PowerPointPresentation by PowerPoint Presentation by Gail B. Wright Professor of Accounting Bryant University © Copyright 2007 Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star Logo, and South-Western are trademarks used herein under license. CARL S. WARREN SURVEY OF ACCOUNTING Chapter 12

2 LEARNING OBJECTIVES When you finish this chapter, you should be able to

3 1.Prepare differential analysis report for 6 special decisions. 2.Determine selling price under 3 cost conditions. 3.Calculate relative profitability in bottleneck production environment. LEARNING OBJECTIVES

4 LEARNING OBJECTIVE 1 Prepare differential analysis report for 6 special decisions.

5 DIFFERENTIAL ANALYSIS Differential analysis looks at effects of different courses of action  Uses estimated revenues, costs  Focuses on relevant revenues, costs  Sunk costs are past costs that are not relevant Differential analysis looks at effects of different courses of action  Uses estimated revenues, costs  Focuses on relevant revenues, costs  Sunk costs are past costs that are not relevant LO 1

6 DIFFERENTIAL ANALYSIS Focuses on effect of alternative courses of action on relevant revenues and costs LO 1

7 DIFFERENTIAL REVENUE Increase or decrease in revenue derived from a particular course of action compared to an alternative LO 1

8 DIFFERENTIAL COSTS Increase or decrease in costs derived from a particular course of action compared to an alternative LO 1

9 6 SPECIAL DECISIONS LO 1  Lease or sell  Discontinue product, segment  Make or buy  Replace equipment  Process or sell  Accept business at special price

10 LO 1 Marcus has equipment to dispose of. Cost = $200,000 Accumulated depreciation = $120,000 Should Marcus lease ($160,000 less $35,000 repairs, Taxes, etc.) Or sell ($100,000 less 6% commission) the equipment ? Marcus has equipment to dispose of. Cost = $200,000 Accumulated depreciation = $120,000 Should Marcus lease ($160,000 less $35,000 repairs, Taxes, etc.) Or sell ($100,000 less 6% commission) the equipment ? LEASE OR SELL: Problem Statement

11 Book value of equipment ($80,000) is a sunk cost and not considered. Analysis focuses on differential revenues and differential costs LEASE OR SELL: Analysis LO 1

12 EXHIBIT 1 Decision : Lease alternative provides $31,000 more income. LO 1

13 LO 1 Battle Creek Cereals produces & sells 3 cereals. Because Bran Flakes exhibits an operating loss, Battle Creek is considering discontinuing production, sale of the product. If fixed costs remain unchanged, Is this the right decision ? Battle Creek Cereals produces & sells 3 cereals. Because Bran Flakes exhibits an operating loss, Battle Creek is considering discontinuing production, sale of the product. If fixed costs remain unchanged, Is this the right decision ? TO DISCONTINUE: Problem Statement

14 EXHIBIT 3 LO 1

15 Fixed costs do not relate to a particular product. We analyze the revenue and costs related to Bran Flakes alone to determine whether Bran Flakes contributes to covering fixed costs in making a discontinue decision. TO DISCONTINUE: Analysis LO 1

16 EXHIBIT 4 LO 1 Decision : Discontinuing Bran Flakes would reduce overall profit by $15,000, the amount that Bran Flakes contributes to covering fixed costs.

17 LO 1 MAKE OR BUY: Problem Statement Direct materials $80Variable overhead $52 Direct labor 80Fixed overhead 68 An automotive company has been buying a part for $240 that it now is considering producing. Cost of production includes Should the company make or buy ?

18 Focus the analysis on differential costs. If the automotive company has excess factory capacity, fixed costs are not relevant to the decision since they will not change. MAKE OR BUY: Analysis LO 1

19 EXHIBIT 6 LO 1 Decision : By including only relevant costs in the analysis, there is a cost savings of $28 per part from making the instrument panel.

20 LO 1 REPLACE EQUIPMENT: Problem Statement A manufacturer is considering replacing several old machines with a total book value, $100,000, remaining useful life, 5 years, with a new machine costing $250,000 less $25,000 proceeds from sale of old equipment. Variable costs with new machine will be reduced from $225,000 to $150,000. Should the company buy the new machine ?

21 Book value of equipment ($100,000) is a sunk cost and not considered. Relevant costs include cost savings of more efficient equipment, product quality. REPLACE EQUIPMENT: Analysis LO 1

22 EXHIBIT 7 LO 1 Decision : Efficiencies achieved with new machine will produce an annual savings of $30,000.

23 OPPORTUNITY COSTS Measures the cost of an alternative choice that is foregone. Ex.: Suppose the net outlay ($225,000) were invested & earned 10% ($22,500). It would still be more beneficial to replace equipment ($30,000). LO 1

24 LO 1 PROCESS OR SELL: Problem Statement A company can produce a 4,000 gallon batch of kerosene with a selling price of $.80 per gallon from 4,000 gallons of raw material costing $.60 per gallon. Alternatively, the company can continue processing the raw material into gasoline selling for $1.25 at an additional cost of $650 per batch and losing 20% of end product. Should the company process or sell ?

