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Chapter 7Differential Cost Analysis (aka
Incremental Analysis)for Operating Decisions
2
Describe & Define Differential Analysis
• Differential analysis focuses on differences among particular alternative actions
– Sometimes referred to as incremental cost analysis
• A differential cost or revenue is a cost or revenue that differs as a result of changing activities or levels of activities
3
Differential Analysis ModelAlternative - Status Quo = Difference
Revenue Revenue Revenue Change in Revenue
Less Variable Costs (VC) VC - VC =
Change in VC
Total Contribution Margin (CM) CM CM
Change in CM
Less Fixed Costs Fixed Costs - Fixed Costs =
Change in Fixed Costs
Operating ProfitProfit - Profit =
Change in Profit
4
Differential Analysis Cont.
• A cost (or revenue) is relevant only if it differs between alternatives under consideration
• Focus is typically on cash flows because:
– Cash is the medium of exchange
– Cash is a common, objective measure of benefits and costs of alternatives
5
Review Short-Run vs. Long-Run Pricing Decisions
• The time horizon of a decision is
important in determining the relevant
costs in a pricing decision
– Short-run decisions include pricing for a
one-time special order
– Long-run decisions include pricing a main
product in a major market
6
What is the differential approach to pricing?
This approach assumes that the price must be at
least equal or greater than the differential cost
of producing and selling the product
– In the short-run the price should provide a
positive contribution to covering fixed costs
and generating profit
– In the long-run the price must cover all
costs, because both fixed and variable costs
become differential in the long run
7
Long-Run Pricing Decisions (Slide 1 of 3)
• Define Full cost
This is the total cost of producing and
selling the product from R & D through
customer service
– Includes all costs incurred by activities
making up the value chain
8
Review the Value Chain
R & D DesignProduc-
tionMarket-
ingDistrib-
utionCustomer Service
Value Chain Activities
Costs
Premanufacturing(Upstream)
Manufacturing
Post-manufacturingDownstream
9
Long-Run Pricing Decisions (Slide 3 of 3)
• The full cost approach is justified in pricing decisions when:
– Entering into long-term contracts to supply a product
– Developing and producing a customized product
– Initially setting prices, then adjusting for market conditions
10
Review Life-Cycle Product Costing and Pricing
The product life cycle covers time period from initial R & D through the point at which support to customers is withdrawn
– This highlights the importance of setting prices that cover all costs in the value chain
– To be profitable, a firm must generate sufficient revenue to cover all costs
11
Explain Using Target Prices to Set Target Costs
• Target costing is the concept of price-based costing– Target price – is the estimated price a potential
customer is willing to pay
– Target Cost = target price – target profit
• The target cost is the estimated long-run cost of the product or service that enables company to realize targeted profit
12
Explain Legal Issues Relating Costs to Prices
• Pricing must not be predatory
– i.e., Cannot price products below cost in an effort to drive out competition
• Cost may be defined as full or variable costs depending on jurisdiction
• Dumping occurs when a foreign company sells products in U.S. at a price below market value in country of origin
13
Customer Profitability
• Differential analysis is useful in
determining which customers to keep or
drop
– Dropping a customer should result in cost
savings in excess of lost revenue
– The alternative uses of extra capacity
available after dropping a customer should
be included in the analysis
14
What are the four general categories of customer costs?
Customer costs generally consist of the
following 4 categories of activities:
1. Cost to acquire customers
2. Cost to provide goods and services
3. Cost to maintain customers
4. Cost to retain customers
ABC provides a better understanding of the cost
of these activities
15
Build a Chart of Activities to Compute Customer Costs
Customer Cost Activities
Acquire ◊Promote Product◊Win Back Lost Customers◊Run Advertising Campaigns
Provide Goods &
Services
◊Process Order◊Deliver Product◊Process Returns
Maintain ◊Bill Customers◊Process Payments◊Issue Refunds
Retain ◊Follow-up Calls
16
Comment on Decisions when Scarce Resources are Limited
• One of the most difficult decisions a
manager must make is how to allocate
scarce resources among multiple
products.
• The decisions is not based upon which
product has the largest selling price or
profit.
17
Decisions with Scarce Resources
• The manager must determine how much contribution
margin each product makes per unit of the scarce
resource.
• Once that is done the manager decides which product
makes the most contribution margin for equal amounts
of scarce resource.
• The product that makes the most contribution margin
per unit of the scarce resource is the product to make.
