1. c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Differential Analysis, Product Pricing, and Activity-Based Costing Chapter 24

2. Learning Objectives 1. Prepare differential analysis reports for a variety of managerial decisions. 2. Determine the selling price of a product, using the product cost concept. 3. Compute the relative profitability of products in bottleneck production processes. 4. Allocate product costs using activity-based costing.

3. c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Learning Objective Prepare differential analysis reports for a variety of managerial decisions. 1

4. c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Differential Analysis o Managerial decision making involves choosing between alternative courses of action.

5. c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Step 1:Identify the objective of the decision Step 2:Identify the alternative courses of action Step 3:Gather relevant information and perform differential analysis. Step 4:Make a decision Step 5:Review, analyze, and assess the results of the decision Differential Analysis o Managerial Decision Making

6. c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Step 1:Identify the objective of the decision Step 2:Identify the alternative courses of action Step 5:Review, analyze, and assess the results of the decision Step 3:Gather relevant information and perform differential analysis. Step 4:Make a decision Tables Salad Bar Revenues$100,000$120,000 Costs 60,000 65,000 Income$ 40,000$ 55,000 Increase its income. Use floor space for existing tables, or… Replace the tables with a salad bar. Differential Analysis o Bryant Restaurants, Inc.

7. c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Differential Analysis o Differential analysis, sometimes called incremental analysis, analyzes differential revenues and costs to determine the differential impact on income of two alternative courses of action.

8. c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Differential Analysis o Differential revenue is the amount of increase or decrease in revenue that is expected from a course of action as compared to an alternative.

9. c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Differential Analysis o Differential cost is the amount of increase or decrease in cost that is expected from a course of action as compared to an alternative.

10. c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Differential Analysis o Differential income (loss) is the difference between the differential revenue and the differential costs. o Differential income indicates that a particular decision is expected to be profitable, while a differential loss indicates that the decision is expected to decrease income.

11. D IFFERENTIAL A NALYSIS

12. c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Differential Analysis o In this chapter, differential analysis is illustrated for the following common decisions:  Leasing or selling equipment  Discontinuing an unprofitable segment  Manufacturing or purchasing a needed part  Replacing fixed assets  Processing further or selling a product  Accepting additional business at a special price

13. c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Lease or Sell o On June 22, 2014, Marcus Company is considering leasing or disposing of the following equipment: Cost of equipment$200,000 Less accumulated depreciation 120,000 Book value$ 80,000 Lease Option: Total revenue for five-year lease 160,000 Total estimated repair, insurance, and property tax expenses during life of lease35,000 Residual value at end of 5th year of lease0 Sell Option: Sales price$100,000 Commission on sales6% (continued)

14. L EASE OR S ELL Marcus Company uses differential analysis to make the decision. Exhibit 2 (next slide) provides key information for making this decision. (continued)

15. L EASE OR S ELL Lease the equipment

16. c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Lease or Sell o The $80,000 book value of the equipment is a sunk cost and is not considered in the differential analysis. o Sunk costs are costs that have been incurred in the past, cannot be recouped, and are not relevant to future decisions.

17. c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Discontinue a Segment or Product o Management may consider discontinuing a product or segment of a business that is generating losses. Based on the information in the condensed income statement in Exhibit 3 (next slide), management of Battle Creek Cereal Co. is considering discontinuing Bran Flakes.

18. D ISCONTINUE A S EGMENT OR P RODUCT

19. Don’t discontinue Bran Flakes! D ISCONTINUE A S EGMENT OR P RODUCT

21. M AKE OR B UY Companies often manufacture products made up of components that are assembled into a final product. Should they make or buy the parts?

22. c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Make or Buy o 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 labor80 Variable factory overhead52 Fixed factory overhead 68 Total estimated cost per unit$280

23. M AKE OR B UY

24. c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Replace Equipment o On November 28, 2014, a business is considering replacing the following machine: Old Machine: Book value$100,000 Estimated annual variable manufacturing costs225,000 Estimated selling price25,000 Estimated remaining useful life5 years (continued)

25. c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Old New Book value$100,000 Cost of new machine$250,000 Estimated annual variable manufacturing costs225,000150,000 Estimated selling price25,000 Estimated residual value0 Estimated remaining useful life5 years5 years (continued) Replace Equipment o The business is considering replacing the old machine with a new one, as shown below:

26. replace old machine R EPLACE E QUIPMENT

27. c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Replace Equipment o The revenue that is forgone from an alternative use of an asset, such as cash, is called an opportunity cost. o Although the opportunity cost is not recorded in the accounting records, it is useful in analyzing alternative courses of action.

