1. Differential Cost Analysis (aka Incremental Analysis)
Chapter 7
Differential Cost Analysis (aka Incremental Analysis)
for Operating Decisions

2. Describe & Define Differential Analysis
Differential analysis focuses on differences among particular alternative actions
Sometimes referred to as incremental cost analysis
A differential cost or revenue is a cost or revenue that differs as a result of changing activities or levels of activities

3. Differential Analysis Model
Alternative -
Status Quo =
Difference
Revenue
Change in Revenue
Less Variable Costs (VC)
VC -
VC =
Change in VC
Total Contribution Margin (CM) CM
Change in CM
Less Fixed Costs
Fixed Costs -
Fixed Costs =
Change in Fixed Costs
Operating Profit
Profit -
Profit =
Change in Profit

4. Differential Analysis Cont.
A cost (or revenue) is relevant only if it differs between alternatives under consideration
Focus is typically on cash flows because:
Cash is the medium of exchange
Cash is a common, objective measure of benefits and costs of alternatives

5. Review Short-Run vs. Long-Run Pricing Decisions
The time horizon of a decision is important in determining the relevant costs in a pricing decision
Short-run decisions include pricing for a one-time special order
Long-run decisions include pricing a main product in a major market

6. What is the differential approach to pricing?
This approach assumes that the price must be at least equal or greater than the differential cost of producing and selling the product
In the short-run the price should provide a positive contribution to covering fixed costs and generating profit
In the long-run the price must cover all costs, because both fixed and variable costs become differential in the long run

7. Long-Run Pricing Decisions (Slide 1 of 3)
Define Full cost
This is the total cost of producing and selling the product from R & D through customer service
Includes all costs incurred by activities making up the value chain

8. Review the Value Chain Value Chain Activities R & D Design Produc-
tion
Market-
ing
Distrib-
ution
Customer Service
Premanufacturing
(Upstream)
Manufacturing
Post-manufacturing
Downstream
Costs

9. Long-Run Pricing Decisions (Slide 3 of 3)
The full cost approach is justified in pricing decisions when:
Entering into long-term contracts to supply a product
Developing and producing a customized product
Initially setting prices, then adjusting for market conditions

10. Review Life-Cycle Product Costing and Pricing
The product life cycle covers time period from initial R & D through the point at which support to customers is withdrawn
This highlights the importance of setting prices that cover all costs in the value chain
To be profitable, a firm must generate sufficient revenue to cover all costs

11. Explain Using Target Prices to Set Target Costs
Target costing is the concept of price-based costing
Target price – is the estimated price a potential customer is willing to pay
Target Cost = target price – target profit
The target cost is the estimated long-run cost of the product or service that enables company to realize targeted profit

12. Explain Legal Issues Relating Costs to Prices
Pricing must not be predatory
i.e., Cannot price products below cost in an effort to drive out competition
Cost may be defined as full or variable costs depending on jurisdiction
Dumping occurs when a foreign company sells products in U.S. at a price below market value in country of origin

13. Customer Profitability
Differential analysis is useful in determining which customers to keep or drop
Dropping a customer should result in cost savings in excess of lost revenue
The alternative uses of extra capacity available after dropping a customer should be included in the analysis

14. What are the four general categories of customer costs?
Customer costs generally consist of the following 4 categories of activities:
Cost to acquire customers
Cost to provide goods and services
Cost to maintain customers
Cost to retain customers
ABC provides a better understanding of the cost of these activities

15. Build a Chart of Activities to Compute Customer Costs
Acquire
Promote Product
Win Back Lost Customers
Run Advertising Campaigns
Provide Goods & Services
Process Order
Deliver Product
Process Returns
Maintain
Bill Customers
Process Payments
Issue Refunds
Retain
Follow-up Calls

16. Comment on Decisions when Scarce Resources are Limited
One of the most difficult decisions a manager must make is how to allocate scarce resources among multiple products.
The decisions is not based upon which product has the largest selling price or profit.

17. Decisions with Scarce Resources
The manager must determine how much contribution margin each product makes per unit of the scarce resource.
Once that is done the manager decides which product makes the most contribution margin for equal amounts of scarce resource.
The product that makes the most contribution margin per unit of the scarce resource is the product to make.

