Visit UMT online at ACCT125© 2006 UMT ACCOUNTING FUNDAMENTALS FOR MANAGERS University of Management and Technology 1901 North Fort Myer Drive Arlington, VA Voice: (703) Fax: (703) Website:

Visit UMT online at ACCT125© 2006 UMT Carl S. Warren Survey of Accounting (2 nd ed.) © 2004 South-Western

12-3 Visit UMT online at ACCT125© 2006 UMT Task Force Clip Art included in this electronic presentation is used with the permission of New Vision Technology of Nepean Ontario, Canada.

Visit UMT online at ACCT125© 2006 UMT Chapter 12 Differential Analysis and Product Pricing

12-5 Visit UMT online at ACCT125© 2006 UMT ContinuedContinued Learning Objectives 1.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. Processing further or selling an intermediate product. Accepting additional business at a special price. After studying this chapter, you should be able to:

12-6 Visit UMT online at ACCT125© 2006 UMT Learning Objectives 2.Determine the selling price of a product using the total cost concept. 3.Calculate the relative profitability of products in bottleneck production environments.

12-7 Visit UMT online at ACCT125© 2006 UMT 1 Prepare a differential analysis report. Learning Objective

12-8 Visit UMT online at ACCT125© 2006 UMT Differential Analysis 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:

12-9 Visit UMT online at ACCT125© 2006 UMT Proposal to Lease or Sell Equipment June 22, 2006 Differential revenue from alternatives: Revenue from lease$160,000 Revenue from sales100,000 Differential revenue from lease$60,000 Differential cost of alternatives: Repairs, insurance, taxesa$ 35,000 Commission expense on sale6,000 Differential cost of lease29,000 Net differential income from leasing$31,000

12-10 Visit UMT online at ACCT125© 2006 UMT Proposal to Lease or Sell Equipment June 22, 2006 Revenue from lease$160,000 Revenue from sales100,000 Repairs, insurance, taxes(35,000) Commission expense on sale(6,000) Totals$125,000 $94,000 LeaseSell This alternative format separates the two options into columns. The net benefit is the same.

12-11 Visit UMT online at ACCT125© 2006 UMT Proposal to Lease or Sell Equipment June 22, 2006 LeaseSell Revenue from lease$160,000 Revenue from sales100,000 Repairs, insurance, taxes(35,000) Commission expense on sale(6,000) Totals$125,000 $94,000 Net benefit from leasing$31,000 This analysis indicates that it would be better to lease the equipment rather then sell it. What other factors should be considered?

12-12 Visit UMT online at ACCT125© 2006 UMT Battle Creek Cereal Co. Condensed Income Statement For the Year Ended August 31, 2006 Bran Corn Toasted Total Flakes Flakes Oats Sales$100,000 $500,000$400,000$1,000,000 Cost of goods sold: Variable costs$ 60,000 $220,000$200,000$ 480,000 Fixed costs20, ,00080,000220,000 Total cost of goods sold$ 80,000 $340,000$280,000$ 700,000 Gross profit$ 20,000 $160,000$120,000$ 300,000 Operating expenses: Variable expenses $ 25,000 $ 95,000$ 60,000$ 180,000 Fixed expenses6,000 25,00020,00051,000 Total operating expenses $31,000 $120,000$ 80,000$ 231,000 Income (loss) from operations$ (11,000)$ 40,000$ 40,000$ 69,000 Should Bran Flakes be discontinued?

12-13 Visit UMT online at ACCT125© 2006 UMT Battle Creek Cereal Co. Condensed Income Statement For the Year Ended August 31, 2006 Bran Corn Toasted Total Flakes Flakes Oats Differential items Sales$100,000 Sales$100,000 $500,000$400,000$1,000,000 Cost of goods sold: Variable costs$ 60,000 $220,000$200,000$ 480,000 Fixed costs20, ,00080,000220,000 Total cost of goods sold$ 80,000 $340,000$280,000$ 700,000 Gross profit$ 20,000 $160,000$120,000$ 300,000 Operating expenses: Variable expenses $ 25,000 $ 95,000$ 60,000$ 180,000 Fixed expenses6,000 25,00020,00051,000 Total operating expenses $31,000 $120,000$ 80,000$ 231,000 Income (loss) from operations$ (11,000)$ 40,000$ 40,000$ 69,000 Should Bran Flakes be discontinued?

