1. Click to edit Master title style 1 Differential Analysis and Product Pricing 24

2. Click to edit Master title style 2 Prepare a differential analysis report for decisions involving leasing or selling equipment, discontinuing an unprofitable segment, manufacturing or purchasing a needed part, replacing usable fixed assets, process further or selling an intermediate product, or accepting additional business at a special price. Objective 1 24-1

3. Click to edit Master title style 3 Differential Analysis Relevant revenues and costs focus on the differences between each alternative. Costs that have been incurred in the past are not relevant to the decision. These costs are called sunk costs. 24-1

4. Click to edit Master title style 4 Differential revenue is the amount of increase or decrease in revenue that is expected from a course of action as compared with an alternative. 24-1

5. Click to edit Master title style 5 Differential cost is the amount of increase or decrease in cost that is expected from a course of action as compared with an alternative. 24-1

6. Click to edit Master title style 6 Differential income or 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 the opposite. 24-1

7. Click to edit Master title style 7 Differential analysis focuses on the effect of alternative courses of action on the relevant revenues and costs. 24-1

8. Click to edit Master title style 8 8 Decisions Differential Analysis Alternative A or Alternative B Differential revenue –Differential cost Differential income or loss Summary 24-1

9. Click to edit Master title style 9 9 Differential Analysis 24-1

10. Click to edit Master title style 10 1.Leasing or selling equipment. 2.Discontinuing an unprofitable segment. 3.Manufacturing or purchasing a needed part. 4.Replacing usable fixed assets. 5.Processing further or selling an intermediate product. 6.Accepting additional business at a special price. Differential analysis is used for analyzing: Uses of Differential Analysis 24-1

11. Click to edit Master title style 11 Marcus Company is considering disposing of equipment that cost $200,000 and that has $120,000 of accumulated depreciation. The equipment can be sold through a broker for $100,000, less a 6% commission. Lease or Sell 24-1

12. Click to edit Master title style 12 Potamkin Company, the lessee, has offered to lease the equipment for five years for a total consideration of $160,000. 24-1

13. Click to edit Master title style 13 At the end of the fifth year of the lease, 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. 24-1

14. Click to edit Master title style 14 Differential Analysis Report—Lease or Sell 24-1 14

15. Click to edit Master title style 15 Traditional Analysis 24-1

16. Click to edit Master title style 16 24-1 Income (Loss) by Product 4 16

17. Click to edit Master title style 17 24-1 Discontinue a Segment or Product Based on the information contained in the condensed income statement (Slide 16), management of Battle Creek Cereal Co. is considering discontinuing Bran Flakes.

18. Click to edit Master title style 18 24-1 Differential Analysis Report—Discontinue an Unprofitable Segment Proposal to Discontinue Bran Flakes September 29, 2008 Differential revenue from annual sales of Bran Flakes: Revenue from sales$100,000 Differential cost of annual sales of Bran Flakes: Variable cost goods sold$60,000 Variable operating expenses 25,000 85,000 Annual differential income from sales of Bran Flakes$15,000 18 Don’t discontinue Bran Flakes!

19. Click to edit Master title style 19 24-1 Traditional Analysis

20. Click to edit Master title style 20 Make or Buy An automobile manufacturer has been purchasing instrument panels for $240 a unit. The factory currently operates at 80% of capacity. The cost per unit is estimated as follows: Direct materials$ 80 Direct labor80 Variable factory overhead52 Fixed factory overhead 68 Total estimated cost per unit$280 24-1

21. Click to edit Master title style 21 Differential Analysis Report—Make or Buy Proposal to Manufacture Instrument Panels February 15, 2008 Purchase price of instrument panel$240.00 Differential cost to manufacture: Direct materials$80.00 Direct labor80.00 Variable factory overhead 52.00 212.00 Cost savings from manufacturing instrument panel$ 28.00 24-1

22. Click to edit Master title style 22 Replace Equipment 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. 24-1

23. Click to edit Master title style 23 The old machines can be sold for $25,000. They can be replaced by a single high-speed machine at a cost of $250,000. The new machine has an estimated useful life of five years and no residual value. 24-1 Using the new machine will reduce variable manufacturing costs from $225,000 to $150,000.

