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Learning Objectives
Fundamentals of Cost Analysis LO 4-1 Use differential analysis to analyze decisions.
for Decision Making
LO 4-2 Understand how to apply differential analysis
Chapter 4 to pricing decisions.
LO 4-3 Understand several approaches for establishing
prices based on costs for long-run pricing decisions.

PowerPoint Authors: LO 4-4 Understand how to apply differential analysis to

Susan Coomer Galbreath, Ph.D., CPA production decisions.
Charles W. Caldwell, D.B.A., CMA
Jon A. Booker, Ph.D., CPA, CIA LO 4-5 Understand the theory of constraints.
Cynthia J. Rooney, Ph.D., CPA

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McGraw-Hill/Irwin Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved.

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LO LO
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Differential Analysis Differential Costs

LO 4-1 Use differential analysis to analyze decisions. With two or more alternatives, costs that differ
among or between alternatives
Differential Analysis
The process of estimating revenues and costs Costs that change in response to an alternative
of alternative actions available to decision makers course of action
and of comparing these estimates to the status quo
Differential costs differ between actions.
Short Run
The period of time over which capacity will be
unchanged, usually one year Alternative A Alternative B

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Differential Costs versus Total

LO LO
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Sunk Costs Costs

Costs incurred in the past that cannot be Information presented to management can show
changed by present or future decisions the detailed costs that are included for making a
decision, or it can show just the differences
between alternatives, as follows.
A sunk cost is NOT relevant for making decisions.
Status Quo Alternative Difference

Sales revenue $750 $900 $150

Variable costs (250) (300) (50)
Contribution margin $500 $600 $100
Fixed costs (350) (350) -0-
Operating profit $150 $250 $100

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 4-2

Differential Analysis and Short-Run versus Long-Run

LO LO
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Pricing Decisions Pricing Decisions

LO 4-2 Understand how to apply differential
analysis to pricing decisions.
Year 0 Year 1

Variable costs must

always be covered. Short-run Long-run
pricing decision: pricing decision:
Less than one year Longer than one year

Fixed costs must be Pricing a one-time

Pricing a new product.
covered in the long run. special order.

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Short-Run Pricing Decisions: Short-Run Pricing Decisions:

LO LO
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Special Orders Special Orders

An order that will not affect other sales • U-Develop has received a one-time offer for 500 prints
and is usually a one-time occurrence at a special price of 40¢ per print ($200).
• The regular price is 50¢ and they have enough idle
capacity in the week to take the offer.

Sales for the week (5,000 prints at 50¢) $2,500

Variable costs, including paper, maintenance,
and usage payment to machine owner
(5,000 copies at 20¢) 1,000
Total contribution margin $1,500
Fixed costs (supplies, plus allocated costs
of the print shop) 1,200
Operating profit for the week $ 300
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Short-Run Pricing Decisions:

LO LO
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Special Orders Long-Run Pricing Decisions

Analysis of Special Order: U-Develop LO 4-3 Understand several approaches for establishing
prices based on costs for long-run pricing decisions.
Status
Quo: Alternative:
Reject Accept
Special Special Full costs are
Offer Offer Difference Full cost is the total
relevant for the long-
Comparison of Totals
cost to produce and
Sales revenue $2,500 $2,700 $200
term pricing
Variable costs (1,000) (1,100) (100)
sell a unit.
Total contribution
Fixed costs
$1,500
(1,200)
$1,600
(1,200)
$100
-0-
decisions.
Operating profit $ 300 $ 400 $100

Alternative Presentation: Differential Analysis

Differential sales, 500 at 40¢ $ 200
Less: Differential costs, 500 at 20¢ 100
Differential operating profit (before taxes) $ 100

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Long-Run versus Short-Run

LO LO
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Pricing Cost Analysis for Pricing

In the short run, In the long run an organization must cover

differential costs may be all variable and fixed costs – both
very low. manufacturing and selling.

In the long run, differential

costs are higher than in
the short run.

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Life-Cycle Product Costing and Target Costing from Target

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Pricing Pricing
Target Price
Product life-cycle is concerned with covering The price based on customers’ perceived
costs in all categories of the life cycle. value for the product and the price that
competitors charge
• What would a customer pay?

R&D Design Manufacturing • How much profit do I need?

• Can I make it at this cost?

Target price – Desired profit = Target cost

Marketing and Customer Take back
distribution service (disposal)

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Legal Issues Relating to Costs Legal Issues Relating to Costs

LO LO
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and Sales Price and Sales Price

Predatory Pricing Peak-load Pricing
Practice of setting price below cost with the intent Practice of setting prices highest when the quantity
to drive competitors out of business demanded for the product approaches capacity.

Dumping Price Fixing

Exporting a product to another country at a price Agreement among businesses to set prices at a
below domestic cost particular level.

