CHAPTER 7

Differential Cost
Analysis for
PowerPoint Presentation by
LuAnn Bean Operating
Professor of Accounting
Florida Institute of Technology
Decisions
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Managerial Accounting 11E

Maher/Stickney/Weil 1
☼ ☼
CHAPTER GOAL
This chapter explains how managers can use
differential analysis to examine the effects on
profits. Differential analysis helps managers
answer relevant questions such as:
What activities differ between the alternatives?
How does that difference affect costs and profits?

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 LO 1

DIFFERENTIAL ANALYSIS:
Definition

Is the analysis of differences

among particular alternative
actions.

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E
M EXAMPLE: Ullman Educational Media
Ullman Educational Media (UEM) is a company that
produces tutorial videos for primary and preschool use.
UEM developed the following estimates:

Units made and sold 800 per month

Maximum production and sales capacity 1,200 units per month

Selling price $ 30

Continued
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E
M ACTIVITY & COSTS
Ullman Educational Media provides the following
information about activities and costs:
VC per unit FC per month
Manufacturing $ 17 $ 3,060
Marketing and Administrative 5 1,740
Total costs $ 22 $4,800

Continued
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E
M

Profit
decreases
by $1,000.

EXHIBIT 7.2
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 LO 1

CASH FLOW

Differential analysis focuses on cash flow

because
Cash is the medium of exchange in business
Cash is a common objective measure of the costs
and benefits of alternatives

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 MANAGERS WANT TO KNOW! LO 2

Customer Competitors’
Demands Actions

Managers must
Will raising consider
prices lose competitors
customers actions both
to a nationally and
competitor Pricing internationally.
or cause Decisions
them to
substitute
cheaper
goods?

Internal focus
on continuous
improvements
Cost of
Products is key to
cutting costs. 8
U MANAGERS WANT TO KNOW! LO 2
E
M SPECIAL ORDERS

Ullman has an opportunity for a one-time

only special order to sell 100 units at
$25 each. The regular price is $28.
Should they accept the special order?

Continued
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E
M

Yes! Since
normal
operations should
EXHIBIT 7.3 be used to cover
FC, not special
orders, this
special order
adds $300 to the
bottom line.
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E
M

EXHIBIT 7.5
Full cost, used for long
run decisions, is the total
cost of producing and
selling a unit.

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PRICING DECISIONS
Use of full cost in pricing decisions is justified
because
In the long run, prices must cover all costs to
survive
Long term contractual agreements must cover all
costs
Prices in regulated industries are often based on
full cost
Although full cost + profit may be used initially,
short term adjustments may reflect market
conditions.
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PRODUCT LIFE CYCLE:

Definition

Covers the time from initial

research and development to
time support to customer is
withdrawn.

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Predatory pricing: Definition

Is when a business deliberately prices

below its costs to drive out competitors.

Dumping: Definition
Occurs when a foreign company sells a
product in the U.S. at a price below the
market value in the country of its creation.
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 LO 3

What is target
cost?

Target cost is the target

price less the target profit.

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EXHIBIT 7.5
Value engineering is a
systematic evaluation of
all aspects of the
business.

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USING ACTIVITY-BASED
COSTING: Analyze Profitability
Customer cost Activities
Cost to acquire customer Promote product; campaign to
win lost customers; run
advertising campaign

Cost to provide goods and services Process order; deliver product;

process returns

Cost to maintain customers Bill customers; process

payments; issue refunds

Cost to retain customers Follow-up calls

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 LO 6

THEORY OF CONSTRAINTS
The theory of constraints (TOC) acknowledges
that businesses often have constraints or
limits on what can be done. TOC encourages
managers to identify where constraints arise
and to develop methods to manage them.
Three factors predominate:
1. Throughput contribution
2. Investments
3. Other operating costs

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 LO 6

BOTTLENECK: Definition

Is an operation in which the

work to be performed equals or
exceeds the available capacity.

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MANAGING THE
BOTTLENECK
Recognize that the bottleneck resource determines
throughput contribution of product
Search for, find bottleneck
Resource with large quantities of inventory waiting to be
worked on
Subordinate all non-bottleneck resources to the
bottleneck resource
Increase bottleneck efficiency, capacity
Repeat 4 steps for any new bottleneck
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MAKE-OR-BUY

The make-or-buy decision is one where the

firm must decide whether to meet its
needs internally or to acquire goods or
services externally. Both cost and non-
quantitative factors are considered.

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MANAGERS WANT TO KNOW! LO 8

JOINT PRODUCTS

In some circumstances, multiple products

can be produced from a single
production process. The question for
management is: What is the effect of
additional processing/production on
profits?

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SPLITOFF POINT: Definition

Is the point up to which all

costs are joint and after which
additional processing costs are
identified with other products.

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MANAGERS WANT TO KNOW! LO 9

ADD OR DROP
Managers must decide when to add or drop
products; when to open or abandon
sales territories. The differential
principle involved can be stated:
If differential revenue from selling exceeds
differential costs of product, the product is
profitable and the firm should continue
production.

Click the button to

skip Example

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MANAGERS WANT TO KNOW! LO 10

INVENTORY MANAGEMENT
Inventory has a direct affect on profit and
must be carefully managed. Key
questions for managers are:
1. How many units should be on hand for use
or sale?
2. How often should the firm order an item
and what is the optimal order size?

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JUST-IN-TIME (JIT)

JIT is a philosophy, not a tool, that

dovetails with total quality
management (TQM) in that TQM
requires reliable processing systems
and disallows defective units. Flexible
manufacturing that reduces both setup
and inventory levels also enhances JIT.

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LINEAR PROGRAMMING

Linear programming: (a) finds the

product mix that will maximize profits
given the constraints, (b) provides
opportunity costs of constraints, and (c)
allows for sensitivity analysis.

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ECONOMIC ORDER
QUANTITY (EOQ)
The economic order quantity (EOQ)
model is a mathematical model that gives
the optimal amount of goods to order
when demand reduces inventory to a
level called the “reorder point.”

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End of CHAPTER 7

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