Chapter 24 Differential Analysis and Product Pricing Student Version Principles of Financial and Managerial Accounting 11e Principles of Managerial Accounting 11e Chapter 24 Principles of Financial and Managerial Accounting Using excel for Success Student Version These slides should be viewed using the presentation mode (left click your mouse on the icon). Prepared by: C. Douglas Cloud Professor Emeritus of Accounting Pepperdine University © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Reeve Warren Duchac

Learning Objective 1 Prepare differential analysis reports for a variety of managerial decisions.

Managerial Decision Making LO 1 Differential Analysis Managerial Decision Making Step 2: Identify the alternative courses of action Step 1: Identify the objective of the decision Step 3: Gather relevant information and perform differential analysis. Step 5: Review, analyze, and assess the results of the decision Step 4: Make a decision

Differential Analysis LO 1 Differential Analysis Differential analysis, sometimes called incremental analysis, analyzes differential revenues and costs to determine the differential impact on income of two alternative courses of action. Differential revenue is the amount of increase or decrease in revenue that is expected from a course of action as compared to an alternative.

Differential Analysis LO 1 Differential Analysis Differential cost is the amount of increase or decrease in cost that is expected from a course of action as compared to an alternative.

Differential Analysis LO 1 Differential Analysis Differential income (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 that the decision is expected to decrease income.

LO 1 Lease or Sell On June 22, 2012, Marcus Company is considering leasing or disposing of the following equipment: 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 lease 35,000 Residual value at end of 5th year of lease 0 Sell Option: Sales price $100,000 Commission on sales 6% (continued)

LO 1 Lease or Sell Lease the equipment

LO 1 Lease or Sell The book value of 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.

Discontinue a Segment or Product LO 1 Discontinue a Segment or Product B attle C reek

LO 1 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 of manufacturing a panel internally is estimated as follows: Direct materials $ 80 Direct labor 80 Variable factory overhead 52 Fixed factory overhead 68 Total estimated cost per unit $280

LO 1 Replace Equipment On November 28, 2012, a business is considering replacing the following machine: Old Machine: Book value $100,000 Estimated annual variable manufacturing costs 225,000 Estimated selling price 25,000 Estimated remaining useful life 5 years (continued)

LO 1 Replace Equipment The business is considering replacing the old machine with a new one, as shown below: Old New Book value $100,000 Cost of new machine $250,000 Estimated annual variable manufacturing costs 225,000 150,000 Estimated selling price 25,000 Estimated residual value 0 Estimated remaining useful life 5 years 5 years (continued)

LO 1 Replace Equipment replace old machine

LO 1 Replace Equipment 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.

LO 1 Process or Sell In some cases, a product can be sold at an intermediate stage of production, or it can be processed further and then sold. A business produces kerosene as follows: Batch size 4,000 gallons Cost of producing kerosene $2,400 per batch Selling price $2.50 per gallon (continued)

LO 1 Process or Sell The kerosene can be processed further to yield gasoline as follows: Input batch size 4,000 gallons Less evaporation (20%) 800 (4,000 x 20%) Output batch size 3,200 Cost of producing gasoline $3,050 per batch Selling price $3.50 per gallon (continued)

LO 1 Process or Sell process further

Accept Business at a Special Price LO 1 Accept Business at a Special Price The differential costs of accepting additional business depend on whether the company is operating at full capacity. If the company is operating at full capacity, any additional production increases fixed and variable manufacturing costs. If the company is operating below full capacity, any additional production does not increase fixed manufacturing costs.

Accept Business at a Special Price LO 1 Accept Business at a Special Price B-Ball Inc. manufactures basketballs as follows: Monthly productive capacity 12,500 basketballs Current monthly sales 10,000 basketballs Normal (domestic) selling price $30.00 per basketball Manufacturing costs: Variable costs $12.50 per basketball Fixed costs 7.50 Total $20.00 per basketball (continued)

Accept Business at a Special Price LO 1 Accept Business at a Special Price On March 10, 2012, B-Ball Inc. 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. The domestic market will not be affected. (continued)

Accept Business at a Special Price LO 1 Accept Business at a Special Price

Learning Objective 2 Determine the selling price of a product, using the product cost concept.

