1. Managerial Accounting: An Introduction To Concepts, Methods, And Uses
Chapter 8
Differential Cost Analysis
for Production Decisions
Maher, Stickney and Weil

2. Learning Objectives (Slide 1 of 2)
Explain why businesses apply differential analysis to product choice decisions.
Explain the theory of constraints.
Identify the factors underlying make-or-buy decisions.
Explain how to identify the costs of producing joint products and the relevant costs for decisions to sell or process further.

3. Learning Objectives (Slide 2 of 2)
Explain the use of differential analysis to determine when to add or drop parts of operations.
Identify the factors of inventory management decisions.
Explain how linear programming optimizes the use of scarce resources.
Identify the use of the economic order quantity model.

4. Product Choice Decisions (Slide 1 of 2)
Due to capacity limitations, firms must often choose which goods to make and services to provide
When the firm has a scarce resource used in production (e.g., machine time, skilled labor)
Firm should produce product that gives the largest contribution margin per unit of constrained resource
If more than one scarce resource is involved, choice is more difficult
May use linear programming to determine best product mix

5. Product Choice Decisions (Slide 2 of 2)
Incorrect use of accounting information
In making short-run product choice decisions, one should not rely on product cost information that includes cost allocations
Full-absorption product costing allocates fixed manufacturing costs to units produced
May result in incorrect decisions

6. Theory of Constraints (Slide 1 of 3)
Focuses on increasing the excess of differential revenue over differential costs when firms face bottlenecks
Bottleneck-an operation in which the work performed equals or exceeds the available capacity
Results in inventory waiting until the bottleneck is free

7. Theory of Constraints (Slide 2 of 3)
Encourages managers to find ways to increase profits by relaxing constraints and increasing throughput
Focuses on the following factors:
Throughput contribution - Sales dollars minus variable costs
Investments - Assets required for production and sales
Other operating costs - Other than short-run variable costs

8. Theory of Constraints (Slide 3 of 3)
Objective is to maximize throughput contribution while minimizing investments and operating costs
Key steps involved:
Recognize that bottlenecks determine throughput contribution for the plant as a whole
Find the bottleneck resource
Subordinate all nonbottleneck resources to the bottleneck resource
Increase bottleneck efficiency and capacity

9. Make-or-Buy Decisions
Involve the decision of whether to meet needs internally or to acquire goods and services from external sources (often called outsourcing)
Decision depends on cost factors as well as nonquantitative factors
Differential cost analysis is useful in making these decisions

10. Example-Make or Buy Decision (Slide 1 of 2)
Ben & Jerry Cookie Co. can buy part of its product or produce it internally. Relevant info is as follows:
Buy Make
Unit Selling Price $ $ 30
Sales Volume 800/mth. 800/mth.
Unit Variable Costs $ $ 22
Purchased Ingredients $ $
Total Fixed Costs $3,840 $4,800

11. Example-Make or Buy Decision (Slide 2 of 2)
__Buy Make Difference
Revenue $24,000 $24,
Less:
Variable Costs
-Produce & Sell 8,800 17,600 $(8,800)
-Costs of Goods Bought 9, ,600
Contribution Margin $ 5,600 $ 6,400 $( 800)
Less Fixed Costs 3,840 4,800 (960)
Operating Profit $ 1,760 $ 1,600 $

12. Joint Products: Sell or Process Further
As part of a single production process, multiple products are produced
The point in the production process at which identifiable products emerge is called the splitoff point
Costs incurred up to this point are called joint costs
Costs incurred after the splitoff point are called additional processing costs

13. Joint Production Process
Additional
Processing Costs
Incurred
Joint Costs:
Direct Materials
Direct Labor
Overhead
Sale of
Product A
Sale of
Product B
Splitoff Point

14. Adding or Dropping Parts of Operations
General Rule: If differential revenue from sale of a product > differential costs of providing the product, then the product generates profits and firm should continue production
Even though product may show a loss on financial statements due to overhead allocation to the product
This rule applies to short-run decisions
If more profitable uses of the facilities can be found, it may outweigh the contribution margin lost by dropping a product

15. Inventory Management Decisions
Inventory management affects profitability
Having correct amount and type of inventory can:
Prevent production shutdowns
Avoid lost sales
Inventory is costly to maintain
Costs include storage, insurance, losses from damage and theft, property taxes, etc.

16. Differential Costs for Inventory Management
Two opposing costs to consider
Setup or order costs - costs of setting up machinery for a production run or costs to process a purchase order
Carrying Costs - e.g., cost of maintaining warehouse facilities
Management would like to find the optimal trade-off point between these two costs
Called the economic order quantity (EOQ)

17. Estimating Costs of Maintaining Inventory
Differential Costs to consider include:
Order costs - costs of salaries, lost time for production setups, receiving and inspecting orders, processing invoices, and freight costs
Carrying costs - insurance, inventory taxes, opportunity cost of funds invested in inventory, additional warehouse space

18. Just-in-Time (Slide 1 of 2)
JIT is a method of managing purchasing, production, and sales where the firm attempts to:
Produce items only as needed for the next step in the production process, or
Time purchases so items arrive just in time for production or sale
Can substantially reduce inventory levels

19. Just-in-Time (Slide 2 of 2)
Requires lay out of production process so there is a continuous flow once production starts
Requires reliable processing systems

20. Linear Programming
Managers may face short-run constraints in production resources such as factory capacity, personnel time, floor space, etc
Linear programming is used to address production decisions involving limited resources
Referred to as a constrained optimization technique

21. Economic Order Quantity
Can be determined through trial and error or use the following formula: N=D/Q
Where: Q =
N = optimal number of orders
Q = economic order quantity
D = period demand
K0= order or setup cost
Kc= cost of carrying one unit in inventory

22. Dr. Donald R. Trippeer, CPA Colorado State University-Pueblo
If you have any comments or suggestions concerning this PowerPoint Presentation for Managerial Accounting, An Introduction To Concepts, Methods, And Uses, please contact:
Dr. Donald R. Trippeer, CPA
Colorado State University-Pueblo