1. Differential Analysis, Product Pricing, and Activity-Based Costing
PRINCIPLES OF ACCOUNTING
24e
ACCOUNTING PRINCIPLES
Using excel for Success 2e
Chapter 25
Prepared by: C. Douglas Cloud
Professor Emeritus of Accounting
Pepperdine University
These slides should be viewed using the presentation mode (click the icon to start presentation).
Reeve Warren Duchac
© 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.

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

3. 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

4. Bryant Restaurants, Inc.
LO 1
Differential Analysis
Bryant Restaurants, Inc.
Step 2: Identify the alternative courses of action
Use floor space for existing tables, or…
replace the tables with a salad bar.
Step 1: Identify the objective of the decision
Increase its income.
Tables Salad Bar
Revenues $100,000 $120,000
Costs 60, ,000
Income $ 40,000 $ 55,000
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
Replace tables with salad bar

5. 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.

6. 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 income (loss) is the difference between the differential revenue and the differential costs.

7. LO 1
Lease or Sell
The $80,000 book value of the 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.

8. Discontinue a Segment or Product
LO 1
Discontinue a Segment or Product
Management may consider discontinuing a product or segment of a business that is generating losses. The management of Battle Creek Cereal Co. is considering discontinuing Bran Flakes.

9. LO 1
Make or Buy
Companies often manufacture products made up of components that are assembled into a final product. Should they make or buy the parts?

10. 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
Total estimated cost per unit $280

11. 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.

12. 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.

13. 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.

14. Learning Objective 2
Prepare differential analysis reports for a variety of managerial decisions.
Determine the selling price of a product, using the product cost concept.

15. 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

16. Setting Normal Product Selling Prices
LO 2
Setting Normal Product Selling Prices
The demand-based concept sets the price according to the demand for the product.
The competition-based concept sets the price according to the price offered by competitors.

17. 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.

18. 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

19. LO 2
Product Cost Concept
Step 2: Estimate the total selling and administrative expenses.

20. 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.
Product Cost per unit =
Total Product Cost
Estimated Units Produced and Sold

21. 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

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

23. 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

24. 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 ,000
Total Manufacturing costs $1,500,000
Selling and administrative expenses ,000
Total cost $1,670,000
Total assets $800,000
Desired rate of return 20%

25. LO 2
Product Cost Concept
Step 1: Estimate the total product cost as follows:
Product costs:
Direct materials $ XXXXX
Direct labor XXXXX
Factory overhead XXX
Total product cost $1,500,000

26. LO 2
Product Cost Concept
Step 2: Estimate the total selling and administrative expenses.
Management expects total selling and administrative expenses to be $170,000.

27. 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 =
Product Cost per Unit =
$1,500,000
100,000 units
= $15.00 per unit

28. 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 Rate of Return x Total Assets
Markup Percentage =
$160,000 + $170,000
$1,500,000
0.20 x $800,000
$330,000
$1,500,000
= 22%
Markup Percentage =

29. 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

30. 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
Normal selling price per unit $18.30

31. 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

32. LO 2
Target Costing
The planned cost reduction is sometimes referred to as the cost “drift.” Costs can be reduced in a variety of ways such as the following:
Simplifying the design
Reducing the cost of direct materials
Reducing the direct labor costs
Eliminating waste

33. Learning Objective 3
Prepare differential analysis reports for a variety of managerial decisions.
Determine the selling price of a product, using the product cost concept.
Compute the relative profitability of products in bottleneck production processes.

34. 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.

35. Production Bottlenecks, Pricing, and Profits
LO 3
Production Bottlenecks, Pricing, and Profits
The theory of constraints (TOC) is a manufacturing strategy that focuses on reducing the influence of bottlenecks on production processes.

36. Production Bottlenecks and Profits
LO 3
Production Bottlenecks and Profits
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)

37. Production Bottlenecks and Profits
LO 3
Production Bottlenecks and Profits
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
Contribution margin per unit $ 90 $100 $120
Heat treatment hours per unit 1 hr. 4 hrs. 8 hrs.
(continued)

38. Unit Contribution Margin Heat Treatment Hours per Unit
LO 3
Production Bottlenecks and Profits
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

39. Production Bottlenecks and Pricing
LO 3
Production Bottlenecks and Pricing
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.

40. Production Bottlenecks and Pricing
LO 3
Production Bottlenecks and Pricing
How much should PrideCraft Tool Co. charge for the large wrench in order to deliver the same contribution margin of $90 that is being provided by the small wrench?

41. Production Bottlenecks and Pricing
LO 3
Production Bottlenecks and Pricing
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

42. Learning Objective 4
Prepare differential analysis reports for a variety of managerial decisions.
Determine the selling price of a product, using the product cost concept.
Compute the relative profitability of products in bottleneck production processes.
Allocate product costs using activity-based costing.

43. Activity-Based Costing Method
LO 4
Activity-Based Costing Method
Activity-based costing (ABC) identifies and traces costs and expenses to activities and then to specific products.
Activities are the types of work, or actions, involved in a manufacturing process or service activity.

44. Estimated Activity Costs
LO 4
Estimated Activity Costs
Ruiz Company produces snowmobiles and riding mowers. The company’s total estimated factory overhead of $1,600,000 is assigned to each activity as shown in Exhibit 11 (p of your textbook).
Setup consists of changing tooling in machines in preparation for making a new product.

45. Estimated Activity Costs
LO 4
Estimated Activity Costs
Ruiz Company produces snowmobiles and riding mowers. The company’s total estimated factory overhead of $1,600,000 is assigned to each activity as shown in Exhibit 11.
Engineering changes consists of processing changes in design or process specifications for a product.

46. Estimated Activity Cost Estimated Activity- Base Usage
LO 4
Activity Rates
The estimated activity costs are allocated to products using an activity rate. Activity rates are determined as follows:
Activity Rate =
Estimated Activity Cost
Estimated Activity- Base Usage

47. LO 4
Activity Rates
The activity base is a measure of physical activity for each activity. If setups are the activity base, then activity-base usage is the number of setups estimated to be used by the operations.

48. Dangers of Product Cost Distortion
LO 4
Dangers of Product Cost Distortion
Using an inappropriate factory overhead allocation method can lead to distorted product costs.

49. Estimated Total Factory Overhead Costs Estimated Activity Base
LO 4
Dangers of Product Cost Distortion
Ruiz Company uses a single predetermined factory overhead rate to allocate factory overhead to the riding mower and snowmobile. The estimated factory overhead was allocated using direct labor hours. The overhead rate for Ruiz is as follows:
Predetermined Factory Overhead Rate
Estimated Total Factory Overhead Costs
Estimated Activity Base =
Predetermined Factory Overhead Rate
$1,600,000
20,000 direct labor hours =
= $80

50. Dangers of Product Cost Distortion
LO 4
Dangers of Product Cost Distortion
As a result of using a single predetermined factory overhead rate, $800 was allocated to each snowmobile and riding mower. Comparing the single rate with the ABC method in the chart below shows how a single-rate method can distort costs.

51. Differential Analysis, Product Pricing, and Activity-Based Costing
The End