each product.The number of heat treatment The number of heat treatment
hours per unit for each product.hours per unit for each product.
Sales price $130 $140 $160
Variable cost 40 40 40
Contribution margin $ 90 $100 $120
Bottleneck hours ÷ 1 ÷ 4 ÷ 8
Bottleneck contribution $ 90 $ 25 $ 15
Small Medium LargeWrench Wrench Wrench
Largest contribution margin per
bottleneck hour
Largest contribution margin per
bottleneck hour
Product Profitability Under Production BottlenecksProduct Profitability Under Production BottlenecksProduct Profitability Under Production BottlenecksProduct Profitability Under Production Bottlenecks
How much should the firm charge for the large wrench in order to deliver the same contribution as
the small wrench?
Product Profitability Under Production BottlenecksProduct Profitability Under Production BottlenecksProduct Profitability Under Production BottlenecksProduct Profitability Under Production Bottlenecks
Contribution margin per
bottleneck hour per small wrench
=
Revised price of large wrench
Variable cost per large wrench–
Bottleneck hours per large wrench
$90 =
Revised price of large wrench –
8
$40
$720 = Revised price of large wrench – $40 $760 = Revised price of large wrench
Product Profitability Under Production BottlenecksProduct Profitability Under Production BottlenecksProduct Profitability Under Production BottlenecksProduct Profitability Under Production Bottlenecks
Revised price of large wrench per formulaon the previous slide $760
Less: Variable cost per unit of large wrench 40
Contribution margin per unit of large wrench $720
Bottleneck hours per unit of large wrench ÷ 8
Revised contribution margin per bottleneck hour $ 90
Product Profitability Under Production BottlenecksProduct Profitability Under Production BottlenecksProduct Profitability Under Production BottlenecksProduct Profitability Under Production Bottlenecks
The EndThe End
Chapter 24Chapter 24