Setting Normal Product Selling Prices LO 2 Setting Normal Product Selling Prices The basic approaches to setting prices are: Market methods Demand-based concept Competition-based concept Cost-plus methods Total cost concept Product cost concept Variable cost concept

LO 2 Product Cost Concept 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.

LO 2 Product Cost Concept Step 1: Estimate the total product costs as follows: Product costs: Direct materials $XXX Direct labor XXX Factory overhead XXX Total product cost $XXX

Estimated Units Produced and Sold LO 2 Product Cost Concept 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, as shown below. Product Cost per unit = Total Product Cost Estimated Units Produced and Sold

Desired Profit + Total Selling and Administrative Expenses LO 2 Product Cost Concept Step 4. Compute the markup percentage as follows: Markup Percentage = Desired Profit + Total Selling and Administrative Expenses Total Product Cost

Desired Profit + Total Selling and Administrative Expenses LO 2 Product Cost Concept Step 4. Compute the markup percentage as follows: Markup Percentage = Desired Profit + Total Selling and Administrative Expenses Total Product Cost Step 5. Determine the markup per unit by multiplying the markup percentage times the product cost per unit as follows: Markup per Unit = Markup Percentage x Product Cost per Unit

LO 2 Product Cost Concept Step 6. Determine the normal selling price by adding the markup per unit to the product cost per unit as follows: Total product cost per unit $XXX Markup per unit XXX Normal selling price per unit $XXX

LO 2 Product Cost Concept Assume the following data for 100,000 calculators that Digital Solutions Inc. expects to produce and sell during the current year: Manufacturing costs: Direct materials ($3.00 x 100,000) $ 300,000 Direct labor ($10.00 x 100,000) 1,000,000 Factory overhead 200,000 Total Manufacturing costs $1,500,000 Selling and administrative expenses 170,000 Total cost $1,670,000 Total assets $800,000 Desired rate of return 20%

LO 2 Product Cost Concept Step 1: Estimate the total product cost. These costs are estimated at $1,500,000. Step 2: Estimate the total selling and administrative expenses. These expenses are estimated at $170,000.

Estimated Units Produced and Sold LO 2 Product Cost Concept 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, as shown below. Total Product Cost Estimated Units Produced and Sold Product Cost per Unit = = $1,500,000 100,000 units = $15.00 per unit

Product Cost Concept Step 4. Compute the markup percentage as follows: Desired Profit + Total Selling and Administrative Expenses Total Product Cost Desired Rate of Return x Total Assets Markup Percentage = Markup Percentage = $160,000 + $170,000 $1,500,000 0.20 x $800,000 Markup Percentage = $330,000 $1,500,000 = 22%

LO 2 Product Cost Concept Step 5. Determine the markup per unit by multiplying the markup percentage times the product cost per unit as follows: Markup per Unit = Markup Percentage x Product Cost per Unit Markup per Unit = 22% x $15.00 = $3.30 per unit

LO 2 Product Cost Concept Step 6. Determine the normal selling price by adding the markup per unit to the product cost per unit as follows: Total product cost per unit $15.00 Markup per unit 3.30 Normal selling price per unit $18.30

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

Learning Objective 3 Compute the relative profitability of products in bottleneck production processes.

Production Bottlenecks, Pricing, and Profits LO 3 Production Bottlenecks, Pricing, and Profits 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.

Production Bottlenecks and Profits LO 3 Production Bottlenecks and Profits P 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)

Production Bottlenecks and Profits LO 3 Production Bottlenecks and Profits P The product unit contribution margin and the number of hours of heat treatment used by each type of wrench are as follows: Small Medium Large Wrench Wrench Wrench 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. (continued)

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

Production Bottlenecks and Pricing LO 3 Production Bottlenecks and Pricing P PrideCraft Tool Company can improve the profitability of producing the large wrenches by any combination of the following: Increase the selling price of the large wrenches. Decrease the variable cost per unit of the large wrenches. Decrease the heat treatment hours required for the large wrenches.

Production Bottlenecks and Pricing LO 3 Production Bottlenecks and Pricing P 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

Differential Analysis and Product Pricing The End