Price Discrimination
Practice of selling identical goods to different
customers at different prices

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 4-4

Use of Differential Analysis

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for Production Decision Make-or-Buy Decisions

U-Develop’s current costs of developing prints:
LO 4-4 Understand how to apply differential
analysis to production decisions. 100,000
Per unit prints
Costs directly traceable:
Decision to make goods or services Direct materials $0.05 $ 5,000
Make or buy
internally or purchase them externally Direct labor 0.12 12,000
Variable manufacturing overhead .03 3,000
Fixed manufacturing overhead 4,000
Add or drop Decision to add or drop a product Common costs allocated to this product line 10,000
a segment line or close a business unit Total costs $34,000

Product Decision on what products or This year’s expected volume is 100,000 prints,
choice services to offer (product mix) so the full cost of processing a print is:
$34,000 ÷ 100,000 = $0.34
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LO LO
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Make-or-Buy Decisions Make-or-Buy Decisions

100,000 Process Outsource
U-Develop received an offer from an outside prints prints processing Difference
developer to process any number of prints for
Direct costs:
25¢ each. Direct materials $ 5,000 $25,000a $20,000 higher
Labor 12,000 -0- 12,000 lower
Should U-Develop accept this offer? Variable overhead 3,000 -0- 3,000 lower
Fixed overhead 4,000 -0- 4,000 lower
Common costs 10,000b 10,000b -0-
The accounting department Total costs $34,000 $35,000 $ 1,000 higher
prepared cost analyses at a 100,000 units purchased at $0.25 = $25,000
b These common costs remain unchanged for these volumes.
volume levels of 50,000 and Because they do not change, they could be omitted from the analysis.
100,000 prints per year.
Differential costs increase by $1,000, so reject
alternative to buy.

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Make-or-Buy Decisions Opportunity Costs of Making

50,000 Process Outsource
prints prints processing Difference U-Develop’s expected volume is 100,000 prints.
Direct costs:
Direct materials $ 2,500 $12,500a $10,000 higher Assume that the facilities used to process prints
Labor 6,000 -0- 6,000 lower could be used to offer a new service that would
Variable overhead 1,500 -0- 1,500 lower provide a $2,000 incremental contribution.
Fixed overhead 4,000 -0- 4,000 lower
Common costs 10,000b 10,000b -0-
Total costs $24,000 $22,500 $ 1,500 lower Should U-Develop accept or
a 50,000 units purchased at $0.25 = $12,500 reject the alternative?
b 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 accept

alternative to buy.

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LO LO
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Opportunity Costs of Making Add or Drop Decisions

Status quo: Alternative:
Process Outsource
U-Develop
prints processing Difference Fourth Quarter Product Line Income Statement
Total cost of 100,000 prints
Total Prints Cameras Frames
Opportunity cost of using $34,000 $35,000 $1,000 highera
facilities to process prints Sales revenue $80,000 $10,000 $50,000 $20,000
Total costs, including 2,000 -0- 2,000 lowera Cost of sales (all variable) 53,000 8,000 30,000 15,000
Contribution margin $27,000 $ 2,000 $20,000 $ 5,000
opportunity costs $36,000 $35,000 $1,000 lowera Less fixed costs:
a
Rent 4,000 1,000 2,000 1,000
These indicate whether the alternative is higher or lower than the status quo.
Salaries 5,000 1,000 2,500 1,500
Marketing and administrative 3,000 500 1,500 1,000
Differential costs decrease by $1,000, so accept the Operating profit (loss) $15,000 $ (500) $14,000 $ 1,500
alternative.

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LO LO
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Add or Drop Decisions Product Choice Decisions

U-Develop
Differential Analysis Constraints
Activities, resources, or policies that limit the
Status quo: Alternative:
Keep prints Drop prints Difference attainment of an objective.
Sales revenue $80,000 $70,000 $10,000 decrease
Cost of sales (all variable) 53,000 45,000 8,000 decrease
Contribution margin $27,000 $25,000 $ 2,000 decrease Contribution Margin per Unit of Scarce Resource
Less fixed costs:
Rent 4,000 4,000 -0-
Contribution margin per unit of a particular input with
Salaries 5,000 4,000 1,000 decrease limited availability.
Marketing and administrative 3,000 2,750 250 decrease
Operating profit (loss) $15,000 $14,250 $ 750 decrease

Profits decrease $750, so keep prints.

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LO LO
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Product Choice Decisions Product Choice Decisions

U-Develop U-Develop
Revenue and Cost Information Revenue and Cost Information
Metal Wood Metal Wood
frames frames frames frames
Price $50 $80 Per unit:
Less: Variable costs per unit Contribution margin $ 30 $ 30
Material 8 22 Machine hours required ÷ 0.5 ÷ 1.0
Labor
8 24 Contribution margin per machine hour $ 60 $ 30
Overhead
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Contribution margin per unit
$30 $30
Fixed costs Metal Frames have a higher contribution margin
Manufacturing $3,000 per machine hour.
Marketing and administrative 1,500
Total $4,500
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Product Choice Decisions The Theory of Constraints

LO 4-5 Understand the theory of constraints.
Suppose U-Develop has 200 machine hours per
month available. Metal Wood Theory of Constraints
frames frames Focuses on revenue and cost management when
Capacity 400 200 faced with bottlenecks
Contribution margin per unit × $30 × $30
Total contribution margin $12,000 $6,000 Bottleneck
Less: Fixed manufacturing costs 3,000 3,000 Operation where the work required limits production;
Less: Fixed marketing and admin. costs 1,500 1,500 Bottleneck is the constraining resource
Operating profit $ 7,500 $1,500
Throughput Contribution
Selling metal frames will result in higher profits than Sales dollars minus direct materials costs and
selling wooden frames. variables such as energy and piecework labor
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End of Chapter 4

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