28. c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Process or Sell o In some cases, a product can be sold at an intermediate stage of production, or it can be processed further and then sold.

29. Batch size4,000gallons Cost of producing kerosene$2,400per batch Selling price$2.50per gallon (continued) P ROCESS OR S ELL A business produces kerosene as follows:

30. c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Input batch size4,000gallons Less evaporation (20%) 800(4,000 x 20%) Output batch size3,200 Cost of producing gasoline$3,050per batch Selling price$3.50per gallon (continued) Process or Sell o The kerosene can be processed further to yield gasoline as follows:

31. process further P ROCESS OR S ELL

32. c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Accept Business at a Special Price o 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.

33. c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Monthly productive capacity12,500basketballs Current monthly sales10,000basketballs Normal (domestic) selling price$30.00per basketball Manufacturing costs: Variable costs$12.50 per basketball Fixed costs 7.50 Total$20.00per basketball (continued) Accept Business at a Special Price o B-Ball Inc. manufactures basketballs as follows:

34. (continued) A CCEPT B USINESS AT A S PECIAL P RICE On March 10, 2014, B-Ball Inc. receives an offer from an exporter for 5,000 basketballs at $18 each. Production can be spread over three months, so these basketballs can be manufactured using normal capacity. The domestic market will not be affected.

35. A CCEPT B USINESS AT A S PECIAL P RICE

36. c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Learning Objective Determine the selling price of a product, using the product cost concept. 2

37. c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Setting Normal Product Selling Prices o The basic approaches to setting prices are:  Market methods Demand-based concept Demand-based concept Competition-based concept Competition-based concept  Cost-Plus Methods Total cost concept Total cost concept Product cost concept Product cost concept Variable cost concept Variable cost concept

38. c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Setting Normal Product Selling Prices o The demand-based concept sets the price according to the demand for the product. o The competition-based concept sets the price according to the price offered by competitors.

39. c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Product Cost Concept o 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.

40. Product Cost Concept Step 1: Estimate the total product costs as follows: Product costs: Direct materials$XXX Direct laborXXX Factory overhead XXX Total product cost$XXX

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

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

43. Product Cost Concept Step 4: Compute the markup percentage as follows: Markup Percentage = Desired Profit + Total Selling and Administrative Expenses Total Product Cost

44. 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

45. Total product cost per unit$XXX Markup per unit XXX Normal selling price per unit$XXX Product Cost Concept Step 6: Determine the normal selling price by adding the markup per unit to the product cost per unit as follows:

46. c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Manufacturing costs: Direct materials ($3.00 x 100,000)$ 300,000 Direct labor ($10.00 x 100,000)1,000,000 Factory overhead 200,000 Total Manufacturing costs$1,500,000 Selling and administrative expenses 170,000 Total cost$1,670,000 Total assets$800,000 Desired rate of return20% Product Cost Concept o Assume the following data for 100,000 calculators that Digital Solutions Inc. expects to produce and sell during the current year:

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

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

49. Product Cost per Unit = Total Product Cost Estimated Units Produced and Sold Product Cost per Unit = $1,500,000 100,000 units $15.00 per unit = $15.00 per unit 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.

50. Markup Percentage = Desired Profit + Total Selling and Administrative Expenses Total Product Cost Markup Percentage = $160,000 + $170,000 $1,500,000 Markup Percentage = $330,000 $1,500,000 22% = 22% Desired Rate of Return x Total Assets 0.20 x $800,000 Product Cost Concept Step 4: Compute the markup percentage as follows:

51. Markup per Unit = Markup Percentage x Product Cost per Unit Markup per Unit = 22% x $15.00 = $3.30 per unit Product Cost Concept Step 5: Determine the markup per unit by multiplying the markup percentage times the product cost per unit as follows:

52. Total product cost per unit$15.00 Markup per unit 3.30 Normal selling price per unit$18.30 Product Cost Concept Step 6: Determine the normal selling price by adding the markup per unit to the product cost per unit as follows:

53. Product Cost Markup Product Cost Concept Desired Selling Price

54. c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Target Costing o 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

55. c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Target Costing o 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

56. T ARGET C OSTING

57. c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Learning Objective Compute the relative profitability of products in bottleneck production processes. 3

58. c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Production Bottlenecks, Pricing, and Profits o 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.

59. c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Production Bottlenecks, Pricing, and Profits o The theory of constraints (TOC) is a manufacturing strategy that focuses on reducing the influence of bottlenecks on production processes.

60. (continued) P RODUCTION B OTTLENECKS AND P ROFITS 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.

