Ch.

10 Pt2- Differential Analysis

V. Situations involving differential analysis

Continuing on differential analysis, I will now go over the different situations that can happen in a business.
Please click on and view the different tabs in this Excel file.
A. Lease or Sell
1. Problem
Monsters, Inc. is deciding what to do with a piece of equipment that cost $200,000 (I) and has $120,000 (I)
accumulated depreciation to date.

Option #1: The company can sell the equipment through a broker for $100,000 (R) less 6% commission (R).

Option #2:
Another company, Peter Pan, Inc. has offered to lease the equipment for 5 yrs for a total of $160,000 (R)
At the end of the 5 yr lease, the equipment is expected to have 0 residual value.
During the lease, Monsters, Inc. will incur repair, insurance, and property taxes estimated to total $35,000 (R)

Which option should the company take and how much would they save compared to the other option?

2. Solution- this is solved similar to the 2 problems I showed you on before

You need to identity the relevant costs and then compare the 2 alternatives.
Sell Lease Diff. Costs & Benefits
Revenue 100,000 160,000
Less VC (100,000 X 0.06) (6,000)
Less FC (35,000)
Net Operating Income 94,000 125,000

125,000 - 94,000 = 31,000 in favor of leasing

Note:
The book value of the equipment (200,000 - 120,000) is sunk cost and is considered to be irrelevant.
B. Make or Buy
1. Problem
Cycles, Inc. makes bikes. It also manufacturers gear shifters, which are part of a bike.
The following are costs of producing 8,000 units of a shifter each year.

Per Unit Cost Total Cost

Direct Materials 6 48,000
Direct Labor 4 32,000
Variable Overhead 1 8,000
Gear Shifter Supervisor salary 3 24,000
Depreciation 2 16,000 Assume no salvage value.
Allocated general overhead 5 40,000
21 168,000

Recently, an outside company offered to sell Cycles, Inc. gear shifters at $19 a piece. The total cost would be
$152,000. Should Cycles, Inc. continue to make gears or should they buy gears from the outsider from now on?

2. Solution
a. Identify which costs are relevant and which are irrelevant.
Cost of buying gear 152,000 Relevant
DM 48,000 Relevant
DL 32,000 Relevant
Variable OH 8,000 Relevant
Gear Shifter Supervisor salary 24,000 Relevant
Depreciation 16,000 Irrelevant Depreciation is a sunk cost if there is no salvage value.
Allocated general OH 40,000 Irrelevant

b. Compare the alternatives.

Make Buy
DM (48,000)
DL (32,000)
Variable OH (8,000)
Supervisor salary (24,000)
Purchase price (152,000)
(112,000) (152,000)

152,000 - 112,000 = $40,000 will be saved if continue to make gear shifters

C. Differential Analysis When Opportunity Cost is a Factor
This is the section of your textbook that talks about replacement equipment.
Note: One such case is when fixed assets you dispose of have a salvage (resale value).

1. Problem (same as make or buy problem, but with a twist)

Cycles, Inc. makes bikes. It also manufacturers gear shifters, which are part of a bike.
The following are costs of producing 8,000 units of a shifter each year.

Per Unit Cost Total Cost

Direct Materials 6 48,000
Direct Labor 4 32,000
Variable Overhead 1 8,000
Gear Shifter Supervisor salary 3 24,000
Depreciation 2 16,000 Assume no salvage value.
Allocated general overhead 5 40,000
21 168,000

Recently, an outside company offered to sell Cycles, Inc. gear shifters at $19 a piece. The total cost would be
$152,000. Should Cycles, Inc. continue to make gears or should they buy gears from the outsider from now
on? Now, in this problem assume that if Cycle's, Inc. were to buy from the outsider, they could use the space
they previously used to make gears to produce a new cross country bike product line that could generate
$60,000 addition revenue per year.

2. Solution
a. Identify which costs are relevant and which are irrelevant.
OC of forgone new product line 60,000 Relevant
Cost of buying gear 152,000 Relevant
DM 48,000 Relevant
DL 32,000 Relevant
VOH 8,000 Relevant
Gear Shifter Supervisor salary 24,000 Relevant
Depreciation 16,000 Irrelevant Depreciation is a sunk cost if there is no salvage value.
Allocated general OH 40,000 Irrelevant

b. Compare the alternatives.

