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Chapter 24

Differential Analysis and


Product Pricing
Accounting, 21st Edition
Warren Reeve Fess

© Copyright 2004 South-Western, a division


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Professor Emeritus of Accounting
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Objectives
Objectives
1. Prepare a differential analysis report for
After
After studying
studying this
this
decisions involving leasing or selling
chapter,
chapter, you
you should
should
equipment, discontinuing an unprofitable
be
be able
able to:
to:or purchasing a
segment, manufacturing
needed part, replacing usable fixed
assets, processing further or selling an
intermediate product, or accepting
additional business at a special price.
Objectives
Objectives
2. Determine the selling price of a product,
using the total cost, product cost, and
variable cost concepts.
3. Calculate the relative profitability of
products in bottleneck production
environments.
Differential
Differential Analysis
Analysis
Differential analysis is used for analyzing:
 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
Differential Analysis
Analysis

Differential
Decisions Analysis
Alternative A Differential revenue
or – Differential costs

Alternative B Differential 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
Sellequipment
equipment The equipment can be sold
to
to through a broker for
$100,000, less a 6%
commission.

Broker
Lease or Sell Equipment
Marcus
Company

Potamkin Company, OR Lease


Lease
equipment
equipmentto
to
the lessee, has offered
to lease the equipment Potamkin
Company
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 Equipment
June 22, 2006
Differential revenue from alternatives:
Revenue from lease $160,000
Revenue from sales 100,000
Differential revenue from lease $60,000
Differential cost of alternatives:
Repairs, insurance, taxes $ 35,000
Commission expense on sale 6,000
Differential cost of lease 29,000
Net differential income from the lease
alternative $31,000

Lease the equipment!


OR
Proposal to Lease or Sell Equipment
June 22, 2006
Lease alternative:
Revenue from lease $160,000
Depreciation expense for remaining 5 years $80,000
Repairs, insurance, and property tax expense 35,000 115,000
Net gain $45,000
Sell alternative:
Sales price $100,000
Book value of equipment $80,000
Commission expense 6,000 86,000
Net gain 14,000
Net differential income from the lease alternative $31,000

This
This isis the
the traditional
traditional analysis.
analysis. The
The
differential
differential income
income isis the
the same.
same.
Discontinue
a Segment
or Product
Battle Creek Cereal Co.
Condensed Income Statement
For the Year Ended August 31, 2006
Differential items Bran Other
Flakes Cereals Total
Sales
Sales $100,000
$100,000 $900,000 $1,000,000
Cost of goods sold:
Variable
Variable costs
cost $ 60,000
60,000 $420,000 $ 480,000
Fixed costs 20,000 200,000 220,000
Total cost of goods sold $ 80,000 $620,000 $ 700,000
Gross profit $ 20,000 $280,000 $ 300,000
Operating expenses:
Variable
Variable expenses
expenses $ 25,000
25,000 $155,000 $ 180,000
Fixed 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

Should
ShouldBran
BranFlakes
Flakesbe
bediscontinued?
discontinued?
Battle Creek Cereal Co.
Condensed Income Statement
For the Year Ended August 31, 2006
Differential items Bran Other
Flakes Cereals Total
Sales
Sales $100,000
$100,000 $900,000 $1,000,000
Cost of goods sold:
Variablecost
Variable costs $$ 60,000
60,000 $420,000 $ 480,000
Fixed costs 20,000 200,000 220,000
Total cost of goods sold $ 80,000 $620,000 $ 700,000
Gross profit $ 20,000 $280,000 $ 300,000
Operating expenses:
Variableexpenses
Variable expenses $$ 25,000
25,000 $155,000 $ 180,000
Fixed 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
IfIfBran
BranFlakes
Flakesisisdiscontinued,
discontinued,net
net
income
incomewill
willdecrease
decreasebyby$15,000.
$15,000.
Proposal to Discontinue Bran Flakes
September 29, 2006
Differential revenue from annual sales
of Bran Flakes:
Revenue from sales $100,000
Differential cost of annual sales of Brian Flakes:
Variable cost goods sold $60,000
Variable operating expenses 25,000 85,000
Annual differential income from sales of
Bran 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 materials $ 80
Direct labor 80
Variable factory overhead 52
Fixed factory overhead 68
Total cost per unit $280

INITIAL REACTION—DON’T MAKE


INTERNALLY
Proposal to Manufacture Automobile Part
February 15, 2006
Purchase price of part $240.00
Differential cost to manufacture:
Direct materials $80.00
Direct labor 80.00
Variable factory overhead 52.00 212.00
Cost savings from manufacturing part $ 28.00

