1. 1 Introduction to Accounting and Business 25 Differential Analysis and Product Pricing

2. 1-2 25-2 2 1-2 After studying this chapter, you should be able to: Differential Analysis and Product Pricing 3 Compute the relative profitability of products in bottleneck production processes. 2 Determine the selling price of a product using the total cost, product cost, and variable cost concepts. 1 Prepare differential analysis reports for a variety of managerial decisions. 25-2

3. 1-3 25-3 3 1 1 Prepare differential analysis reports for a variety of managerial decisions. 25-3

4. 1-4 25-4 4 Managerial Decision Making Step 1:Identify the objective of the decision Step 2:Identify the alternative courses of action Step 3:Gather relevant information Step 4:Make a decision Step 5:Review, analyze, and assess the results of the decision 1

5. 1-5 25-5 5 Sunk Costs Costs that have been incurred in the past are not relevant to the decision. These costs are called sunk costs. 1

6. 1-6 25-6 6 Differential revenue is the amount of increase or decrease in revenue that is expected from a course of action as compared with an alternative action. Differential Revenue 1

7. 1-7 25-7 7 Differential cost is the amount of increase or decrease in cost that is expected from a course of action as compared with an alternative action. Differential Cost 1

8. 1-8 25-8 8 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. Differential Income or Loss 1

9. 1-9 25-9 9 Differential analysis focuses on the effect of alternative courses of action on the relevant revenues and costs. Differential Analysis 1

10. 1-10 25-10 10 Differential Analysis Exhibit 1 1

11. 1-11 25-11 11 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 Differential analysis is used to analyze the following alternatives: 1

12. 1-12 25-12 12 Marcus Company is considering leasing or disposing of the following equipment: Lease or Sell 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 lease35,000 Sell Option: Sales price$100,000 Commission on sale6% 1

13. 1-13 25-13 13 Differential Analysis Report—Lease or SellExhibit 2 1

14. 1-14 25-14 14 Traditional AnalysisExhibit 3 1

15. 1-15 25-15 15 Example Exercise 25-1 Lease or Sell 1 25-15 Casper Company owns office space with a cost of $100,000 and accumulated depreciation of $30,000 that can be sold for $150,000, less a 6% broker commission. Alternatively, the office space can be leased by Casper Company for ten years for a total of $170,000 at the end of which there is no salvage value. In addition, repair, insurance, and property tax that would be incurred by Casper Company on the rented office space would total $24,000 over the ten years. Determine the differential income or loss from the lease alternative for Casper Company.

16. 1-16 25-16 16 1 For Practice: PE 25-1A, PE 25-1B 25-16 Follow My Example 25-1 Example Exercise 25-1 (continued) Differential revenue from alternatives: Revenue from lease……………………………..$170,000 Revenue from sale……………………………… 150,000 Differential revenue from lease…………...$20,000 Differential cost of alternatives: Repair, insurance, and property tax expense……………………………………….$ 24,000 Commission expense…………………………... 9,000 Differential cost of lease…………………… 15,000 Net differential income from lease alternatives$ 5,000

17. 1-17 25-17 17 Management may consider discontinuing the product or segment of a business that is generating losses. Based on the information contained in the condensed income statement (Slide 18), management of Battle Creek Cereal Co. is considering discontinuing Bran Flakes. Discontinue a Segment or Product 1

18. 1-18 25-18 18 Income (Loss) by ProductExhibit 4 1

19. 1-19 25-19 19 Differential Analysis Report—Discontinue an Unprofitable Segment Don’t discontinue Bran Flakes! Exhibit 5 1

20. 1-20 25-20 20 Traditional Analysis Exhibit 6 1

21. 1-21 25-21 21 Example Exercise 25-2 Discontinue a Segment 1 25-21 Product A has revenue of $65,000, variable cost of goods sold of $50,000, variable selling expenses of $12,000, and fixed costs of $25,000, creating a loss from operations of $22,000. a. Determine the differential income or loss from sales of Product A. b. Should Product A be discontinued?