18
Define the Following
• Theory of Constraints
Focusing on increasing incremental revenue over incremental costs when bottlenecks exist
• Bottleneck
When work performed at an operation equals or exceeds its capacity
19
List the Five Steps to Managing Bottlenecks
1. Recognize bottlenecks determine throughput for the whole plant
2. Search for the bottlenecks by finding where inventory backs up
3. Subordinate non-bottleneck resources to bottleneck resources
4. Increase bottleneck capacity and efficiency
5. Repeat steps 1 through 4 for new bottlenecks
20
Explain Make or Buy Decisions
• Companies have the option of deciding to
meet needs internally or to acquire goods
or services externally (outsourcing)
• You should compare the relevant costs of
making to buying. The lower cost is the
better alternative, all other things being
equal. Only costs that differ between the
alternatives are relevant costs.
21
Define the Following
• Split-Off Point
Is the point at which multiple identifiable products emerge from a joint process
• Joint Costs
Are costs incurred up to the split-off point, they must be allocated to the multiple products
• Additional Processing Costs
Costs occurring after the split-off point
22
How do you decide whether to process further or not?
• List additional revenue of products if processed further
• List additional costs of products if processed further
• Subtract additional costs from additional revenue: if positive, then process further; if negative do not process further
23
Make or Buy
Outsourcing: The decision to buy parts or services rather than making them
Example:Baron Co. incurs the following costs to make 25,000 switches:
Switches can be purchased for $8 per switch ($200,000) Eliminates all variable costs and $10,000 of fixed
costs; however, $50,000 of fixed costs remain
24
Make or Buy Example (Continued)
Based on analysis of costs under both alternatives: Purchasing adds $25,000 to cost of switches
Net Income Make Buy Increase (Decrease)Direct materials $ 50,000 $ - 0 - $ 50,000 Direct labor 75,000 - 0 - 75,000 Variable manufacturing costs 40,000 - 0 - 40,000 Fixed manufacturing costs 60,000 50,000 10,000 Purchase price -0- 200,000 (200,000) Total annual cost $225,000 $250,000 $ (25,000)
Decision: Continue to make switches.
25
Opportunity CostsExample – Baron Company Continued
Assume that buying the switches allows Baron to use the released capacity to generate $28,000 additional income.
Thus, the $28,000 lost income is an additional cost of making the switches
Net Income Make Buy Increase (Decrease)Total annual cost $225,000 $250,000 $(25,000) Opportunity cost 28,000 - 0 - 28,000 Total cost $253,000 $250,000 $ 3,000
Decision: Based on the analysis, Baron should buy the switches
as the company will be $3,000 better off.
26
Sell or Process Further
Manufacturers may have to decide, at a given point in production, whether to sell now or to process further and sell at a higher price later.
Decision Rule:Process further as long as the incremental revenue from such processing exceeds the incremental processing costs
27
Sell or Process FurtherSingle-Product Case
Cost to manufacture one unfinished table:Direct materials $15Direct labor 10Variable manufacturing overhead 6Fixed manufacturing overhead 4Manufacturing cost per unit $35
Selling price of unfinished unit is $50 Unused capacity will be used to finish the tables
and sell them for $60 per table. Relevant unit costs of finishing tables:
Direct materials increase $2 Direct labor increase $4 Variable manufacturing overhead costs increase
by $2.40 (60 percent of direct labor increase) Fixed manufacturing costs will not increase
28
Sell or Process FurtherSingle-Product Case (Continued)
Process Net Income Sell Further Increase (Decrease)Sales per unit $50.00 $60.00 $10.00 Cost per unit Direct materials 15.00 17.00 (2.00) Direct labor 10.00 14.00 (4.00) Variable manufacturing overhead 6.00 8.40 (2.40) Fixed manufacturing overhead 4.00 4.00 - 0 - Total $35.00 $43.40 $(8.40) Net income per unit $15.00 $16.60 $1.60
Decision: Process further.
Incremental revenue ($10) exceeds incremental processing costs ($8.40); income increases $1.60 per unit
29
Sell or Process FurtherMultiple-Product Case
Incremental analysis is especially appropriate when multiple products are produced simultaneously
Many end-products are produced from a single raw material and a common production process
Joint products – are when you have multiple end products
Petroleum – gasoline, lubricating oil, kerosene Joint costs
Are all costs incurred prior to split-off point
And are allocated to individual products based on relative sales value
Joint costs are sunk costs for sell or process further decisions.