18. Define the Following Theory of Constraints Bottleneck
Focusing on increasing incremental revenue over incremental costs when bottlenecks exist
Bottleneck
When work performed at an operation equals or exceeds its capacity

19. List the Five Steps to Managing Bottlenecks
Recognize bottlenecks determine throughput for the whole plant
Search for the bottlenecks by finding where inventory backs up
Subordinate non-bottleneck resources to bottleneck resources
Increase bottleneck capacity and efficiency
Repeat steps 1 through 4 for new bottlenecks

20. Explain Make or Buy Decisions
Companies have the option of deciding to meet needs internally or to acquire goods or services externally (outsourcing)
You should compare the relevant costs of making to buying. The lower cost is the better alternative, all other things being equal. Only costs that differ between the alternatives are relevant costs.

21. Define the Following Split-Off Point Joint Costs
Is the point at which multiple identifiable products emerge from a joint process
Joint Costs
Are costs incurred up to the split-off point, they must be allocated to the multiple products
Additional Processing Costs
Costs occurring after the split-off point

22. How do you decide whether to process further or not?
List additional revenue of products if processed further
List additional costs of products if processed further
Subtract additional costs from additional revenue: if positive, then process further; if negative do not process further

23. Make or Buy
Outsourcing: The decision to buy parts or services rather than making them
Example:
Baron Co. incurs the following costs to make 25,000 switches:
Switches can be purchased for $8 per switch ($200,000)
Eliminates all variable costs and $10,000 of fixed costs; however, $50,000 of fixed costs remain

24. Make or Buy Example (Continued)
Net Income Make Buy Increase (Decrease)
Direct materials $ 50, $ $ 50,000
Direct labor 75, ,000
Variable manufacturing costs 40, ,000
Fixed manufacturing costs 60, , ,000
Purchase price , (200,000)
Total annual cost $225, $250, $ (25,000)
Based on analysis of costs under both alternatives:
Purchasing adds $25,000 to cost of switches
Decision: Continue to make switches.

25. Opportunity Costs Example – Baron Company Continued
Assume that buying the switches allows Baron to use the released capacity to generate $28,000 additional income.
Thus, the $28,000 lost income is an additional cost of making the switches
Net Income
Make Buy Increase (Decrease)
Total annual cost $225, $250, $(25,000)
Opportunity cost , ,000
Total cost $253, $250, $ 3,000
Decision: Based on the analysis,
Baron should buy the switches
as the company will be $3,000 better off.

26. Sell or Process Further
Manufacturers may have to decide, at a given point in production, whether to sell now or to process further and sell at a higher price later.
Decision Rule:
Process further as long as the incremental revenue from such processing exceeds the incremental processing costs

27. Sell or Process Further Single-Product Case
Cost to manufacture one unfinished table:
Direct materials $15
Direct labor
Variable manufacturing overhead 6
Fixed manufacturing overhead 4
Manufacturing cost per unit $35
Selling price of unfinished unit is $50
Unused capacity will be used to finish the tables and sell them for $60 per table.
Relevant unit costs of finishing tables:
Direct materials increase $2
Direct labor increase $4
Variable manufacturing overhead costs increase by $2.40 (60 percent of direct labor increase)
Fixed manufacturing costs will not increase

28. Sell or Process Further Single-Product Case (Continued)
Process Net Income Sell Further Increase (Decrease)
Sales per unit $ $ $10.00
Cost per unit
Direct materials (2.00)
Direct labor (4.00)
Variable manufacturing overhead (2.40)
Fixed manufacturing overhead
Total $ $ $(8.40)
Net income per unit $ $ $1.60
Decision: Process further.
Incremental revenue ($10) exceeds incremental processing costs ($8.40); income increases $1.60 per unit

29. Sell or Process Further Multiple-Product Case
Incremental analysis is especially appropriate when multiple products are produced simultaneously
Many end-products are produced from a single raw material and a common production process
Joint products – are when you have multiple end products
Petroleum – gasoline, lubricating oil, kerosene
Joint costs
Are all costs incurred prior to split-off point
And are allocated to individual products based on relative sales value
Joint costs are sunk costs for sell or process further decisions.