22. 1-22 25-22 22 1 For Practice: PE 25-2A, PE 25-2B 25-22 Example Exercise 25-2 (continued) b. Product A should not be discontinued. Follow My Example 25-2 a.Differential revenue from sales of Product A: a. Revenue from sales$65,000 Differential costs of Product A: Variable cost of goods sold$50,000 Variable selling expenses 12,000 62,000 Annual differential income from Product A$ 3,000

23. 1-23 25-23 23 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 1

24. 1-24 25-24 24 Differential Analysis Report—Make or BuyExhibit 7 1

25. 1-25 25-25 25 Example Exercise 25-3 Make or Buy 1 25-25 A company manufactures a subcomponent of an assembly for $80 per unit, including fixed costs of $25 per unit. A proposal is offered to purchase the subcomponent from an outside source for $60 per unit, plus $5 per unit freight. Provide a differential analysis of the outside purchase proposal.

26. 1-26 25-26 26 1 For Practice: PE 25-3A, PE 25-3B 25-26 Example Exercise 25-3 (continued) Follow My Example 25-3 a. Differential cost to purchase: Purchase price of the subcomponent..……..$60 Freight for subcomponent..…………………... 5$65 Differential cost to manufacture: Variable manufacturing costs ($80 – $25 fixed cost)……………………………………. 55 Cost savings from manufacturing subcomponent.................................................$10

27. 1-27 25-27 27 Replace Equipment A business is considering replacing the following machine: Old Machine Book value$100,000 Estimated variable manufacturing costs225,000 Estimated selling price25,000 Estimated remaining useful life5 years (continued) 1

28. 1-28 25-28 28 Replace Equipment New Machine Cost of new machine$250,000 Estimated variable manufacturing costs150,000 Estimated residual value0 Estimated useful life5 years 1

29. 1-29 25-29 29 Differential Analysis Report—Replace MachineExhibit 8 1

30. 1-30 25-30 30 The amount of income that is foregone from an alternative use of an asset, such as cash, is called an opportunity cost. Opportunity Cost 1

31. 1-31 25-31 31 Example Exercise 25-4 Replace Equipment 1 25-31 A machine with a book value of $32,000 has an estimated four-year life. A proposal is offered to sell the old machine for $10,000 and replace it with a new machine at a cost of $45,000. The new machine has a four-year life with no salvage value. The new machine would reduce annual direct labor costs by $11,000. Provide a differential analysis on the proposal to replace the machine.

32. 1-32 25-32 32 1 For Practice: PE 25-4A, PE 25-4B 25-32 Example Exercise 25-4 (continued) Follow My Example 25-4 a. Annual direct labor cost reduction………………$11,000 Number of years applicable……………………….× 4 Total differential decrease in cost………………..$44,000 Proceeds from sale of old equipment…………... 10,000$54,000 Cost of new equipment……………………………. 45,000 Net differential decrease in cost from replacing equipment, 4-year total……………...$ 9,000

33. 1-33 25-33 33 A business produces kerosene as follows: Process or Sell Batch size4,000gallons Cost of producing kerosene$2,400per batch Selling price$0.80per gallon (continued) 1

34. 1-34 25-34 34 The kerosene can be processed further to yield gasoline as follows: Process or Sell Input batch size4,000gallons Less evaporation (20%) 800(4,000 × 20%) Output batch size3,200 Additional processing costs$650per batch Selling price$1.25per gallon 1 (continued)

35. 1-35 25-35 35 Differential Analysis Report—Process or Sell Exhibit 9 1

36. 1-36 25-36 36 Example Exercise 25-5 Process or Sell 1 25-36 Product T is produced for $2.50 per gallon, including $1.00 per gallon fixed cost. Product T can be sold without additional processing for $3.50 per gallon, or processed further into Product V at an additional cost of $1.60 per gallon, including $0.90 per gallon fixed cost. Product V can be sold for $4.00 per gallon. Provide a differential analysis for further processing into Product V.

