No Slide Title · Replacing fixed assets 5. ... On June 22, 2012, Marcus Company is considering ... Estimated annual variable manufacturing costs 225,000

Prepared by: C. Douglas Cloud

Professor Emeritus of Accounting

Pepperdine University

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as

permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Chapter 24

Differential Analysis and Product Pricing



Learning Objectives

1. Prepare differential analysis reports for a

variety of managerial decisions.

2. Determine the selling price of a product,

using the product cost concept.

3. Compute the relative profitability of

products in bottleneck production

processes.



Learning Objective 1

Prepare differential

analysis reports for a

variety of managerial

decisions.



Managerial decision making involves

choosing between alternative courses of

action.

LO 1

Differential Analysis



Managerial Decision Making

Step 1: Identify the

objective of

the decision


alternative

courses of

action

Step 3: Gather relevant

information and

perform differential

analysis.

Step 4: Make a

decision

Step 5: Review, analyze, and

assess the results of

the decision


LO 1




LO 1

Bryant Restaurants, Inc.


objective of

the decision


alternative

courses of

action

Step 5: Review, analyze, and

assess the results of

the decision

Step 3: Gather relevant

information and

perform differential

analysis.

Step 4: Make a

decision

Tables Salad

Bar

Revenues $100,000 $120,000

Costs 60,000 65,000

Income $ 40,000 $ 55,000

Increase

its income.

Use floor

space for

existing

tables, or…

replace the

tables with a

salad bar.




Differential analysis, sometimes called

incremental analysis, analyzes differential

revenues and costs to determine the

differential impact on income of two

alternative courses of action.

LO 1




Differential revenue is the amount of

increase or decrease in revenue that is

expected from a course of action as

compared to an alternative.

LO 1




Differential cost is the amount of increase or

decrease in cost that is expected from a

course of action as compared to an

alternative.

LO 1




Differential income (loss) is the difference

between the differential revenue and the

differential costs.

Differential income indicates that a

particular decision is expected to be

profitable, while a differential loss indicates

that the decision is expected to decrease

income.

LO 1



LO 1




In this chapter, differential analysis is

illustrated for the following common

decisions:

1. Leasing or selling equipment

2. Discontinuing an unprofitable segment

3. Manufacturing or purchasing a needed part

4. Replacing fixed assets

5. Processing further or selling a product

6. Accepting additional business at a special price

LO 1




Lease or Sell

On June 22, 2012, Marcus Company is considering

leasing or disposing of the following equipment: Cost of equipment $200,000

Less accumulated depreciation 120,000

Book value $ 80,000

Lease Option:

Total revenue for five-year lease 160,000

Total estimated repair, insurance, and

property tax expenses during life of lease 35,000

Residual value at end of 5th year of lease 0

Sell Option:

Sales price $100,000

Commission on sales 6%

LO 1

(continued)



Lease or Sell

Marcus Company

uses differential

analysis to make the

decision. Exhibit 2

(next slide) provides

key information for

making this decision.

LO 1

(continued)



Lease or Sell

Lease the

equipment

LO 1



Lease or Sell

LO 1

The book value of equipment is a sunk cost

and is not considered in the differential

analysis.

Sunk costs are costs that have been

incurred in the past, cannot be recouped,

and are not relevant to future decisions.



EE 24-1



Discontinue a Segment or Product

Management may consider discontinuing a

product or segment of a business that is

generating losses. Based on the information in the

condensed income statement in Exhibit 3 (next

slide), management of Battle Creek Cereal Co. is

considering discontinuing Bran Flakes.

LO 1

B attle C reek




LO 1

B attle C reek




Don’t discontinue Bran Flakes!

LO 1

B attle C reek




LO 1

B attle C reek



EE 24-2



Make or Buy

Companies often

manufacture

products made up

of components that

are assembled into

a final product.

Should they make

or buy the parts?

