1. AC239 Managerial Accounting Seminar 9 Jim Eads, CPA, MST, MSF Differential Analysis and Product Pricing 1

2. Differential Analysis Relevant revenues and costs focus on the differences between possible future alternatives. Sunk costs are costs that have been incurred in the past. They are not relevant to the decisions about the future. 2

3. Differential Analysis Differential revenue is the amount of increase or decrease in revenue that is expected from a course of action as compared with an alternative. Differential cost is the amount of increase or decrease in cost that is expected from a course of action as compared with an alternative. 3

4. Differential Analysis 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. 4

5. Differential Analysis Differential analysis focuses on the effect of alternative courses of action on the relevant revenues and costs. 5

6. Differential Analysis 6

7. Differential analysis is used to analyze the following alternatives: 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. 7

8. Lease or Sell Alternative 1: 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. 8

9. Lease or Sell Alternative 2: Potamkin Company has offered to lease the equipment from Marcus for five years for a total consideration of $160,000. At the end 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. 9

10. Lease or Sell Differential Analysis: 10

11. Lease or Sell Traditional Analysis: 11

12. Discontinue a Segment or Product Based on the information contained in the condensed income statement (next slide), management of Battle Creek Cereal Co. is considering discontinuing Bran Flakes. 12

13. Discontinue a Segment or Product 13

14. Discontinue a Segment or Product Differential Analysis: 14 Proposal to Discontinue Brand 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 of goods sold$60,000 Variable operating expenses25,00085,000 Annual differential income from sales of Bran Flakes$15,000

15. Discontinue a Segment or Product Traditional Analysis: 15

16. 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: 16 Direct materials$80 Direct labor80 Variable factory overhead52 Fixed factor overhead68 Total estimated cost per unit$280

17. Make or Buy Differential Analysis: 17 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 overhead52.00212.00 Cost savings from manufacturing$28.00

18. Replace Equipment A business is considering the disposal of several identical machines having a total book value of $100,000, an estimated remaining life of five years, and annual total variable costs of $225,000. The old machines can be sold for $25,000 and replaced by a single high-speed machine at a cost of $250,000 and with annual variable costs of $150,000. The new machine has an estimated useful life of five years and no residual value. 18

19. Replace Equipment Differential Analysis: 19 Proposal to Replace Equipment November 28, 2008 Annual variable costs – present equipment$225,000 Annual variable costs – new equipment150,000 Annual differential decrease in cost$75,000 Number of years applicablex 5 Total differential decrease in cost$375,000 Proceeds from sale of present equipment25,000$400,000 Cost of new equipment250,000 Net difference decrease in cost over 5 years$150,000 Annual difference decrease in cost$30,000

20. Opportunity Cost Opportunity cost is the amount of income that is foregone from an alternative use of an asset, such as cash. 20

21. Process or Sell A business produces kerosene in batches of 4,000 gallons at a standard cost of $0.60 per gallon. Kerosene can be sold without further processing for $0.80 per gallon or it can be 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. 21

22. Process or Sell Differential Analysis: 22 Proposal to Process Kerosene Further October 1, 2008 Differential revenue from further processing per batch: Revenue from sale of gasoline (4,000 gallons – 800 gallons evaporation @ $1.25)$4,000 Less revenue from sale of kerosene (4000 @ $0.80)3,200 Differential revenue$800 Additional cost of producing gasoline650 Differential income from further processing gasonline per batch$150

23. Example Exercise 25-5 (page 1141) 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. 23

24. Example Exercise 25-5 (page 1141) Differential Analysis: 24 Proposal to Process Product T into Product V Different revenue from further processing: Revenue per gallon from sale of Product V$4.00 Revenue per gallon from sale of Product T3.50 Differential Revenue per gallon$0.50 Differential cost per gallon: Additional cost to produce Product V: ($1.60 - $0.90)0.70 Differential loss from producing Product V:$0.20

25. 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. 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. 25

26. Accept Business at a Special Price Differential Analysis: 26 Proposal to Sell Basketballs to Exporter March 10, 2008 Differential revenue from accepting offer: Total revenue (5,000 @ $18)$90,000 Differential cost of accepting offer: Total variable cost (5,000 @ $12.50)62,000 Differential income from accepting offer$27,500

27. Setting Normal Selling Prices Market Methods Market Methods –Demand-based methods –Competition-based methods Cost-Plus Methods Cost-Plus Methods –Total cost concept –Product cost concept –Variable cost concept 27

28. 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. 28

29. Cost-Plus Methods 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. 29

30. Total Cost Concept Using the total cost concept, all costs of manufacturing a product plus the selling and administrative expenses are included in the cost to which the markup is added. Market Percentage = Desired Profit / Total Cost 30

31. Total Cost Concept Total cost to make a calculator is $16.70. Desired profit is $1.60 per calculator Markup Percentage = $1.60 / $16.70 = 9.6%. Selling price = $16.70 + $1.60 = $18.30. 31

32. Product Cost Concept Using the product cost concept, only the product costs (direct materials, direct labor, and factory overhead) are included in the cost amount to which the markup is added. Markup Percentage = (Desired Profit + Selling and Administrative Expenses) / Total Product Costs 32

33. 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. Markup Percentage = (Desired Profit + Fixed Costs) / Variable Costs 33

34. 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. 34

35. Bottleneck Constraint 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. The theory of constraints (TOC) is a manufacturing strategy that focuses on reducing the influence of bottlenecks on a process. Produce the product that provides the maximum contribution margin per unit of bottleneck (typically hours). Or, re-price other products to increase contribution margin per unit of bottleneck. 35

36. Questions? 36

37. One last thought…. It has been my pleasure! Best of luck on your final exam! 37