37. 1-37 25-37 37 1 For Practice: PE 25-5A, PE 25-5B 25-37 Example Exercise 25-5 (continued) Follow My Example 25-5 a. Differential revenue from further processing per gallon: Revenue per gallon from sale of Product V…………$4.00 Revenue per gallon from sale of Product T………… 3.50 Differential revenue……………………………………$0.50 Differential cost per gallon: Additional cost for producing Product V ($1.60 – $0.90)………………………………………….. 0.70 Differential loss from further processing into Product V…………………………………………………...$0.20

38. 1-38 25-38 38 Accept Business at a Special Price B-Ball Inc. manufactures basketballs as follows: Monthly productive capacity12,500basketballs Current monthly sales10,000basketballs Normal (domestic) selling price$30.00per basketball Manufacturing costs: Variable costs$12.50 per basketball Fixed costs 7.50 Total$20.00per basketball (continued) 1

39. 1-39 25-39 39 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. Accept Business at a Special Price 1

40. 1-40 25-40 40 Differential Analysis Report— Sell at Special Price Exhibit 10 1

41. 1-41 25-41 41 Example Exercise 25-6 Accept Business at Special Price 1 25-41 Product D is normally sold for $4.40 per unit. A special price of $3.60 is offered for the export market. The variable production cost is $3.00 per unit. An additional export tariff of 10% of revenue will be required to be paid for all export products. Determine the differential income or loss per unit from selling Product D for export.

42. 1-42 25-42 42 1 For Practice: PE 25-6A, PE 25-6B 25-42 Example Exercise 25-6 (continued) Follow My Example 25-6 a. Differential revenue from export: Revenue per unit from export sale………………………………………..$3.60 Differential cost from export: Variable manufacturing costs…………..$3.00 Export tariff (10% × $3.60)………………. 0.36 3.36 Differential income from accepting export sale………………………………….$0.24

43. 1-43 25-43 43 1 2 Determine the selling price of a product using the total cost, product cost, and variable cost concepts. 25-43

44. 1-44 25-44 44 Setting Normal Product Selling Prices 1.Demand-based concept 2.Competition-based concept Cost-Plus Methods Market Methods 1.Total cost concept 2.Product cost concept 3.Variable cost concept The basic approaches to setting prices are: 2

45. 1-45 25-45 45 Market Methods Demand-based concepts set the price according to the demand for the product. Competition-based concepts set the price according to the price offered by competitors. 2

46. 1-46 25-46 46 Markup Using the cost-plus methods, managers add to the cost an amount called a markup. This allows for all costs plus a profit to be included in the selling price. 2

47. 1-47 25-47 47 Under the total cost concept, all costs of manufacturing a product... Manufacturing Cost Total Cost Concept 2

48. 1-48 25-48 48 …plus the selling and administrative expenses... Manufacturing Cost Selling Expenses Administrative Expenses 2

49. 1-49 25-49 49 …are included in the cost to which the markup is added. Manufacturing Cost Selling Expenses Administrative Expenses Total cost 2

50. 1-50 25-50 50 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 2

51. 1-51 25-51 51 To illustrate the seven steps used when the total concept is applied examine the data in Slide 52. Digital Solutions Inc. is expected 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. 2

52. 1-52 25-52 52 Manufacturing costs: Direct materials ($3.00 × 100,000)$ 300,000 Direct labor ($10.00 × 100,000)1,000,000 Factory overhead: Variable costs ($1.50 × 100,000) $150,000 Fixed costs 50,000 200,000 Total manufacturing costs$1,500,000 Selling and administrative expenses: Variable expenses ($1.50 × 100,000)$150,000 Fixed costs 20,000 Total selling and administrative expenses 170,000 Total cost$1,670,000 2

53. 1-53 25-53 53 Only the desired profit is covered in the markup. Desired profit Total costs = 9.6% = Total cost per calculator$16.70 Markup ($16.70 × 9.6%) 1.60 Selling price$18.30 $160,000 $1,670,000 Markup Percentage 2

54. 1-54 25-54 54 Proof that selling the calculators at $18.30 will generate the desired profit of $160,000 is shown below: 2