12-14 Visit UMT online at ACCT125© 2006 UMT Battle Creek Cereal Co. Condensed Income Statement For the Year Ended August 31, 2006 Bran Corn Toasted Total Flakes Flakes Oats Differential items Sales$100,000 Sales$100,000 $500,000$400,000$1,000,000 Cost of goods sold: Variable costs$ 60,000 Variable costs$ 60,000 $220,000$200,000$ 480,000 Fixed costs20, ,00080,000220,000 Total cost of goods sold$ 80,000 $340,000$280,000$ 700,000 Gross profit$ 20,000 $160,000$120,000$ 300,000 Operating expenses: Variable expenses $ 25,000 $ 95,000$ 60,000$ 180,000 Fixed expenses6,000 25,00020,00051,000 Total operating expenses $31,000 $120,000$ 80,000$ 231,000 Income (loss) from operations$ (11,000)$ 40,000$ 40,000$ 69,000 Should Bran Flakes be discontinued?

12-15 Visit UMT online at ACCT125© 2006 UMT Battle Creek Cereal Co. Condensed Income Statement For the Year Ended August 31, 2006 Bran Corn Toasted Total Flakes Flakes Oats Differential items Sales$100,000 Sales$100,000 $500,000$400,000$1,000,000 Cost of goods sold: Variable costs$ 60,000 Variable costs$ 60,000 $220,000$200,000$ 480,000 Fixed costs20, ,00080,000220,000 Total cost of goods sold$ 80,000 $340,000$280,000$ 700,000 Gross profit$ 20,000 $160,000$120,000$ 300,000 Operating expenses: Variable expenses $ 25,000 Variable expenses $ 25,000 $ 95,000$ 60,000$ 180,000 Fixed expenses6,000 25,00020,00051,000 Total operating expenses $31,000 $120,000$ 80,000$ 231,000 Income (loss) from operations$ (11,000)$ 40,000$ 40,000$ 69,000 If Bran Flakes are discontinued, how would net income be affected?

12-16 Visit UMT online at ACCT125© 2006 UMT Battle Creek Cereal Co. Condensed Income Statement For the Year Ended August 31, 2006 Differential items Bran Corn Toasted Total Flakes Flakes Oats Sales$100,000 Sales$100,000 $500,000$400,000$1,000,000 Cost of goods sold: Variable costs$ 60,000 Variable costs$ 60,000 $220,000$200,000$ 480,000 Fixed costs20, ,00080,000220,000 Total cost of goods sold$ 80,000 $340,000$280,000$ 700,000 Gross profit$ 20,000 $160,000$120,000$ 300,000 Operating expenses: Variable expenses $ 25,000 Variable expenses $ 25,000 $ 95,000$ 60,000$ 180,000 Fixed expenses6,000 25,00020,00051,000 Total operating expenses $31,000 $120,000$ 80,000$ 231,000 Income (loss) from operations$ (11,000)$ 40,000$ 40,000$ 69,000 If Bran Flakes are discontinued, $15,000 of net income will be lost and overall net income would be reduced to $54,000.

12-17 Visit UMT online at ACCT125© 2006 UMT Annual variable costspresent$225,000 Annual variable costsnew equip.150,000 Annual differential decrease in cost$ 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 differential decrease in cost, 5-years$150,000 Annual net differentialnew equipment$ 30,000 Proposal to Replace Equipment November 28, 2006

12-18 Visit UMT online at ACCT125© 2006 UMT Proposal to Replace Equipment November 28, 2006 PresentNewEquipment This analysis indicates that it would be better to replace the existing equipment. What other factors should be considered? Annual variable costs$ 225,000$150,000 Number of years applicablex 5x 5 Total variable costs$1,125,000$750,000 Cost of new equipment250,000 Less proceeds from sale(25,000) Total costs$1,125,000$975,000 Net total benefit to replace $150,000 Net annual benefit to replace$ 30,000

12-19 Visit UMT online at ACCT125© 2006 UMT Differential revenue from further processing per batch: Revenue from sale of gasoline [(4,000 gallons 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 gasoline650 Differential income from further processing gasoline per batch$150 Proposal to Process Kerosene Further October 1, 2006

12-20 Visit UMT online at ACCT125© 2006 UMT Determine the selling price of a product using the total cost concept. 2 Learning Objective