24. Click to edit Master title style 24 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 x 5 Total differential decrease in cost$375,000 Proceeds from sale of present equipment 25,000$400,000 Cost of new equipment 250,000 Net differential decrease in cost, 5-years$150,000 Annual net differential decrease in cost—new equipment$ 30,000 Proposal to Replace Equipment November 28, 2008 Differential Analysis Report—Replace Equipment 24-1 24

25. Click to edit Master title style 25 A business produces kerosene in batches of 4,000 gallons. Standard quantities of 4,000 gallons of direct materials are processed, which cost $0.60 per gallon. Process or Sell 24-1

26. Click to edit Master title style 26 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 costs $650 per batch, and 20% of the gallons of kerosene will evaporate during production. 24-1

27. Click to edit Master title style 27 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 Proposal to Process Kerosene Further October 1, 2008 Differential Analysis Report—Process or Sell 24-1 27

28. Click to edit Master title style 28 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 per unit (variable, $12.50; fixed, $7.50). The domestic unit selling price is $30. 24-1

29. Click to edit Master title style 29 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. 24-1

30. Click to edit Master title style 30 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 Proposal to Sell Basketballs to Exporter March 10, 2008 Differential Analysis Report—Sell at Special Price 24-1

31. Click to edit Master title style 31 Determine the selling price of a product using the total cost, product cost, variable cost, and target cost concepts. Objective 2 24-2

32. Click to edit Master title style 32 Setting Normal Product Selling Prices 1.Demand-based methods 2.Competition-based methods Cost-Plus Methods Market Methods 1.Total cost concept 2.Product cost concept 3.Variable cost concept The basic approaches to setting prices are: 24-2

33. Click to edit Master title style 33 Market Methods  Demand-based methods set the price according to the demand for the product.  Competition-based methods set the price according to the price offered by competitors. 24-2

34. Click to edit Master title style 34 Markup Using the cost-plus methods, managers add to the cost an amount called a markup, so that all costs plus a profit are included in the selling price. 24-2

35. Click to edit Master title style 35 Using the total cost concept, all costs of manufacturing a product... Manufacturing Cost Total Cost Concept 24-2

36. Click to edit Master title style 36 …plus the selling and administrative expenses... Manufacturing Cost Selling Expenses Administrative Expenses 24-2

37. Click to edit Master title style 37 …are included in the cost to which the markup is added. Manufacturing Cost Selling Expenses Administrative Expenses Total cost 24-2

38. Click to edit Master title style 38 Manufacturing Cost Selling Expenses Administrative Expenses The markup is determined by applying the following formula: Markup percentage = Desired profit Total costs Desired selling price Desired Profit 24-2

39. Click to edit Master title style 39 Per UnitTotalCost Variable Costs: Direct materials$ 3.00$ 300,000 Direct labor10.001,000,000 Factory overhead1.50150,000 Selling and admin. exp. 1.50 150,000 Total variable costs$16.00$1,600,000 Fixed Costs: Factory overhead.5050,000 Selling and admin. exp..20 20,000 Total fixed costs. 70 70,000 Total costs$16.70$1,670,000 Digital Solutions Inc.—100,000 calculators 39 24-2

40. Click to edit Master title style 40 Only the desired profit is covered in the markup. Desired profit Total costs = 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 Markup Percentage 24-2

41. Click to edit Master title style 41 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 Digital Solutions Inc. Income Statement For the Year Ended December 31, 2008 Proof That Selling the Calculators at $18.30 Will Generate the Desired Profit 24-2

42. Click to edit Master title style 42 Using the product cost concept, only the costs of manufacturing the product, termed the product cost, are included in the cost amount to which the markup is added. Product Cost Concept 24-2

43. Click to edit Master title style 43 Per UnitTotalCost Variable Costs: Direct materials$ 3.00$ 300,000 Direct labor10.001,000,000 Factory overhead1.50150,000 Selling and administrative 1.50 150,000 Total variable costs $16.00$1,600,000 Fixed Costs: Factory overhead.5050,000 Selling and administrative.20 20,000 Total fixed costs.70 70,000 Total costs$16.70$1,670,000 Digital Solutions Inc.—100,000 calculators Product cost $1.5 million 24-2

44. Click to edit Master title style 44 Manufacturing Cost Product Cost Markup Administrative Expense + Selling Expense + Desired Profit Desired Selling Price 24-2

45. Click to edit Master title style 45 Markup Percentage Desired Profit + = Total Selling and Administrative Expenses Total Manufacturing Costs The markup percentage for the product cost concept is determined by applying the following formula: Markup Percentage Formula 24-2

46. Click to edit Master title style 46 Markup Percentage 24-2 Markup Percentage Desired Profit + = Total Selling and Administrative Expenses Total Manufacturing Costs