55. 1-55 25-55 55 Example Exercise 18-2 2 Total Cost Markup Percentage 2 Example Exercise 25-7 25-55 For Practice: PE 25-7A, PE 25-7B Apex Corporation produces and sells Product Z at a total cost of $30 per unit of which $20 is product cost and $10 is selling and administrative expenses. In addition, the total cost of $30 is made up of $18 variable cost and $12 is fixed cost. The desired profit is $3 per unit. Determine the markup percentage on total cost. Follow My Example 25-7 Markup percentage: $3/$30 = 10.0%

56. 1-56 25-56 56 Using the product cost concept, only the costs of manufacturing the product are included in the cost amount to which the markup is added. The markup percentage is computed as follows: Product Cost Concept Markup Percentage = Desired Profit + Total Selling and Administrative Expenses Total Product Cost 2

57. 1-57 25-57 57 Manufacturing costs: Direct materials ($3.00 × 100,000)$ 300,000 Direct labor ($10.00 × 100,000)1,000,000 Factory overhead: Variable costs ($1.50 × 100,000) $150,000 Fixed costs 50,000 200,000 Total manufacturing costs$1,500,000 Selling and administrative expenses: Variable expenses ($1.50 × 100,000)$150,000 Fixed costs 20,000 Total selling and administrative expenses 170,000 Total cost$1,670,000 2

58. 1-58 25-58 58 Manufacturing Cost Product Cost Markup Administrative Expense + Selling Expense + Desired Profit Desired Selling Price 2

59. 1-59 25-59 59 Markup Percentage Desired Profit + = Total Selling and Administrative Expenses Total Manufacturing Costs Calculating the Markup Percentage Markup Percentage $160,000 + $170,000 = $1,500,000 Markup Percentage = 22% 2

60. 1-60 25-60 60 Digital Solutions Inc. would price each calculator at $18.30 per unit, as shown below: 2 Manufacturing cost per calculator$15.00 Markup ($15.00 × 22%) 3.30 Selling price$18.30

61. 1-61 25-61 61 Example Exercise 18-2 2 Product Cost Markup Percentage Example Exercise 25-8 25-61 For Practice: PE 25-8A, PE 25-8B Apex Corporation produces and sells Product Z at a total cost of $30 per unit of which $20 is product cost and $10 is selling and administrative expenses. In addition, the total cost of $30 is made up of $18 variable cost and $12 is fixed cost. The desired profit is $3 per unit. Determine the markup percentage on product cost. Follow My Example 25-8 Markup percentage: ($3 + $10)/$20 = 65.0%

62. 1-62 25-62 62 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. 2

63. 1-63 25-63 63 Product Cost Markup Variable Manufacturing Cost + Variable Administrative and Selling Expenses Total Fixed Costs + Desired Profit Desired Selling Price 2

64. 1-64 25-64 64 Markup Percentage Desired Profit + = Total Fixed Costs Total Variable Costs Markup Percentage $160,000 + $50,000 + $20,000 = $1,600,000 Direct materials ($3 × 100,000)$ 300,000 Direct labor ($10 × 100,000)1,000,000 Variable factory overhead ($1.50 × 100,000)150,000 Variable selling and administrative expenses ($1.50 × 100,000) 150,000 Total variable costs$1,600,000 2

65. 1-65 25-65 65 Markup Percentage Desired Profit + = Total Fixed Costs Total Variable Costs Markup Percentage $160,000 + $50,000 + $20,000 = $1,600,000 Markup Percentage = $230,000 $1,600,000 = 14.4% 2

66. 1-66 25-66 66 Variable cost per calculator $16.00 Markup ($16.00 × 14.4%) 2.30 Selling price $18.30 Digital Solutions Inc. would price each calculator at $18.30 per unit, as shown below: 2

67. 1-67 25-67 67 Example Exercise 18-2 2 Variable Cost Markup Percentage 2 Example Exercise 25-9 25-67 For Practice: PE 25-9A, PE 25-9B Apex Corporation produces and sells Product Z at a total cost of $30 per unit. Of this amount, $10 per unit is selling and administrative costs. The total variable cost is $18 per unit. The desired profit is $3 per unit. Determine the markup percentage on variable cost, rounded to one decimal place. Follow My Example 25-9 Markup percentage on variable cost: ($3 + $12)/$18 = 83.3%, rounded to one decimal place