LO 1



Make or Buy

An automobile manufacturer has been purchasing

instrument panels for $240 a unit. The factory

currently operates at 80% of capacity. The cost per

unit of manufacturing a panel internally is

estimated as follows:

Direct materials $ 80

Direct labor 80

Variable factory overhead 52

Fixed factory overhead 68

Total estimated cost per unit $280

LO 1



Make or Buy

LO 1



EE 24-3



EE 24-3



Replace Equipment

On November 28, 2012, a business is

considering replacing the following machine:

Old Machine:

Book value $100,000

Estimated annual variable

manufacturing costs 225,000

Estimated selling price 25,000

Estimated remaining useful life 5 years

(continued)

LO 1



Replace Equipment

The business is considering replacing the old

machine with a new one, as shown below: Old New

Book value $100,000

Cost of new machine $250,000

Estimated annual variable

manufacturing costs 225,000 150,000

Estimated selling price 25,000

Estimated residual value 0

Estimated remaining useful life 5 years 5 years

(continued)

LO 1



Replace Equipment

LO 1

replace old

machine



Replace Equipment

The revenue that is forgone from an

alternative use of an asset, such as cash, is

called an opportunity cost.

Although the opportunity cost is not

recorded in the accounting records, it is

useful in analyzing alternative courses of

action.

LO 1



EE 24-4



EE 24-4



In some cases, a product can be sold at an

intermediate stage of production, or it can

be processed further and then sold.

LO 1

Process or Sell



A business produces kerosene as follows:

Batch size 4,000 gallons

Cost of producing kerosene $2,400 per batch

Selling price $2.50 per gallon

Process or Sell

LO 1

(continued)



The kerosene can be processed further to yield

gasoline as follows: Input batch size 4,000 gallons

Less evaporation (20%) 800 (4,000 x 20%)

Output batch size 3,200

Cost of producing

gasoline $3,050 per batch

Selling price $3.50 per gallon

(continued)

Process or Sell

LO 1



Process or Sell

LO 1

process

further



EE 24-5



Accept Business at a Special Price

LO 1

The differential costs of accepting

additional business depend on whether the

company is operating at full capacity.

If the company is operating at full capacity,

any additional production increases fixed and variable manufacturing costs.

If the company is operating below full

capacity, any additional production does

not increase fixed manufacturing costs.




LO 1

B-Ball Inc. manufactures basketballs as follows:

Monthly productive capacity 12,500 basketballs

Current monthly sales 10,000 basketballs

Normal (domestic) selling price $30.00 per basketball

Manufacturing costs:

Variable costs $12.50 per basketball

Fixed costs 7.50

Total $20.00 per basketball

(continued)




LO 1

On March 10, 2012, B-Ball Inc. 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. The domestic market will not be affected.

(continued)




LO 1



EE 24-6



EE 24-6




Determine the

selling price of a

product, using the

product cost

concept.



Setting Normal Product Selling Prices

The basic approaches to setting prices are:

Market methods

Demand-based concept

Competition-based concept

Cost-plus methods

Total cost concept

Product cost concept

Variable cost concept

LO 2



Setting Normal Product Selling Prices

The demand-based concept sets the price

according to the demand for the product.

The competition-based concept sets the

price according to the price offered by

competitors.

LO 2



Under the product cost concept, only the

costs of manufacturing the product, termed

the product costs, are included in the cost

amount per unit to which the markup is

added.

LO 2

Product Cost Concept



Step 1: Estimate the total product costs as

follows:

LO 2

Product costs:

Direct materials $XXX

Direct labor XXX

Factory overhead XXX

Total product cost $XXX




Step 2: Estimate the total selling and

administrative expenses.

LO 2




Step 3: Divide the total product cost by the

number of units expected to be

produced and sold to determine the

total product cost per unit, as shown

below.


LO 2

Product Cost per unit = Total Product Cost

Estimated Units

Produced and Sold



Step 4. Compute the markup percentage

as follows:


LO 2

Markup Percentage =

Desired Profit + Total Selling

and Administrative Expenses

Total Product Cost



Step 5. Determine the markup per unit by

multiplying the markup percentage

times the product cost per unit as

follows:


LO 2

Markup per Unit = Markup Percentage x Product Cost per Unit



Step 6. Determine the normal selling price

by adding the markup per unit to

the product cost per unit as follows:


LO 2

Total product cost per unit $XXX

Markup per unit XXX

Normal selling price per unit $XXX




LO 2


Direct materials ($3.00 x 100,000) $ 300,000

Direct labor ($10.00 x 100,000) 1,000,000

Factory overhead 200,000

Total Manufacturing costs $1,500,000

Selling and administrative expenses 170,000

Total cost $1,670,000

Total assets $800,000

Desired rate of return 20%

Assume the following data for 100,000 calculators

that Digital Solutions Inc. expects to produce and sell

during the current year:




LO 2

Step 1: Estimate the total product cost as

follows:

Product costs:

Direct materials $ XXXXX

Direct labor XXXXX

Factory overhead XXX

Total product cost $1,500,000



Step 2: Estimate the total selling and

administrative expenses.