47. Click to edit Master title style 47 Markup Percentage Desired Profit + = Total Selling and Administrative Expenses Total Manufacturing Costs Markup Percentage DM ($3 x 100,000)$ 300,000 DL ($10 x 100,000)1,000,000 Factory overhead: Variable ($1.50 x 100,000)150,000 Fixed 50,000 Total manufacturing costs$1,500,000 DM ($3 x 100,000)$ 300,000 DL ($10 x 100,000)1,000,000 Factory overhead: Variable ($1.50 x 100,000)150,000 Fixed 50,000 Total manufacturing costs$1,500,000 Markup Percentage $160,000 + $170,000 = $1,500,000 24-2

48. Click to edit Master title style 48 Markup Percentage Desired Profit + = Total Selling and Administrative Expenses Total Manufacturing Costs Markup Percentage $160,000 + $170,000 = $1,500,000 Markup Percentage = $330,000 $1,500,000 = 22% 24-2

49. Click to edit Master title style 49 Manufacturing cost per calculator $15.00 Markup ($15.00 x 22%) 3.30 Selling price $18.30 Digital Solutions Inc. would price each calculator at $18.30 per unit, as shown below: 24-2

50. Click to edit Master title style 50 Variable Cost Concept The variable cost concept emphasizes the distinction between variable and fixed costs in product pricing. Only variable costs are include in the cost amount to which the markup is added. 24-2

51. Click to edit Master title style 51 Product Cost Markup Variable Manufacturing Cost + Variable Administrative and Selling Expenses Total Fixed Costs + Desired Profit Desired Selling Price 24-2

52. Click to edit Master title style 52 Markup Percentage Desired Profit + = Total Fixed Costs Total Variable Costs 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 52 24-2

53. Click to edit Master title style 53 Markup Percentage Desired Profit + = Total Fixed Costs Total Variable Costs Markup Percentage = $230,000 $1,600,000 = 14.4% Markup Percentage $160,000 + $50,000 + $20,000 = $1,600,000 53 24-2

54. Click to edit Master title style 54 Variable cost per calculator $16.00 Markup ($16.00 x 14.4%) 2.30 Selling price $18.30 Digital Solutions Inc. would price each calculator at $18.30 per unit, as shown below: 24-2

55. Click to edit Master title style 55 Choosing a Cost-plus approach All three of the cost-plus methods just shown resulted in the same selling price…so how does a company choose which method? 24-2 Primarily it boils down to the costs of gathering data – which set of costs is it easiest to get?

56. Click to edit Master title style 56 Target Costing Under target costing, a future selling price is anticipated, using the demand-based methods or the competition-based methods. The targeted cost is determined by subtracting a desired profit from the expected selling price. 24-2

57. Click to edit Master title style 57 Target Cost Concept Present Future 24-2

58. Click to edit Master title style 58 Calculate the relative profitability of products in bottleneck production environments. Objective 3 24-3

59. Click to edit Master title style 59 24-3 Product Profitability Under Production Bottlenecks A production bottleneck (or constraint) occurs at the point in the process where the demand for the company’s product exceeds the ability to produce the product.

60. Click to edit Master title style 60 24-3 Pridecraft Tool company makes three types of wrenches: S, M, and L. All three must goes through heat treatment, which hardens the tool. The heat treatment process is operating at full capacity, and is a production bottleneck. What can Pridecraft do to maximize profit?

61. Click to edit Master title style 61 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 4 8 SmallMediumLarge WrenchWrenchWrench 24-3 Pride Craft Tool Co. Example

62. Click to edit Master title style 62 Sales price$130$140$160 Variable cost per unit 40 40 40 Contribution margin per unit$ 90$100$120 Bottleneck (heat treatment) hours per unit / 1/ 4 / 8 Contribution margin (per unit) per bottleneck hour$ 90$ 25$ 15 SmallMediumLarge WrenchWrenchWrench Greatest contribution margin (per unit) per bottleneck hour 24-3 Contribution Margin (per unit) per Bottleneck Hour

63. Click to edit Master title style 63 How much should the firm charge for the large wrench in order to deliver the same contribution margin [$90 (see Slide 62)] as the small wrench? Product Pricing Under Production Bottlenecks 24-3

64. Click to edit Master title style 64 24-3 64 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

65. Click to edit Master title style 65 Revised price of large wrench (Slide 82)$760 Less: Variable cost per unit of large wrench 40 Contribution margin per unit of large wrench$720 Bottleneck hours per unit of large wrench/ 8 Revised contribution margin (per unit) per bottleneck hour$ 90 Proof 24-3