The
The fixed
fixed factory
factory overhead
overhead isis excluded
excluded
because
because itit isis not
not relevant—so
relevant—so continue
continue
making
making the the part.
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?
Proposal to Replace Equipment
November 28, 2006
Annual variable costs—present equipment $225,000
Annual variable costs—new equipment 150,000
Annual differential decrease in cost $ 75,000
Number of years applicable x5
Total differential decrease in cost $375,000
Proceeds from sale of present equipment 5,000 $400,000
Cost of new equipment 250,000
Net differential decrease in cost, 5-years $150,000
Annual net differential—new equipment $ 30,000

Buy
Buy the
the new
new equipment!
equipment!
Process
Process or
or Sell
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.
Proposal to Process Kerosene Further
October 1, 2006
Differential revenue from further processing per 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 processing gasoline
per batch $150

Process
Process further!
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
Should the
the offer
offer be
be accepted
accepted or
or
rejected?
rejected?
Proposal to Sell Basketballs to Exporter
March 10, 2006
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

Accept
Accept the
the offer!
offer!
Setting Normal
Product Selling Prices
Setting
Setting Normal
Normal Product
Product
Selling
Selling Prices
Prices
Market Methods
1. Demand-based methods
2. Competition-based methods

Cost-Plus Methods
1. Total cost concept
2. Product cost concept
3. Variable cost concept
Market
Market Methods
Methods

Demand-based
Demand-based methods
methods setset
the
the price
price according
according toto the
the
demand
demand for
for the
the product.
product.
Market
Market Methods
Methods
Competition-based
Competition-based methods
methods set set
the
the price
price according
according toto the
the price
price
offered
offered by
by the
the competitors.
competitors.
Total Cost Concept

Using
Using the
the Total
Total cost
cost
concept,
concept, all
all cost
cost of
of
manufacturing
manufacturing aa product...
product...

Manufacturing
Cost
Total Cost Concept
…plus
…plus the
the selling
selling and
and
administrative
administrative
expenses...
expenses...

Administrative
Expenses

Selling Expenses

Manufacturing
Cost
Total Cost Concept

…are
…are included
included in
in the
the
cost
cost to
to which
which the
the
markup
markup isis added.
added.
Desired Profit
Administrative
Expenses

Selling Expenses
Total cost

Manufacturing
Cost
Total Cost Concept
The
The company’s
company’s
desired
desired profit
profit isis
Desired $160,000.
$160,000.
selling price
Desired Profit
Administrative
Expenses

Selling Expenses

Manufacturing
Cost
Total Cost Concept
Cost Structure Example (100,000 units)
Per Unit Total
Variable Costs (per unit): Cost Cost
Direct materials $ 3.00 $ 300,000
Direct labor 10.00 1,000,000
Factory overhead 1.50 150,000
Selling and administrative 1.50 150,000
Total variable costs $16.00 $1,600,000
Fixed Costs:
Factory overhead .50 50,000
Selling and administrative .20 20,000
Total fixed costs . 70 70,000
Total costs $16.70 $1,670,000
Total Cost Concept
Markup Percentage:
Desired profit $160,000
Total costs =
$1,670,000 = 9.6%

Total cost per calculator $16.70


Markup ($16.70 x 9.6%) 1.60
Selling price $18.30

Only
Only the
the desired
desired profit
profit isis
covered
covered inin the
the markup.
markup.
Total Cost Concept
Proof
Proof that
that aa sale
sale of
of 100,000
100,000 computers
computers atat $18.30
$18.30
each
each will
will generate
generate aa desired
desired profit
profit of
of $160,000.
$160,000.
Digital Solutions Inc.
Income Statement
For the Year Ended December 31, 2006
Sales (100,000 units x $18.30) $1,830,000
Expenses: Variable (100,000
units x $16.00) $1,600,000
Fixed ($50,000 + $20,000) 70,000 1,670,000
Income from operations $ 160,000
Product
Product Cost
Cost Concept
Concept
Using
Using the
the product
product cost
cost concept
concept
only
only the
the manufacturing
manufacturing costs
costs are
are
included
included inin the
the amount
amount to
to which
which
the
the markup
markup isis applied.
applied.
Product
Product Cost
Cost Concept
Concept
Cost Structure Example (100,000 units)
Per Unit Total
Variable Costs: Cost Cost
Direct materials $ 3.00 $ 300,000
Direct labor 10.00 1,000,000
Factory overhead 1.50 150,000
Selling and administrative 1.50 150,000
Total variable costs $16.00 $1,600,000
Fixed Costs:
Factory overhead .50 50,000
Selling and administrative .20 20,000
Total fixed costs .70 70,000
Total costs $16.70 $1,670,000

