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Fundamentals of Cost Analysisfor Decision Making
Chapter 4
Acc 355 4 - 1
Learning Objectives
L.O. 1 Use differential analysis to analyze decisions.
L.O. 2 Understand how to apply differential analysisto pricing decisions.
L.O. 3 Understand several approaches for establishingprices based on costs for Full cost pricing decisions.
L.O. 4 Understand how to apply differential analysis toproduction decisions.
L.O. 5 Understand the theory of constraints.
4 - 2
Differential Analysis
L.O. 1 Use differential analysis to analyze decisions.
Differential analysis:The process of estimating revenues and costs
of alternative actions available to decision makersand of comparing these estimates to the status quo
Short run:The period of time over which capacity will be
unchanged, usually one year
4 - 3
Differential Costs
With two or more alternatives, costs that differamong or between alternatives
Costs that change in response to an alternativecourse of action
Differential costs differ between actions.
Alternative A Alternative B
LO1
4 - 4
Sunk Costs
Costs incurred in the past that cannot bechanged by present or future decisions
A sunk cost is NOT relevant for making decisions.
LO1
4 - 5
Differential Costsversus Total Costs
Sales revenueVariable costsContribution marginFixed costsOperating profit
$750 (250)$500 (350)$150
$900 (300)$600 (350)$250
$150 (50)$100 -0- $100
Status Quo DifferenceAlternative
• Information presented to management canshow the detailed costs that are included formaking a decision, or it can show just thedifferences between alternatives, as follows.
LO1
4 - 6
Differential Analysisand Pricing Decisions
L.O. 2 Understand how to apply differentialanalysis to pricing decisions.
Variable costs mustalways be covered.
Fixed costs must becovered in the long run.
Activity Level
Co
st
Activity Level
Co
st
4 - 7
Special Order versus Full costPricing Decisions
Special Orderpricing decision:
No additional fixed cost
Pricing a one-timespecial order.
Full costpricing decision:
Additional Fixed Costs
Pricing a new product.
Year
0 1
LO2
4 - 8
Special Orders
• An order that will not affect other salesand is usually a one-time occurrence
Value ofoption 1
Value ofoption 2
Acceptspecialorder?
Isoption 1
> option 2?
Option 1
Option 2
Status quo: Reject special order
Alternative: Accept special order
LO2
4 - 9
Special Orders
• U-Develop has received a one-time offer for 500 printsat a special price of 40¢ per print ($200).
• The regular price is 50¢ and they haveenough idle capacity in the week to take the offer.
Sales for the week (5,000 prints at 50¢) $2,500Variable costs, including paper, maintenance,
and usage payment to machine owner(5,000 copies at 20¢) 1,000
Total contribution margin $1,500Fixed costs (supplies, plus allocated costs
of the print shop) 1,200Operating profit for the week $ 300
LO2
4 - 10
Special Orders
Comparison of TotalsSales revenueVariable costsTotal contributionFixed costsOperating profit
Alternative Presentation: Differential AnalysisDifferential sales, 500 at 40¢Less: Differential costs, 500 at 20¢Differential operating profit (before taxes)
$2,500 (1,000)$1,500 (1,200)$ 300
$2,700 (1,100)$1,600 (1,200)$ 400
$ 200 100$ 100
$200 (100)$100 -0- $100
StatusQuo:
RejectSpecial
Offer
Alternative:AcceptSpecial
Offer Difference
Analysis of Special Order: U-Develop
LO2
4 - 11
Full Cost Pricing Decisions
L.O. 3 Understand several approaches for establishingprices based on costs for Full cost pricing decisions.
• Full cost is the total cost to produce and sell a unit.
• Full costs are relevant for the long-term pricing decisions.
4 - 12
Cost Analysis for Pricing
• In the long run an organization mustcover all variable and fixed costs –both manufacturing and selling.
LO3
4 - 13
Life-Cycle ProductCosting and Pricing
• Product life-cycle is concerned with coveringcosts in all categories of the life cycle.
R & D Design Manufacturing
Marketing anddistribution
Customerservice
Take back(disposal)
LO3
4 - 14
Target Costing fromTarget Pricing
• Target price:The price based on customers’ perceivedvalue for the product and the price thatcompetitors charge
• What would a customer pay?
• How much profit do I need?
• Can I make it at this cost?
Target price – Desired profit = Target cost
LO3
4 - 15
Use of Differential Analysisfor Production Decision
L.O. 4 Understand how to apply differentialanalysis to production decisions.
Make or buyDecision to make goods or services
internally or purchase them externally
Add or dropa segment
Decision to add or drop a productline or close a business unit
Productchoice
Decision on what products or services to offer (product mix)
4 - 16
Make-or-Buy Decisions
• U-Develop’s current costs of developing prints:
Costs directly traceable:Direct materialsDirect laborVariable manufacturing overheadFixed manufacturing overheadCommon costs allocated to this product lineTotal costs
$0.05 0.12 .03
$ 5,000 12,000 3,000 4,000 10,000$34,000
Per unit100,000prints
• This year’s expected volume is 100,000 prints,so the full cost of processing a print is$34,000 ÷ 100,000 = $0.34
LO4
4 - 17
Make-or-Buy Decisions
• U-Develop received an offer from an outsidedeveloper to process any number of printsfor 25¢ each.