25 Initial raw material cost will be incurred in both alternatives & is not considered. Differential revenues from 2 alternatives are only relevant issues. PROCESS OR SELL: Analysis LO 1

26 EXHIBIT 8 LO 1 Decision : Processing further will result in an additional $150 per batch after considering product loss & additional costs.

27 LO 1 SPECIAL BUSINESS: Problem Statement A company currently produces 10,000 basketballs on average each month, although the factory has a capacity of `12,500 basketballs. Variable costs are $12.50, fixed costs are $7.50, and domestic selling price is $30. An offer to sell 5,000 additional basketballs for $18 to a foreign buyer & produced over 3 months is considered. Should the company accept the business ?

28 The company has excess capacity and can produce additional product without incurring additional fixed costs. Whether differential revenue covers relevant costs and produces income is the issue. SPECIAL BUSINESS: Analysis LO 1

29 EXHIBIT 9 LO 1 Decision : This special business should be accepted because the additional revenue covers the variables costs & increases income.

30 LEARNING OBJECTIVE 2 Determine selling price under 3 cost conditions.

31 ROLE OF COST CONCEPT Uses “cost + ” to set selling price that provides sufficient profit. LO 2

32 3 COST DETERMINANTS LO 2  Total cost concept  Markup added to total cost  Product cost concept  Markup added to product costs  Variable cost concept  Markup added to variable costs

33 COST INFORMATION LO 2 VARIABLE COSTS* Direct materials$ 3.00 Direct labor10.00 Factory overhead1.50 Selling & Admin Exp1.50 Total$ FIXED COSTS Factory overhead$50,000 Selling & Admin Exp20,000 *per unit

34 MARKUP FORMULA: Total Cost LO 2 Markup % = Desired profit / Total cost

35 BASIC INFORMATION: Total Cost A manufacturer wants to earn a 20% return on assets valued at $800, ,000 calculators will be produced. LO 2

36 SELLING PRICE UNDER TOTAL COST LO 2 Desired profit (800,000 * 20%) $160,000 Selling price {$ (160,000/100,000)} $18.30 CHECK: (100,000 * $18.30) - $1,670,000 = $1,830,000 – 1,670,000 = $160,000

37 CALCULATING MARKUP: Total Cost LO 2 Markup % Desired profit / Total cost = $160,000 / $1,670,000 = 9.6%

38 MARKUP FORMULA: Product Cost LO 2 Markup % = (Desired profit + Selling, Administrative expense) / Manufacturing cost

39 BASIC INFORMATION: Product Cost LO 2 MANUFACTURING COSTS (100,000 UNITS) Direct materials$ 300,000 Direct labor1,000,000 Factory overhead-var150,000 Factory overhead-fix50,000 Total$1,500,000 MANUFACTURING COSTS PER UNIT ($1,500,000/100,000)$15 Desired profit$160,000

40 CALCULATING MARKUP: Product Cost LO 2 Markup % = (Desired profit + Selling, Administrative expense) / Manufacturing cost {$160,000 + ($1.50*100,000) + $20,000} / $1,500,000 22%

41 SELLING PRICE UNDER PRODUCT COST LO 2 Desired profit (800,000 * 20%) $160,000 Selling price {$ ($15 * 22%)} $18.30 CHECK: {100,000 * ($15 + $3.30)} = $18.30

42 MARKUP FORMULA: Variable Cost LO 2 Markup % = (Desired profit + Total fixed costs) / Variable costs

43 BASIC INFORMATION: Product Cost LO 2 VARIABLE COSTS Direct materials$ 300,000 Direct labor1,000,000 Factory overhead-var150,000 Selling, Admin Exp150,000 Total$1,600,000 VARIABLE COSTS PER UNIT ($1,500,000/100,000)$16 Desired profit$160,000

44 CALCULATING MARKUP: Variable Cost LO 2 Markup % = (Desired profit + Total fixed costs) / Variable costs {$160,000 + $50,000 + $20,000} / $1,600, %

45 SELLING PRICE UNDER PRODUCT COST LO 2 Desired profit (800,000 * 20%) $160,000 Selling price {$ ($16 * 14.4%)} $18.30 CHECK: {100,000 * ($16 + $2.30)} = $18.30

46 OTHER COST CONCEPTS LO 2  Activity based costing  Identifies, traces costs to specific activities  Target cost concept  Combines market-based pricing with cost containment  Variable cost concept  Markup added to variable costs

47 LO 2 EXHIBIT 10

48 LEARNING OBJECTIVE 3 Calculate relative profitability in bottleneck production environment.

49 PRODUCTION BOTTLENECKS LO 3 A production bottleneck (constraint) occurs at a point in the production process where demand exceeds the ability to produce the product. Theory of constraints attempts to reduce influence of bottlenecks.

50 ANALYZING PROFIT IN BOTTLENECK LO 3 CM suggests large wrench most profitable BUT Small wrench produces most bottleneck profit.

51 THE END CHAPTER 12