Warren Reeve Duchac Managerial Accounting 13e Differential Analysis and Product Pricing 9 C H A P T E R human/iStock/360/Getty Images

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Differential Analysis(slide 1 of 2)

• Managerial decision making involves choosing between alternative courses of action.

• Although the managerial decision-making process varies by the type of decision, it normally involves the following steps:o Step 1. Identify the objective of the decision, which is

normally maximizing income.o Step 2. Identify alternative courses of action.o Step 3. Gather information and perform a differential

analysis.o Step 4. Make a decision.o Step 5. Review, analyze, and assess the results of the

decision.

©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Differential Analysis(slide 2 of 2)

• Differential analysis, sometimes called incremental analysis, analyzes differential revenues and costs in order to determine the differential impact on income of two alternative courses of action.o Differential revenue is the amount of increase or

decrease in revenue that is expected from a course of action compared to an alternative.

o Differential cost is the amount of increase or decrease in cost that is expected from a course of action as compared to an alternative.

o Differential income (loss) is the difference between the differential revenue and differential costs.


Lease or Sell

• Management may lease or sell a piece of equipment that is no longer needed. In making a decision, differential analysis can be used.

• Only the differential revenues and differential costs associated with the lease-or-sell decision are included in the differential analysis.o The book value of the 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.©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

• A product, department, branch, territory, or other segment of a business may be generating losses. As a result, management may consider discontinuing (eliminating) the product or segment.

• Discontinuing the product or segment usually eliminates all of the product’s or segment’s variable costs such as direct materials, direct labor, variable factory overhead, and sales commissions.

• However, fixed costs such as depreciation, insurance, and property taxes may not be eliminated.

Discontinuing a Segment or Product


• Companies that manufacture products made up of components that are assembled into a final product, such as automobile manufacturers, must decide whether to make a part or purchase it from a supplier.

• Differential analysis can be used to decide whether to make or buy a part.

Make or Buy


Replace Equipment(slide 1 of 2)

• The usefulness of a fixed asset may decrease before it is worn out.o For example, old equipment may no longer be

as efficient as new equipment.

• Differential analysis can be used for decisions to replace fixed assets such as equipment and machinery.o The analysis normally focuses on the costs of

continuing to use the old equipment versus replacing the equipment. The book value of the old equipment is a sunk cost

and, thus, is irrelevant.


• 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.

Replace Equipment(slide 2 of 2)


• During manufacturing, a product normally progresses through various stages or processes. In some cases, a product can be sold at an intermediate stage of production, or it can be processed further and then sold.

• Differential analysis can be used to describe whether to sell a product at an intermediate stage or to process it further.

Process or Sell


• A company may be offered the opportunity to sell its products at prices other than normal prices.o For example, an exporter may offer to sell a company’s

products overseas at special discount prices.

• Differential analysis can be used to decide whether to accept business at a special price.o If the company is operating at less than full capacity,

then the additional production does not increase fixed manufacturing costs.

o Fixed costs are not affected by the decision and are, thus, omitted from the analysis.

o However, selling and administrative expenses may change because of the additional business.

Accept Business at a Special Price


• The normal selling price is the target selling price to be achieved in the long term.

• The normal selling price must be set high enough to cover all costs and expenses (fixed and variable) and provide a reasonable profit.

Setting Normal Product Selling Prices(slide 1 of 3)


• Managers can use one of two market methods to determine selling price:o Demand-based concept

The demand-based concept sets the price according to the demand for the product.

– If there is high demand for the product, then the price is set high.

– Likewise, if there is low demand for the product, then the price is set low.

o Competition-based concept The competition-based concept sets the price

according to the price offered by competitors.– For example, if a competitor reduces the price, then

management adjusts the price to meet the competition.



• Managers can also use one of three cost-plus methods to determine the selling price:o Product cost concepto Total cost concepto Variable cost concept



• Cost-plus methods determine the normal selling price by estimating a cost amount per unit and adding a markup, computed as follows:

o Management determines the markup based on the desired profit for the product.

o The markup should be sufficient to earn the desired profit plus cover any costs and expenses that are not included in the cost amount.

Product Cost Concept(slide 1 of 4)


• 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.

• Estimated selling expenses, administrative expenses, and desired profit are included in the markup.

• The markup per unit is then computed and added to the product cost per unit to determine the normal selling price.



• Step 1. Estimate the total product costs as follows:

• Step 2. Estimate the total selling and administrative expenses.

• 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, computed as follows:



• Step 4. Compute the markup percentage as follows:

o The desired profit is normally computed based on a rate of return on assets as follows:

• Step 5. Determine the markup per unit by multiplying the markup percentage times the product cost per unit as follows:

• Step 6. Determine the normal selling price by adding the markup per unit to the product cost per unit as follows:



• Target costing is a method of setting prices that combines market-based pricing with a cost-reduction emphasis.

• Under target costing, a future selling price is anticipated, using the demand-based or the competition-based methods.

• The target cost is then determined by subtracting a desired profit from the expected selling price, computed as follows:

Target Costing(slide 1 of 2)


• The target cost is normally less than the current cost.

• Managers must try to reduce costs from the design and manufacture of the product.o The planned cost reduction is sometimes

referred to as the cost drift. o Costs can be reduced by:

Simplifying the design Reducing the cost of direct materials Reducing the direct labor costs Eliminating waste

Target Costing(slide 2 of 2)


• 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.

• The theory of constraints (TOC) is a manufacturing strategy that focuses on reducing the influence of bottlenecks on production processes.

• When a company has a production bottleneck in its production process, it should attempt to maximize its profits, subject to the production bottleneck. o In doing so, the unit contribution margin of

each product per production bottleneck constraint is used.

Production Bottlenecks


• Under the total cost concept, manufacturing cost plus the selling and administrative expenses are included in the total cost per unit.

• The markup per unit is then computed and added to the total cost per unit to determine the normal selling price.

Appendix: Total Cost Concept(slide 1 of 3)


• Step 1. Estimate the total manufacturing cost as follows:

• Step 2. Estimate the total selling and administrative expenses.

• Step 3. Estimate the total cost as follows:

• Step 4. Divide the total cost by the number of units expected to be produced and sold to determine the total cost per unit, as follows:





• Step 6. Determine the markup per unit by multiplying the markup percentage times the cost per unit as follows:

• Step 7. Determine the normal selling price by adding the markup per unit to the cost per unit as follows:



• Under the variable cost concept, only variable costs are included in the cost amount per unit to which the markup is added.

• All variable manufacturing costs, as well as variable selling and administrative expenses, are included in the cost amount.

• Fixed manufacturing costs, fixed selling and administrative expenses, and desired profit are included in the markup.

• The markup per unit is then added to the variable cost per unit to determine the normal selling price.

Appendix: Variable Cost Concept(slide 1 of 3)


• Step 1. Estimate the total variable product cost as follows:

• Step 2. Estimate the total variable selling and administrative expenses.

• Step 3. Determine the total variable cost as follows:

• Step 4. Compute the variable cost per unit as follows:





• Step 6. Determine the markup per unit by multiplying the markup percentage times the variable cost per unit as follows:

• Step 7. Determine the normal selling price by adding the markup per unit to the variable cost per unit as follows:



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Warren Reeve Duchac Managerial Accounting 13e Differential Analysis and Product Pricing 9 C H A P T E R human/iStock/360/Getty Images