Product Cost = $15 per unit


Product
Product Cost
Cost Concept
Concept

De Administrative
Se sir
l l ed Expense
Pr ng i
ice + Markup
Selling Expense
+
Desired Profit
Manufacturing Product Cost
Cost
Product
Product Cost
Cost Concept
Concept

Total selling and


Markup Desired profit + administrative expenses
=
percentage Total manufacturing costs
Product
Product Cost
Cost Concept
Concept

Markup = $160,000 + $170,000


percentage $1,500,000

Markup
= 22%
percentage
DM
DM($3
($3xx100,000)
100,000) $$ 300,000
300,000
DL
DL($10
($10xx100,000)
100,000) 1,000,000
1,000,000
Factory
Factoryoverhead:
overhead:
Variable
Variable($1.50
($1.50xx100,000)
100,000) 150,000
150,000
Fixed
Fixed 50,000
50,000
Total
Totalmanufacturing
manufacturingcosts
costs $1,500,000
$1,500,000
Product
Product Cost
Cost Concept
Concept

Manufacturing
Manufacturing cost
cost per
per calculator
calculator $15.00
$15.00
Markup
Markup ($15
($15 xx 22%)
22%) 3.30
3.30
Selling
Selling price
price $18.30
$18.30
Variable
Variable Cost
Cost Concept
Concept
The
The variable
variable cost
cost concept
concept uses
uses total
total of
of the
the
variable
variable manufacturing
manufacturing costs
costs and
and the
the
variable
variable selling
selling and
and administrative
administrative
expenses
expenses as
as the
the amount
amount to
to apply
apply aa markup.
markup.
Variable
Variable Cost
Cost Concept
Concept

De Total Fixed Markup


Se sir Costs +
l l ed
Pr ng i Desired
ice
Profit

Variable
Manufacturing
Cost Product Cost
+
Variable
Administrative
and Selling
Expenses
Variable
Variable Cost
Cost Concept
Concept

Markup Desired profit + Total fixed costs


=
percentage Total variable costs
Variable
Variable Cost
Cost Concept
Concept

Markup $160,000 + $50,000 + $20,000


=
percentage $1,600,000
Markup
= 14.4%
percentage
Direct
Directmaterials
materials($3
($3xx100,000)
100,000) $$ 300,000
300,000
Direct
Directlabor
labor($10
($10xx100,000)
100,000) 1,000,000
1,000,000
Variable
Variablefactory
factoryoverhead
overhead
($1.50
($1.50xx100,000)
100,000) 150,000
150,000
Variable
Variableselling
sellingand
andadministrative
administrative
expenses
expenses($1.50
($1.50xx100,000)
100,000) 150,000
150,000
Total
Totalvariable
variablecosts
costs $1,600,000
$1,600,000
Variable
Variable Cost
Cost Concept
Concept

Variable
Variable cost
cost per
per calculator
calculator $16.00
$16.00
Markup
Markup ($16
($16 xx 14.4%)
14.4%) 2.30
2.30
Selling
Selling price
price $18.30
$18.30
Target
Target Costing
Costing
Using
Using target
target costing
costing the
the cost
cost isis determined
determined by
by
subtracting
subtracting aa desired
desired profit
profit from
fromthe theselling
sellingprice.
price.
Present Market Price
Expected
Profit
Drif Market Price
t Profit
Required
Actual cost Target
Cost reduction Cost

Present Future
Bottlenecks
Product
Product Profitability
Profitability Under
Under Production
Production Bottlenecks
Bottlenecks
Small Medium Large
Wrench Wrench Wrench

Sales price $130 $140 $160


Variable cost 40 40 40
Contribution margin $ 90 $100 $120
Bottleneck hours 1 4 8

The
The number
number of of heat
heat treatment
treatment
hours
hours per
per unit
unit for
for each
each product.
product.
Product
Product Profitability
Profitability Under
Under Production
Production Bottlenecks
Bottlenecks
Small Medium Large
Wrench Wrench Wrench

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

Largest
Largest contribution
contribution
margin
margin per
per
bottleneck
bottleneck hour
hour
Product
Product Profitability
Profitability Under
Under Production
Production Bottlenecks
Bottlenecks

How much should the firm charge


for the large wrench in order to
deliver the same contribution as
the small wrench?
Product
Product Profitability
Profitability Under
Under Production
Production Bottlenecks
Bottlenecks
Contribution Revised price of Variable cost
margin per large wrench – per large wrench
bottleneck hour =
Bottleneck hours per large wrench
per small wrench
Revised price of

$90 =
large wrench – $40
8
$720 = Revised price of large wrench – $40
$760 = Revised price of large wrench
Product
Product Profitability
Profitability Under
Under Production
Production Bottlenecks
Bottlenecks

Revised price of large wrench per formula


on 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
Chapter 24

The
The End
End