• Should U-Develop accept this offer?
• The accounting department prepared costanalyses at volume levels of 50,000 and100,000 prints per year.
LO4
4 - 18
Make-or-Buy Decisions
Direct costs:Direct materialsLaborVariable overheadFixed overheadCommon costsTotal costs
$ 5,000 12,000 3,000 4,000 10,000b
$34,000
$25,000a
-0- -0- -0-
10,000b
$35,000
Processprints
100,000prints
$20,000 higher 12,000 lower 3,000 lower 4,000 lower -0- $ 1,000 higher
Outsourceprocessing Difference
a 100,000 units purchased at $0.25 = $25,000b These common costs remain unchanged for these volumes.
Because they do not change, they could be omitted from the analysis.
• Differential costs increase by $1,000, so rejectalternative to buy.
LO4
4 - 19
Make-or-Buy Decisions
Direct costs:Direct materialsLaborVariable overheadFixed overheadCommon costsTotal costs
$ 2,500 6,000 1,500 4,000 10,000b
$24,000
$12,500a
-0- -0- -0-
10,000b
$22,500
Processprints
50,000prints
$10,000 higher 6,000 lower 1,500 lower 4,000 lower -0- $ 1,500 lower
Outsourceprocessing Difference
a 50,000 units purchased at $0.25 = $12,500b These common costs remain unchanged for these volumes.
Because they do not change, they could be omitted from the analysis.
• Differential costs decrease by $1,500, so acceptalternative to buy.
LO4
4 - 20
Opportunity Costs of Making
• Assume that the facilities used to process printscould be used to offer a new service that wouldprovide a $2,000 incremental contribution.
• Should U-Develop accept or reject the alternative?
• U-Develop’s expected volume is 100,000 prints.
LO4
4 - 21
Opportunity Costs of Making
Total cost of 100,000 printsOpportunity cost of using
facilities to process printsTotal costs, including
opportunity costs
$34,000
2,000$36,000
$35,000
-0- $35,000
Status quo:Process
prints
$1,000 highera
2,000 lowera
$1,000 lowera
Alternative:Outsourceprocessing Difference
a These indicate whether the alternative is higher or lower than the status quo.
• Differential costs decrease by $1,000, so accept the alternative.
LO4
4 - 22
Add or Drop Decisions
Sales revenueCost of sales (all variable)Contribution marginLess fixed costs:
RentSalariesMarketing and administrative
Operating profit (loss)
$80,000 53,000$27,000
4,000 5,000 3,000$15,000
$10,000 8,000$ 2,000
1,000 1,000 500$ (500)
$50,000 30,000$20,000
2,000 2,500 1,500$14,000
Total
$20,000 15,000$ 5,000
1,000 1,500 1,000$ 1,500
Prints Cameras Frames
U-DevelopFourth Quarter Product Line Income Statement
LO4
4 - 23
Add or Drop Decisions
Sales revenueCost of sales (all variable)Contribution marginLess fixed costs:
RentSalariesMarketing and administrative
Operating profit (loss)
$80,000 53,000$27,000
4,000 5,000 3,000$15,000
$70,000 45,000$25,000
4,000 4,000 2,750$14,250
$10,000 decrease 8,000 decrease$ 2,000 decrease
-0- 1,000 decrease 250 decrease$ 750 decrease
Status quo:Keep prints
Alternative:Drop prints Difference
U-DevelopDifferential Analysis
• Profits decrease $750, so keep prints.
LO4
4 - 24
Product Choice Decisions
• Constraints:Activities, resources, or policies that limit theattainment of an objective.
• Contribution margin per unit of scarce resource:Contribution margin per unit of a particular inputwith limited availability.
LO4
4 - 25
Product Choice DecisionsU-Develop
Revenue and Cost Information
$50
8 8 4$30
PriceLess: Variable costs per unit
MaterialLaborOverhead
Contribution margin per unitFixed costs
ManufacturingMarketing and administrative
$80
22 24 4$30
Metalframes
Total$3,000 1,500$4,500
Woodframes
LO4
4 - 26
Product Choice DecisionsU-Develop
Revenue and Cost Information
$ 30÷ 0.5$ 60
Per unit:Contribution marginMachine hours requiredContribution margin per machine hour
$ 30÷ 1.0$ 30
Metalframes
Woodframes
• Metal Frames have a higher contribution marginper machine hour.
LO4
4 - 27
Product Choice Decisions
• Suppose U-Develop has 200 machine hoursper month available.
400 × $30
$12,000 3,000 1,500$ 7,500
CapacityContribution margin per unitTotal contribution marginLess: Fixed manufacturing costsLess: Fixed marketing and admin. costsOperating profit
200 × $30$6,000 3,000 1,500$1,500
Metalframes
Woodframes
• Selling metal frames will result in higher profitsthan selling wooden frames.
LO4
4 - 28
The Theory of ConstraintsL.O. 5 Understand the theory of constraints.
• Theory of constraints:Focuses on revenue and cost managementwhen faced with bottlenecks
• Bottleneck:Operation where the work required limits productionThe bottleneck is the constraining resource.
• Throughput contribution:Sales dollars minus direct materials costs andvariables such as energy and piecework labor
4 - 29
Using Excel SolverProduct Choice Decisions
Problem 4-59