2 Describe & Define Differential Analysis Differential analysis focuses on differences among particular alternative actionsSometimes referred to as incremental cost analysisA differential cost or revenue is a cost or revenue that differs as a result of changing activities or levels of activities
3 Differential Analysis Model Alternative -Status Quo =DifferenceRevenueChange in RevenueLess Variable Costs (VC)VC -VC =Change in VCTotal Contribution Margin (CM)CMChange in CMLess Fixed CostsFixed Costs -Fixed Costs =Change in Fixed CostsOperating ProfitProfit -Profit =Change in Profit
4 Differential Analysis Cont. A cost (or revenue) is relevant only if it differs between alternatives under considerationFocus is typically on cash flows because:Cash is the medium of exchangeCash 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 decisionShort-run decisions include pricing for a one-time special orderLong-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 productIn the short-run the price should provide a positive contribution to covering fixed costs and generating profitIn 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 costThis is the total cost of producing and selling the product from R & D through customer serviceIncludes all costs incurred by activities making up the value chain
8 Review the Value Chain Value Chain Activities R & D Design Produc- tionMarket-ingDistrib-utionCustomer ServicePremanufacturing(Upstream)ManufacturingPost-manufacturingDownstreamCosts
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 productDeveloping and producing a customized productInitially 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 withdrawnThis highlights the importance of setting prices that cover all costs in the value chainTo 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 costingTarget price – is the estimated price a potential customer is willing to payTarget Cost = target price – target profitThe 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 predatoryi.e., Cannot price products below cost in an effort to drive out competitionCost may be defined as full or variable costs depending on jurisdictionDumping 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 dropDropping a customer should result in cost savings in excess of lost revenueThe 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:Cost to acquire customersCost to provide goods and servicesCost to maintain customersCost to retain customersABC provides a better understanding of the cost of these activities
15 Build a Chart of Activities to Compute Customer Costs AcquirePromote ProductWin Back Lost CustomersRun Advertising CampaignsProvide Goods & ServicesProcess OrderDeliver ProductProcess ReturnsMaintainBill CustomersProcess PaymentsIssue RefundsRetainFollow-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 Bottleneck Focusing on increasing incremental revenue over incremental costs when bottlenecks existBottleneckWhen work performed at an operation equals or exceeds its capacity
19 List the Five Steps to Managing Bottlenecks Recognize bottlenecks determine throughput for the whole plantSearch for the bottlenecks by finding where inventory backs upSubordinate non-bottleneck resources to bottleneck resourcesIncrease bottleneck capacity and efficiencyRepeat 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 Joint Costs Is the point at which multiple identifiable products emerge from a joint processJoint CostsAre costs incurred up to the split-off point, they must be allocated to the multiple productsAdditional Processing CostsCosts occurring after the split-off point
22 How do you decide whether to process further or not? List additional revenue of products if processed furtherList additional costs of products if processed furtherSubtract additional costs from additional revenue: if positive, then process further; if negative do not process further
23 Make or BuyOutsourcing: The decision to buy parts or services rather than making themExample: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) Net Income Make Buy Increase (Decrease)Direct materials $ 50, $ $ 50,000Direct labor 75, ,000Variable manufacturing costs 40, ,000Fixed manufacturing costs 60, , ,000Purchase price , (200,000)Total annual cost $225, $250, $ (25,000)Based on analysis of costs under both alternatives:Purchasing adds $25,000 to cost of switchesDecision: Continue to make switches.