68. 1-68 25-68 68 Target Costing Target costing is a method of setting prices that combines market-based pricing with a cost reductive emphasis. A future price is anticipated, using the demand-based methods or the competition-based methods. Target Cost = Expected Selling Price – Desired Profit 2

69. 1-69 25-69 69 Target Cost Concept Exhibit 12 PresentFuture $ 2

70. 1-70 25-70 70 1 3 Compute the relative profitability of products in bottleneck production processes. 25-70

71. 1-71 25-71 71 Production Bottlenecks and Profits 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. 3

72. 1-72 25-72 72 The theory of constraints (TOC) is a manufacturing strategy that focuses on reducing the influence of bottlenecks on a process. Theory of Constraints 3

73. 1-73 25-73 73 PrideCraft Tool Company Example 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. (continued) 3

74. 1-74 25-74 74 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. SmallMediumLarge WrenchWrench Wrench The product unit contribution margin and the number of hours of heat treatment used by each wrench are as follows: (continued) 3

75. 1-75 25-75 75 Unit Contribution Margin per Bottleneck Hour = Unit Contribution Margin Heat Treatment Hours per Unit Small Wrenches Unit Contribution Margin per Bottleneck Hour = $90 1 hr. = $90 per hour Medium Wrenches Unit Contribution Margin per Bottleneck Hour = $100 4 hrs. = $25 per hour Large Wrenches Unit Contribution Margin per Bottleneck Hour = $120 8 hrs. = $15 per hour 3

76. 1-76 25-76 76 Unit Contribution Margin per Bottleneck Hour = Unit Contribution Margin Heat Treatment Hours per Unit Small Wrenches Unit Contribution Margin per Bottleneck Hour = $90 1 hr. = $90 per hour Medium Wrenches Unit Contribution Margin per Bottleneck Hour = $100 4 hrs. = $25 per hour Large Wrenches Unit Contribution Margin per Bottleneck Hour = $120 8 hrs. = $15 per hour The small wrench is the most profitable product per bottleneck hour. 3

77. 1-77 25-77 77 Example Exercise 18-2 3 Bottleneck Profit Example Exercise 25-10 25-77 For Practice: PE 25-10A, PE 25-10B Product A has a contribution margin of $15 per unit. Product B has a contribution margin of $20 per unit. Product A requires three furnace hours, while Product B requires five furnace hours. Determine the most profitable product assuming the furnace is a constraint. Follow My Example 25-10 Product A Product B Contribution margin per unit…………………..$15$20 Furnace hours per unit………………………….÷ 3÷ 5 Contribution margin per bottleneck hour……$ 5$ 4 Product A is the most profitable in using bottleneck resources.

78. 1-78 25-78 78 How much should the firm charge for the large wrench in order to deliver the same contribution margin as the small wrench [$90 (Slide 76)]? Production Bottlenecks and Pricing 3

79. 1-79 25-79 79 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 3

80. 1-80 25-80 80 Proof Unit Contribution Margin per Bottleneck Hour = Unit Contribution Margin Heat Treatment Hours per Unit Unit Contribution Margin per Bottleneck Hour = $760 – $40 8 hrs. Unit Contribution Margin per Bottleneck Hour = $90 per hr. 3

81. 1-81 25-81 81 1 Appendix Activity-Based Costing 25-81

82. 1-82 25-82 82 Activity-Based Costing Exhibit 13

83. 1-83 25-83 83 Each product uses different amounts of machine and direct labor hours in the fabrication and assembly activities.

84. 1-84 25-84 84 Estimated Activity-Based Costing—Ruiz Company Exhibit 14 Activity Rate = Budgeted Activity Cost Activity Base Usage

85. 1-85 25-85 85 Activity Rates—Ruiz Company Exhibit 15

86. 1-86 25-86 86 Activity-Base Product Cost Calculations Exhibit 16

87. 1-87 25-87 87