12-21 Visit UMT online at ACCT125© 2006 UMT Setting Normal Product Selling Prices 1.Demand-based methods 2.Competition-based methods 1.Total cost concept 2.Product cost concept 3.Variable cost concept Cost-Plus Methods Cost-Plus Methods Market Methods Market Methods

12-22 Visit UMT online at ACCT125© 2006 UMT Per UnitTotalCost Cost Structure Example (100,000 units) Variable Costs: Direct materials$ 3.00$ 300,000 Direct labor10.001,000,000 Factory overhead ,000 Selling and admin ,000 Fixed Costs: Factory overhead.5050,000 Selling and admin..2020,000 Total costs$16.70$1,670,000 Product costs$15.00$1,500,000 Variable costs$16.00$1,600,000

12-23 Visit UMT online at ACCT125© 2006 UMT Per UnitTotalCost Cost Structure Example (100,000 units) Variable Costs: Direct materials$ 3.00$ 300,000 Direct labor10.001,000,000 Factory overhead ,000 Selling and admin ,000 Fixed Costs: Factory overhead.5050,000 Selling and admin..2020,000 Total costs$16.70$1,670,000 Product costs$15.00$1,500,000 Variable costs$16.00$1,600,000

12-24 Visit UMT online at ACCT125© 2006 UMT Per UnitTotalCost Cost Structure Example (100,000 units) Variable Costs: Direct materials$ 3.00$ 300,000 Direct labor10.001,000,000 Factory overhead ,000 Selling and admin ,000 Fixed Costs: Factory overhead.5050,000 Selling and admin..2020,000 Total costs$16.70$1,670,000 Product costs$15.00$1,500,000 Variable costs$16.00$1,600,000

12-25 Visit UMT online at ACCT125© 2006 UMT Selling Price: Desired profit$ 1.60$ 160,000 Total to markup $ 1.60$ 160,000 Total costs16.701,670,000 Selling price$18.30$1,830,000 Markup Percentage: Markup amount$1.60 Total costs$16.70 Per UnitTotal Total Cost Concept = 9.6% Only the desired profit is covered in the markup. =

12-26 Visit UMT online at ACCT125© 2006 UMT Per UnitTotal Selling Price: Desired profit$ 1.60$ 160,000 Total to markup $ 1.60$ 160,000 Total costs16.701,670,000 Selling price$18.30$1,830,000 Markup Percentage: Markup amount$1.60 Total costs$16.70 Total Cost Concept = 9.6% Markup on total cost =

12-27 Visit UMT online at ACCT125© 2006 UMT Calculate the relative profitability of products in bottleneck production environments. 3 Learning Objective

12-28 Visit UMT online at ACCT125© 2006 UMT ProductsUnit Analysis SmallMediumLarge WrenchWrenchWrench Sales price$130$140$160 Variable cost Contribution margin$ 90$100$120 Profitability Under Production Bottlenecks The process is currently operating at full capacity and is a production bottleneck.

12-29 Visit UMT online at ACCT125© 2006 UMT Sales price$130$140$160 Variable cost Contribution margin$ 90$100$120 Bottleneck hours ProductsUnit Analysis SmallMediumLarge WrenchWrenchWrench Profitability Under Production Bottlenecks The number of hours per unit for each product.

12-30 Visit UMT online at ACCT125© 2006 UMT ProductsUnit Analysis SmallMediumLarge WrenchWrenchWrench Profitability Under Production Bottlenecks Contribution after dividing by the bottleneck hours. Sales price$130$140$160 Variable cost Contribution margin$ 90$100$120 Bottleneck hours Bottleneck contribution$ 90$ 25$ 15

12-31 Visit UMT online at ACCT125© 2006 UMT ProductsUnit Analysis SmallMediumLarge WrenchWrenchWrench Sales price$130$140$160 Variable cost Contribution margin$ 90$100$120 Bottleneck hours Bottleneck contribution$ 90$ 25$ 15 Profitability Under Production Bottlenecks What price for Product C would equate its profitability to Product A?

12-32 Visit UMT online at ACCT125© 2006 UMT ProductsUnit Analysis SmallMediumLarge WrenchWrenchWrench Sales price$130$140$160$760 Variable cost Contribution margin$ 90$100$120$720 Bottleneck hours Bottleneck contribution$ 90$ 25$ 15$ 90 Profitability Under Production Bottlenecks A price of $760 will provide the same contribution as Product A.