Method 1 Make Buy
DM (48,000)
DL (32,000)
VOH (8,000)
Gear Shifter Supervisor salary (24,000)
Purchase price (152,000)
OC of forgone new product line (60,000)
(172,000) (152,000)

172,000 - 152,000 = 20,000 in favor of buying the gear shifters

Method 2 Make Buy

Revenue from new produce line 60,000
DM (48,000)
DL (32,000)
VOH (8,000)
Gear Shifter Supervisor salary (24,000)
Purchase price (152,000)
OC of forgone new product line
(112,000) (92,000)

112,000 - 92,000 = 20,000 in favor of buying the gear shifters

e is no salvage value.
D. Special Orders
- This is the section of your textbook that talks about accepting business at a special price.
- Sometimes, a company takes on an order when it is operating below capacity.

1. Problem
Cycles, Inc. recently received a special request from the local police department. The police department
recently is having a budget problem, so it asked Cycles, Inc. if it could produce 100 specially modified mountain
bikes at a price of $179 each. Normally, a regular mountain bike costs $182 to make and sells for $249. The
breakdown of the $182 cost is listed below.

Per Unit Cost

Direct Materials 86 R
Direct Labor 45 R
Manufacturing Overhead 51 R
182

Modification of the bikes to the police departments specs will result in $17 addition VC per bike.
Cycles, Inc. is not currently operating at max production capacity so the variable portion of OH is $6 per unit.
Should Cycles, Inc. take on this offer?

2. Solution
a. Identify which costs are relevant and which are irrelevant.
DM 86 Relevant
DL 45 Relevant
MOH 6 Only $6 per unit is relevant, the remaining 45 is irrelevant.
Special modifications 17 Relevant
Revenue 179 Relevant

b. Compare the alternatives.

Per unit revenue or expense Make Not Make
Revenue 179
DM (86)
DL (45)
VOH (6)
Special modifications (17)
25 0

25 - 0 = $25 X 100 = $2,500 additional income in favor of making

Had the company been operating at full capacity, Cycles, Inc. may not have taking on this order since Var
OH cost per unit would be higher (i.e. the company would have to get more space, use more air
conditioning, etc.)
 Acct 2
Ming Lu

E. Sell or Process Further

Some products go through various stages of production. It can be sold at any intermediate stage or can
be processed further. The best example is crude oil.

1. Problem
Texans, Inc. produces kerosene in batches of 4,000 gallons.
It costs $0.60 per gallon to process direct materials to make kerosene.
Kerosene can be sold without further processing for $0.80 per gallon.
Instead of selling the batch as kerosene, Texans, Inc. also has the option of further processing the kerosene
to be sold as gasoline for $1.25 per gallon. This would cost $650 per batch and 20% of the kerosene will
be lost through evaporation during the production process.

Given these 2 options, which product is more favorable for production and by how much?

2. Solution
a. Identify which items are relevant and which are irrelevant.
Cost to produce kerosene ($0.60 X 4,000) 2,400 I
Additional cost to produce gas 650 R
Kerosene revenue (4,000 X $0.80) 3,200 R
Gasoline revenue (4,000 X $1.25 X [100% - 20%]) 4,000 R

b. Compare the alternatives.

Kerosene Gasoline
Revenue (4,000 X $0.80) & (4,000 X [100%-20%] X $1.25 ) 3,200 4,000
Additional cost to produce gas (650)
Net income 3,200 3,350
3,350 - 3,200 = $150 in favor of processing to make gasoline
F. Dropping a Product Line
1. Problem
Assume you are given the following info about a company's 3 product lines.