30. Sell or Process Further Multiple-Product Case
Example - Marais Creamery decision:
Sell cream and skim milk or
Process them further before selling

31. Sell or Process Further Multiple-Product Case – Example (Continued)
Sell cream or process further into cottage cheese?
Joint cost allocated to cream $ 9,000
Processing cream into cottage cheese $10,000
Expected revenue per day:
Cream $19, Cottage cheese $27,000
Process Net Income Sell Further Increase (Decrease)
Sales per day $19, $27, $ 8,000
Cost per day
Processing cream into
cottage cheese , (10,000)
$19, $17, $ (2,000)
Decision: Do not process the cream further.
Incremental revenue ($8,000) is less than incremental costs ($10,000); income decreases $2,000.

32. Sell or Process Further Multiple-Product Case – Example (Continued)
Sell skim milk or process further into condensed milk?
Joint cost allocated to skim milk $ 5,000
Processing skim milk into condensed milk $ 8,000
Expected revenue per day:
Skim milk $11,000 Condensed milk $26,000
Process Net Income Sell Further Increase (Decrease)
Sales per day $11, $26, $ 15,000
Cost per day
Processing skim milk into
condensed milk , ( 8,000)
$11, $18, $ 7,000
Decision: Process the skim milk further.
Incremental revenue ($15,000) exceeds incremental costs ($8,000); income increases $7,000.

33. Eliminate an Unprofitable Segment
Key: Focus on relevant costs
Consider effect on related product lines
Determine if fixed costs allocated to the unprofitable segment must be absorbed by the other segments
Net income may decrease when an unprofitable segment is eliminated
Decision Rule:
Retain the segment unless fixed costs eliminated exceed the contribution margin lost

34. Eliminate an Unprofitable Segment
Example – Martina Company
Manufactures three models of tennis racquets:
Profitable lines: Pro and Master
Unprofitable line: Champ
Champs fixed costs are not eliminated
Condensed Income Statement data:
Should Champ be eliminated?
Pro Master Champ Total
Sales $800,000 $300,000 $100,000 $1,200,000
Variable expenses , , , ,000
Contribution margin 280,000 90,000 10, ,000
Fixed expenses , , , ,000
Net income $200,000 $ 40,000 $(20,000) $ 220,000

35. Eliminate an Unprofitable Segment Example (Continued)
If Champ is eliminated, allocate its $30,000 fixed costs:
2/3 to Pro and 1/3 to Master
Revised Income Statement data:
Total income has decreased by $10,000 ($220,000 - $210,000)
Pro Master Total
Sales $800,000 $300,000 $1,100,000
Variable expenses , , ,000
Contribution margin 280,000 90, ,000
Fixed expenses , , ,000
Net income $180, $ 30,000 $ 210,000
ELIMINATE CHAMP?

36. Eliminate an Unprofitable Segment Example (Continued)
Incremental analysis of Champ provides the same results
The decrease in net income is due to Champ’s contribution margin ($10,000) that will not be realized if the segment is discontinued
ELIMINATE CHAMP? Net Income
Continue Eliminate Increase (Decrease)
Sales $100,000 $ $(100,000)
Variable expenses , ,000
Contribution margin 10, (10,000)
Fixed expenses , ,
Net income $(20,000) $ (30,000) $ (10,000)
Decision: Do not eliminate Champ.

37. Allocate Limited Resources
Resources are always limited. For example:
floor space for a retail firm
raw material, direct labor hours, or machine capacity for a manufacturing firm
Management must decide which products to make and sell to maximize net income

38. Allocate Limited Resources
Example – Collins Company
Produces standard and deluxe pen and pencil sets
Limiting resource – 3,600 machine hours per month
The deluxe set has the higher contribution margin: $8
The standard set takes fewer machine hours per unit
Deluxe set Standard set
Contribution margin per unit $ $6
Machine hours required per unit per unit

39. Allocate Limited Resources Example (Continued)
Must compute contribution margin per unit of limited
resource
The standard sets have higher contribution margin per unit of limited resources
Decision:
Shift sales mix to standard sets or increase machine capacity