LO 2

Management expects total

selling and administrative

expenses to be $170,000.



Step 3: Divide the total product cost by the

number of units expected to be

produced and sold to determine the

total product cost per unit, as shown

below.


LO 2

Product Cost per Unit = Total Product Cost

Estimated Units Produced

and Sold

= $1,500,000

100,000 units = $15.00 per unit



Step 4. Compute the markup percentage

as follows:


LO 2

Markup Percentage =

Desired Profit + Total Selling and

Administrative Expenses

Total Product Cost

Markup Percentage = $160,000 + $170,000

$1,500,000

Markup Percentage = $330,000

$1,500,000 = 22%

Desired Rate of

Return x Total

Assets

0.20 x $800,000




LO 2

Step 5. Determine the markup per unit by

multiplying the markup percentage

times the product cost per unit as

follows:

Markup per Unit = Markup Percentage x Product Cost per Unit

Markup per Unit = 22% x $15.00 = $3.30 per unit



Step 6. Determine the normal selling price

by adding the markup per unit to

the product cost per unit as follows:

LO 2

Total product cost per unit $15.00

Markup per unit 3.30

Normal selling price per unit $18.30





LO 2

Manufacturing

Cost

Product Cost

Markup Administrative

Expense

+

Selling Expense

+

Desired Profit



EE 24-7



Target Costing

Target costing is a method of setting prices

that combines market-based pricing with a

cost-reduction emphasis. A future selling

price is anticipated, using the demand-

based or the competition-based methods.

LO 2

Target Cost = Expected Selling Price –

Desired Profit



Target Costing

LO 2

The planned cost reduction is sometimes

referred to as the cost “drift.” Costs can be

reduced in a variety of ways such as:

Simplifying the design

Reducing the cost of direct materials

Reducing the direct labor costs

Eliminating waste



Target Costing

LO 2




Compute the relative

profitability of

products in bottleneck

production processes.



Production Bottlenecks, Pricing, and Profits

A production bottleneck (or constraint) is a

point in the manufacturing process where

the demand for the company’s product

exceeds the ability to produce the product.

LO 3



Production Bottlenecks, Pricing, and Profits

The theory of constraints (TOC) is a

manufacturing strategy that focuses on

reducing the influence of bottlenecks on

production processes.

LO 3



Production Bottlenecks and Profits

PrideCraft Tool Company makes

three types of wrenches: small,

medium, and large. All three

products are processed through a

heat treatment operation, which

hardens the steel tools. PrideCraft

Tool’s heat treatment process is

operating at full capacity and is a

production bottleneck.

LO 3

(continued)

http://rds.yahoo.com/_ylt=A0PDoTAokGlN1zAAYgCjzbkF/SIG=13hpst9ru/EXP=1298792616/**http%3a//images.all-free-download.com/images/graphiclarge/wrench_outline_icon_clip_art_9263.jpg




LO 3

Small Medium Large

Wrench Wrench Wrench

The product unit contribution margin and the

number of hours of heat treatment used by each

type of wrench are as follows:

Sales price per unit $130 $140 $160

Variable cost per unit 40 40 40

Contribution margin per unit $ 90 $100 $120

Heat treatment hours per unit 1 hr. 4 hrs. 8 hrs.

(continued)





LO 3

= Unit Contribution Margin

Heat Treatment Hours per Unit

Small Wrenches

Unit Contribution Margin per

Production Bottleneck Hour =

$90

1 hr.

= $90 per hour

Medium Wrenches



$100

4 hrs. = $25 per hour

Large Wrenches



$120

8 hrs. = $15 per hour


Production Bottleneck Hour

$90 per hour

The small wrench is the

most profitable product

per bottleneck hour.




PrideCraft Tool Company can improve the

profitability of producing the large wrenches by

any combination of the following:

Increase the selling price of the large

wrenches.

Decrease the variable cost per unit of the

large wrenches.