25 Opportunity Costs Example – 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 switchesNet IncomeMake Buy Increase (Decrease)Total annual cost $225, $250, $(25,000)Opportunity cost , ,000Total cost $253, $250, $ 3,000Decision: Based on the analysis,Baron should buy the switchesas 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 Further Single-Product Case Cost to manufacture one unfinished table:Direct materials $15Direct laborVariable manufacturing overhead 6Fixed manufacturing overhead 4Manufacturing cost per unit $35Selling price of unfinished unit is $50Unused capacity will be used to finish the tables and sell them for $60 per table.Relevant unit costs of finishing tables:Direct materials increase $2Direct labor increase $4Variable manufacturing overhead costs increase by $2.40 (60 percent of direct labor increase)Fixed manufacturing costs will not increase
28 Sell or Process Further Single-Product Case (Continued) Process Net Income Sell Further Increase (Decrease)Sales per unit $ $ $10.00Cost per unitDirect materials (2.00)Direct labor (4.00)Variable manufacturing overhead (2.40)Fixed manufacturing overheadTotal $ $ $(8.40)Net income per unit $ $ $1.60Decision: Process further.Incremental revenue ($10) exceeds incremental processing costs ($8.40); income increases $1.60 per unit
29 Sell or Process Further Multiple-Product Case Incremental analysis is especially appropriate when multiple products are produced simultaneouslyMany end-products are produced from a single raw material and a common production processJoint products – are when you have multiple end productsPetroleum – gasoline, lubricating oil, keroseneJoint costsAre all costs incurred prior to split-off pointAnd are allocated to individual products based on relative sales valueJoint costs are sunk costs for sell or process further decisions.
30 Sell or Process Further Multiple-Product Case Example - Marais Creamery decision:Sell cream and skim milkorProcess them further before selling
31 Sell or Process Further Multiple-Product Case – Example (Continued) Sell cream or process further into cottage cheese?Joint cost allocated to cream $ 9,000Processing cream into cottage cheese $10,000Expected revenue per day:Cream $19, Cottage cheese $27,000Process Net Income Sell Further Increase (Decrease)Sales per day $19, $27, $ 8,000Cost per dayProcessing cream intocottage cheese , (10,000)$19, $17, $ (2,000)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 Further Multiple-Product Case – Example (Continued) Sell skim milk or process further into condensed milk?Joint cost allocated to skim milk $ 5,000Processing skim milk into condensed milk $ 8,000Expected revenue per day:Skim milk $11,000 Condensed milk $26,000Process Net Income Sell Further Increase (Decrease)Sales per day $11, $26, $ 15,000Cost per dayProcessing skim milk intocondensed milk , ( 8,000)$11, $18, $ 7,000Decision: 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 costsConsider effect on related product linesDetermine if fixed costs allocated to the unprofitable segment must be absorbed by the other segmentsNet income may decrease when an unprofitable segment is eliminatedDecision Rule:Retain the segment unless fixed costs eliminated exceed the contribution margin lost
34 Eliminate an Unprofitable Segment Example – Martina CompanyManufactures three models of tennis racquets:Profitable lines: Pro and MasterUnprofitable line: ChampChamps fixed costs are not eliminatedCondensed Income Statement data:Should Champ be eliminated?Pro Master Champ TotalSales $800,000 $300,000 $100,000 $1,200,000Variable expenses , , , ,000Contribution margin 280,000 90,000 10, ,000Fixed expenses , , , ,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 MasterRevised Income Statement data:Total income has decreased by $10,000 ($220,000 - $210,000)Pro Master TotalSales $800,000 $300,000 $1,100,000Variable expenses , , ,000Contribution margin 280,000 90, ,000Fixed expenses , , ,000Net income $180, $ 30,000 $ 210,000ELIMINATE CHAMP?
36 Eliminate an Unprofitable Segment Example (Continued) Incremental analysis of Champ provides the same resultsThe decrease in net income is due to Champ’s contribution margin ($10,000) that will not be realized if the segment is discontinuedELIMINATE CHAMP? Net IncomeContinue Eliminate Increase (Decrease)Sales $100,000 $ $(100,000)Variable expenses , ,000Contribution margin 10, (10,000)Fixed expenses , ,Net income $(20,000) $ (30,000) $ (10,000)Decision: Do not eliminate Champ.
37 Allocate Limited Resources Resources are always limited. For example:floor space for a retail firmraw material, direct labor hours, or machine capacity for a manufacturing firmManagement must decide which products to make and sell to maximize net income
38 Allocate Limited Resources Example – Collins CompanyProduces standard and deluxe pen and pencil setsLimiting resource – 3,600 machine hours per monthThe deluxe set has the higher contribution margin: $8The standard set takes fewer machine hours per unitDeluxe set Standard setContribution margin per unit $ $6Machine hours required per unit per unit
39 Allocate Limited Resources Example (Continued) Must compute contribution margin per unit of limitedresourceThe standard sets have higher contribution margin per unit of limited resourcesDecision:Shift sales mix to standard sets or increase machine capacity