Total Drugs Cosmetics Housewares

Sales 250,000 125,000 75,000 50,000
Less VC 105,000 50,000 25,000 30,000
CM 145,000 75,000 50,000 20,000
Less FC -
Salaries 50,000 29,500 12,500 8,000
Advertising 15,000 1,000 7,500 6,500
Utilities 2,000 500 500 1,000
Depreciation-fixtures 5,000 1,000 2,000 2,000
Rent 20,000 10,000 6,000 4,000
Insurance 3,000 2,000 500 500
Gen. admin 30,000 15,000 9,000 6,000
Total FC 125,000 59,000 38,000 28,000
Net oper. Income 20,000 16,000 12,000 (8,000)

In addition, the following info is also given:

1. Salaries are directly related to the product line. Only employees working in housewares will be fired if the
product line is dropped.
2. Advertising is specific to each product line.
3. Utilities represents costs for the entire company and are allocated to each product line.
Whether or not a certain product line exists, utilites would roughly still be the same.
4. Depreciation is related to fixtures used to display each product line. These fixtures have no resale
value if the line is dropped.
5. Rent is for the entire building. It's expense is currently allocated to the 3 product lines.
6. Insurance represent insurance carried on inventories within each product line.
7. Total GA expense are allocated to the 3 product lines. It will not change if a line is dropped.

Given these facts, should you drop the Housewares product line?

2. Solution
Instinctively, you might think that you would drop the Housewares since it is operating at a loss.
However, the correct way is the reevaluate the situation after taking into consideration relevant and
irrelevant costs.

a. Identify which costs are relevant and which are irrelevant.

Sales 50,000 Relevant item
VC 30,000 Relevant cost
Salaries 8,000 Relevant cost
Advertising 6,500 Relevant cost
Utilities 1,000 Irrelevant cost
Depreciation-fixtures 2,000 Irrelevant cost
 Rent 4,000 Irrelevant cost
Insurance 500 Relevant cost
Gen. admin 6,000 Irrelevant cost

b. Compare the alternatives.

1. Method 1 (The long way method)- Had you not taken this class you would have probably done this.
This method takes too long. You should NOT use this method on the exam. Otherwise, you will not finish in
time.

Keep Drop
Housewares Housewares
Sales 50,000 -
Less VC (30,000) -
CM 20,000 -
Less FC
Salaries (8,000) -
Advertising (6,500) -
Utilities (1,000) (1,000)
Depreciation-fixtures (2,000) (2,000)
Rent (4,000) (4,000)
Insurance (500) -
Gen. admin (6,000) (6,000)
Total FC (28,000) (13,000)
Net oper. Income (8,000) (13,000) (5,000) more loss if we drop the
Housewares product line.

2. Method 2- (Method focusing on the relevant cost)

This is the method you should be using on your exams so that you can efficiently solve your problems.

Keep Drop
Housewares Housewares
Sales 50,000 -
Less VC (30,000) -
Salaries (8,000) -
Advertising (6,500) -
Insurance (500) -

Net oper. Income 5,000 0

5,000 - 0 = 5,000 loss if we drop the Housewares product line.

Thus, you should keep the product line.
G. Bottlenecks
1. Facts
a. Managers constantly face problems with use of constrained resources.
Example: A department store has a limited amount of floor space. A CPA firm has a limited amount of staff hours.
b. Before we mentioned high CM is good, but now I am going to add an additional piece of information--
Company's do not always promote those products with the highest unit CM. Rather, companies promote
products that provide the highest CM in relation to a constrained resource.
c. A bottleneck is a machine or process that is limiting/constraining overall output.
d. Example: Patients going into surgery at a hospital.
Draw diagram on board.

B. Practice Problem
1. Problem
Knucklehead, Inc. makes 3 types of wrenches-- small, medium, and large.
All 3 wrenches go through the same heat treatment operation which hardens the wrenches.
Unfortunately, the heat treatment department is always operating at full capacity and is the bottle neck.

Additional info about the 3 products is given below

Small Medium Large

Sales price per unit $ 130 $ 140 $ 160
VC per unit (40) (40) (40)
Heat treatment hrs per unit 1 4 8

Which wrench should the company try to produce more of given these facts?

2. Solution
The large wrench seem to be the most profitable b/c it's CM is the greatest. This would be true had there
been no bottleneck in the heat treatment dept.
However, given the bottleneck situation, the small wrenches would be the most profitable to make. The small
wrench produces the highest CM per bottleneck hour as shown below.

Small Medium Large

Sales price per unit $ 130 $ 140 $ 160
VC per unit (40) (40) (40)
CM per unit $ 90 $ 100 $ 120
Heat treatment hrs per unit 1 4 8
CM per bottleneck hr $ 90 $ 25 $ 15