30
Sell or Process FurtherMultiple-Product Case
Example - Marais Creamery decision:
Sell cream and skim milk
or
Process them further before selling
31
Sell or Process FurtherMultiple-Product Case – Example
(Continued)
Process Net Income Sell Further Increase (Decrease)Sales per day $19,000 $27,000 $ 8,000 Cost per day Processing cream into cottage cheese - 0 - 10,000 (10,000) $19,000 $17,000 $ (2,000)
Sell cream or process further into cottage cheese? Joint cost allocated to cream $ 9,000 Processing cream into cottage cheese $10,000 Expected revenue per day:
Cream $19,000 Cottage cheese $27,000
Decision: Do not process the cream further.Incremental revenue ($8,000) is less than incremental costs
($10,000); income decreases $2,000.
32
Sell or Process FurtherMultiple-Product Case – Example
(Continued)
Process Net Income Sell Further Increase (Decrease)Sales per day $11,000 $26,000 $ 15,000 Cost per day Processing skim milk into condensed milk - 0 - 8,000 ( 8,000) $11,000 $18,000 $ 7,000
Sell skim milk or process further into condensed milk? Joint cost allocated to skim milk $ 5,000 Processing skim milk into condensed milk $ 8,000 Expected revenue per day:
Skim milk $11,000 Condensed milk $26,000
Decision: Process the skim milk further.Incremental revenue ($15,000) exceeds incremental costs
($8,000); income increases $7,000.
33
Eliminate an Unprofitable Segment
Key: Focus on relevant costs
Consider effect on related product lines
Determine if fixed costs allocated to the unprofitable segment must be absorbed by the other segments
Net income may decrease when an unprofitable segment is eliminated
Decision Rule:
Retain the segment unless fixed costs eliminated exceed the contribution margin lost
34
Eliminate an Unprofitable Segment
Example – Martina Company Manufactures three models of tennis racquets:
Profitable lines: Pro and Master Unprofitable line: Champ Champs fixed costs are not eliminated
Condensed Income Statement data:
Should Champ be eliminated?
Pro Master Champ Total Sales $800,000 $300,000 $100,000 $1,200,000Variable expenses 520,000 210,000 90,000 820,000Contribution margin 280,000 90,000 10,000 380,000Fixed expenses 80,000 50,000 30,000 160,000Net income $200,000 $ 40,000 $(20,000) $ 220,000
35
Eliminate an Unprofitable Segment
Example (Continued)
If Champ is eliminated, allocate its $30,000 fixed costs:
2/3 to Pro and 1/3 to Master Revised Income Statement data:
Total income has decreased by $10,000 ($220,000 - $210,000)
Pro Master Total Sales $800,000 $300,000$1,100,000Variable expenses 520,000 210,000 730,000Contribution margin 280,000 90,000 370,000Fixed expenses 100,000 60,000 160,000Net income $180,000 $ 30,000 $ 210,000
ELIMINATE CHAMP?
36
Eliminate an Unprofitable Segment
Example (Continued) Incremental analysis of Champ provides the same
results
The decrease in net income is due to Champ’s contribution margin ($10,000) that will not be realized if the segment is discontinued
ELIMINATE CHAMP? Net Income Continue Eliminate Increase (Decrease)Sales $100,000 $ - 0 - $(100,000) Variable expenses 90,000 - 0 - 90,000 Contribution margin 10,000 - 0 - (10,000) Fixed expenses 30,000 30,000 - 0 - Net income $(20,000) $ (30,000) $ (10,000)
Decision: Do not eliminate Champ. Decision: Do not eliminate Champ.
37
Allocate Limited Resources
Resources are always limited. For example: floor space for a retail firm raw material, direct labor hours, or
machine capacity for a manufacturing firm
Management must decide which products to make and sell to maximize net income
38
Allocate Limited Resources
Example – Collins Company Produces standard and deluxe pen and pencil sets Limiting resource – 3,600 machine hours per month
The deluxe set has the higher contribution margin: $8 The standard set takes fewer machine hours per unit
Deluxe set Standard setContribution margin per unit $8 $6Machine hours required 0.4 per unit 0.2 per unit
39
Allocate Limited ResourcesExample (Continued)
Must compute contribution margin per unit of limited
resource
The standard sets have higher contribution margin per unit of limited resources
Decision:Shift sales mix to standard sets or increase
machine capacity