61. c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. SmallMediumLarge WrenchWrench Wrench Sales price per unit$130$140$160 Variable cost per unit 40 40 40 Contribution margin per unit$ 90$100$120 Heat treatment hours per unit 1 hr. 4 hrs. 8 hrs. (continued) Production Bottlenecks and Profits o The product unit contribution margin and the number of hours of heat treatment used by each type of wrench are as follows:

62. = Unit Contribution Margin Heat Treatment Hours per Unit Small Wrenches Unit Contribution Margin per Production Bottleneck Hour = $90 1 hr. = $90 per 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 = $15 per hour Unit Contribution Margin per Production Bottleneck Hour $90 per hour The small wrench is the most profitable product per bottleneck hour. Production Bottlenecks and Profits

63. c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Production Bottlenecks and Pricing o 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.

64. c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Learning Objective Allocate product costs using activity-based costing. 4

65. c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Activity-Based Costing Method o Activity-based costing (ABC) identifies and traces costs and expenses to activities and then to specific products. o Activities are the types of work, or actions, involved in a manufacturing process or service activity.

66. c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Estimated Activity Costs o 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. Setup Setup consists of changing tooling in machines in preparation for making a new product.

67. c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Engineering changes Engineering changes consist of processing changes in design or process specifications for a product. Estimated Activity Costs o 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.

68. c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Activity Rates o 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

69. c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Activity Rates o 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.

70. A CTIVITY R ATES

72. O VERHEAD A LLOCATION

74. c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Dangers of Product Cost Distortion o Using an inappropriate factory overhead allocation method can lead to distorted product costs.

75. c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. 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 = $80 Dangers of Product Cost Distortion o 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:

76. c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Dangers of Product Cost Distortion o 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.

77. c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Appendix Total and Variable Cost Concepts to Setting Normal Price

78. T OTAL C OST C ONCEPT Under the total cost concept, manufacturing cost plus the selling and administrative expenses are included in the total cost per unit. The markup per unit is then computed and added to the total cost per unit to determine the normal selling price. Total cost Selling Expense Manufacturing Cost Administrative Expense

79. Markup percentage = Desired profit Total cost T OTAL C OST C ONCEPT The markup percentage is determined by applying the following formula: Selling Expense Manufacturing Cost Administrative Expense

80. c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Total Cost Concept o To illustrate the seven steps used when the total cost concept is applied, examine the data in the next slide. Digital Solutions Inc. expects to produce and sell 100,000 calculators during the current year. The company desires a 20% rate of return on its total assets of $800,000.

81. Manufacturing costs: Direct materials ($3.00 x 100,000)$ 300,000 Direct labor ($10.00 x 100,000)1,000,000 Factory overhead: Variable costs ($1.50 x 100,000) $150,000 Fixed costs 50,000 200,000 Total Manufacturing costs$1,500,000 Selling and administrative expenses: Variable expenses ($1.50 x 100,000)$150,000 Fixed costs 20,000 Total selling and administrative expenses 170,000 Total cost$1,670,000 Total Cost Concept

82. Only the desired profit is covered in the markup. = 9.6% = Total cost per calculator$16.70 Markup ($16.70 x 9.6%) 1.60 Selling price$18.30 $160,000 $1,670,000 Desired profit Total cost Total Cost Concept

83. T OTAL C OST C ONCEPT The ability of the selling price of $18.30 to generate the desired profit of $160,000 is illustrated by the income statement shown below.

84. c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Variable Cost Concept o Under the variable cost concept, only variable costs are included in the cost amount per unit to which the markup is added.

85. V ARIABLE C OST C ONCEPT Product Cost Markup Desired Selling Price

86. Markup Percentage Desired Profit + Total Fixed Costs and Expenses = Total Variable Cost Markup Percentage $160,000 + $50,000 + $20,000 = $1,600,000 Direct materials ($3 x 100,000)$ 300,000 Direct labor ($10 x 100,000)1,000,000 Variable factory overhead ($1.50 x 100,000)150,000 Variable selling and administrative expenses ($1.50 x 100,000) 150,000 Total variable costs$1,600,000 Variable Cost Concept

87. Markup Percentage $160,000 + $50,000 + $20,000 = $1,600,000 Markup Percentage = $230,000 $1,600,000 = 14.4% Markup Percentage Desired Profit + Total Fixed Costs and Expenses = Total Variable Cost Variable Cost Concept

88. c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Variable Cost Concept o Digital Solutions Inc. would price each calculator at $18.30 per unit, as shown below: Variable cost per calculator $16.00 14.4% Markup ($16.00 x 14.4%) 2.30 Selling price $18.30

89. c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Differential Analysis, Product Pricing, and Activity-Based Costing The End