Decrease the heat treatment hours

required for the large wrenches.

Production Bottlenecks and Pricing

LO 3




EE 24-8




LO 3

How much should PrideCraft Tool Co. charge for

the large wrench in order to deliver the same

contribution margin of $90 that is being provided

by the small wrench?

(continued)





LO 3

Contribution

Margin (per unit)

per Bottleneck

Hour for Small

Wrench

=

Revised Price of

Large Wrench

Variable Cost per Unit

for Large Wrench –

Bottleneck Hours per Unit for

Large Wrench

$90 =

Revised Price of

Large Wrench – $40

8

$720 = Revised Price of Large Wrench – $40

$760 = Revised Price of Large Wrench

(continued)




Proof

Unit Contribution Margin

per Bottleneck Hour =


Heat Treatment Hours per Unit


per Bottleneck Hour =

$760 - $40

8 hrs.


per Bottleneck Hour = $90 per hr.


LO 3

(concluded)




Appendix

Total and Variable

Cost Concepts to

Setting Normal Price



Under the total

cost concept, all

costs of

manufacturing a

product plus the

selling and

administrative

expenses are

included in the

total cost to which

the markup is

added.

Manufacturing

Cost

Selling

Expenses

Administrative

Expenses Total cost

Total Cost Concept

Appendix



Total Cost Concept

Appendix

The markup percentage is

determined by applying

the following formula:

Markup

percentage = Desired profit

Total cost

Manufacturing

Cost

Selling

Expenses

Administrative

Expenses

Desired Profit



Total Cost Concept

Appendix

To illustrate the seven steps used when the total

cost concept is applied, examine the data in the

next slide. Digital Solutions Inc. expects to

produce and sell 100,000 calculators during the

current year. The company desires a 20% rate of

return on its total assets of $800,000.



Total Cost Concept

Appendix


Direct materials ($3.00 x 100,000) $ 300,000

Direct labor ($10.00 x 100,000) 1,000,000

Factory overhead:

Variable costs ($1.50 x 100,000) $150,000

Fixed costs 50,000 200,000

Total Manufacturing costs $1,500,000

Selling and administrative expenses:

Variable expenses ($1.50 x 100,000) $150,000

Fixed costs 20,000

Total selling and administrative expenses 170,000

Total cost $1,670,000



Total Cost Concept

Appendix

Only the desired profit is

covered in the markup.

= 9.6% =

Total cost per calculator $16.70

Markup ($16.70 x 9.6%) 1.60

Selling price $18.30

$160,000

$1,670,000

Desired profit

Total cost



Total Cost Concept

Appendix

The ability of the selling price of $18.30 to generate

the desired profit of $160,000 is illustrated by the

income statement shown below.



Variable Cost Concept

Under the variable cost concept, only

variable costs are included in the cost

amount per unit to which the markup is

added.

Appendix



Product Cost

Markup

Variable

Manufacturing

Cost

+

Variable

Administrative

and Selling

Expenses

Total Fixed

Costs +

Desired

Profit


Appendix




Appendix

Markup

Percentage

Desired Profit + Total Fixed Costs and

Expenses =

Total Variable Cost

Markup

Percentage

$160,000 + $50,000 + $20,000 =

$1,600,000

Direct materials ($3 x 100,000) $ 300,000

Direct labor ($10 x 100,000) 1,000,000

Variable factory overhead

($1.50 x 100,000) 150,000

Variable selling and

administrative expenses

($1.50 x 100,000) 150,000

Total variable costs $1,600,000




Appendix

Markup

Percentage

$160,000 + $50,000 + $20,000 =

$1,600,000

Markup

Percentage =

$230,000

$1,600,000 = 14.4%

Markup

Percentage

Desired Profit + Total Fixed Costs and

Expenses =

Total Variable Cost



Digital Solutions Inc. would price each calculator at

$18.30 per unit, as shown below:


Variable cost per calculator $16.00

Markup ($16.00 x 14.4%) 2.30

Selling price $18.30

Appendix

Prepared by: C. Douglas Cloud

Professor Emeritus of Accounting

Pepperdine University



The End

Differential Analysis and Product Pricing

Documents

No Slide Title · Replacing fixed assets 5. ... On June 22, 2012, Marcus Company is considering ... Estimated annual variable manufacturing costs 225,000