1. Differential Cost Analysis
Chapter 25

2. Management decisions Accepting/Rejecting certain orders
Reducing the price of a single order
Making a price cut in a competitive market
Evaluating Make-or-buy alternatives
Expanding or reducing plant capacity
Increasing, curtailing or stopping production
Replacing present equipment
Spending additional amounts for sales promotion

3. Differential Cost Difference between cost of alternative choices
Marginal/Incremental cost
Deals with determination of incremental revenue, costs and margins
Variable costs are significant
Fixed costs might be included

4. Example Total cost at 60,000 units = $324,250
Calculate total differential cost
Calculate differential cost/unit

5. Solution Differential cost = 423,400 – 324,250 = $99,150
Differential cost/unit = 99,150/20,000
= $4.96

6. Accepting Additional Orders
Differential cost must be considered involving a change in output
Difference between the cost of producing present smaller output and that of the planned larger output
Possibility of selling additional output at a figure lower or greater than the existing average unit cost
New or additional business can be accepted as long as the variable cost is recovered

7. Example Maximum capacity=100,000 units Normal capacity = 80,000 units
Variable cost per unit = $5
Fixed cost= $100,000
Sales price per unit= $9
Profit at 80,000 and 81,000 units?

8. Solution Present business Additional business Total
Sales $720,000 $9, $729,000
Variable cost , , ,000
Contribution
Margin , , ,000
Fixed cost , _-0-____ ,000
Profit , , ,000

9. Reducing the Price of a Special Order
At what minimum price the firm can afford to sell additional goods

10. Example Company manufactures 450,000 units using 90% of its capacity
Fixed factory overhead is $335,000
Variable factory overhead = $0.50/unit
Direct materials = $1.80/unit
Direct labor = $1.40/unit
Each unit sells for $5

11. Example Sales $2,250,000 Cost of goods sold:
Direct materials(450,000*1.80) ,000
Direct labor(450,000*1.40) 630,000
Variable factory overheads(450,000*0.50) 225,000
Fixed factory overheads(335,000*90%) 301, ,966,500
Income from operations ,500
Unabsorbed fixed factory overheads(335,000*10%] ,500
Income from operations (adjusted) ,000

12. Special Order
Additional fixed cost if special order of 100,000 units is accepted = $10,000
Sales price of a special order=$4.25

13. Solution Sales (100,000 units@4.25) $425,000 Cost of goods sold:
Direct 180,000
Direct labor 1.40) 140,000
Variable factory overheads
(100, ,000
Additional fixed cost 10, ,000
Gain on the order $45,000

14. Exercise
The wood River plant of the Union Company has a normal capacity 0f 90,000 units per month. Monthly production costs are $12 variable cost per unit and $240,000 fixed. By increasing the fixed cost $10,000 a month, the plant can produce 95,000 units.
Differential cost of the production between 80% and 90% of normal capacity.
Differential cost of producing the 5,000 units above the normal capacity.
Per unit total production cost of the 95,000 units
Per unit differential production cost of the 5,000 units.

15. Solution
Differential cost of the production between 80% and 90% of normal capacity.
90,000 units *90% 81,000 units
90,000 units *80% 72,000 units
9,000 units
9,000 units *$12 = $108,000

16. Solution
Differential cost of producing the 5,000 units above the normal capacity.
5,000 units *12 $60,000
Differential Fixed cost 10,000
70,000

17. Solution Per unit total production cost of the 5,000 units
Fixed costs(240,000+10,000) 250,000
1,390,000

18. Solution Per unit differential production cost of the 5,000 units.
= $14

19. Exercise Fixed cost per month $122,000
Poppycrock,Inc., manufactures large crates of microwavable popcorn that are typically sold to distributors. Their main factory has the capacity to manufacture and sell 35,000 crates per month. The following information is available for the factory:
Sales price per crate $24
Variable cost per crate:
Direct materials
Direct labor
Variable overhead
Fixed cost per month $122,000
ABC of Canada offered to pay Poppycrock $20 per crate for the special batch of 5,000 crates. The additional cost of label is estimated at $1 per crate. In addition, the variable overhead for these special order crates would decrease by $0.50 because there would be no distribution costs for these special order crates .
What is the cost of creating a normal crate of popcorn? What is the incremental cost of creating a special order crate of popcorn?

20. Make-Or-Buy Decisions
Compare the cost of making the parts with the cost of buying them
Costs for each of the alternatives must be based on the identical product specifications, quantities and quality standards

21. Decisions to Shut Down Facilities
In the short run, a firm seems to be better off operating than not operating if revenue > variable costs
Shutting down of facilities
Does not eliminate all costs
Loss of investment spent on training employees
Recruiting and training costs after reopening
Loss of losing established markets & customers

22. Decisions to Shut Down Facilities
If operations are continued
Certain expenses connected with the shutting down of the facilities can be saved
Costs that would have to be incurred when a closed facility is reopened will be saved

23. Decisions to Discontinue Products
Requires careful analysis of relevant differential cost and revenue data
Following benefits can be achieved with the correct decision:
Expanded sales
Increased profits
Reduced inventory levels
Resources made available for more promising projects

24. Decisions to Discontinue Products
Not only the profitability of the products being analyzed be considered but also the extent to which sales of other products will be affected when one product is removed should be evaluated

25. Decisions to Discontinue Products
Management needs following signals to identify troubled products:
Declining sales volume
Decreasing market share
Malfunctioning of the product or introduction of a superior competitive product
Expected future sales and market potential not favorable
Return on investment below minimum acceptable level
Variable costs approaching or exceeding revenue
Price required to be constantly lowered to maintain sales

26. Other Cost Concepts Opportunity costs Imputed costs
Measurable value of an opportunity bypassed by rejecting an alternative use to resources
Measurement of sacrifices associated with alternatives
Imputed costs
Hypothetical costs representing the cost/value of a resource measured by its use value
Interest on invested capital, rental value of company-owned properties, salaries of owners of sole proprietors
Do not involve actual cash flows

27. Other Cost Concepts Out-Of-Pocket Costs Sunk Costs
Involves cash outlays
Often identified as variable costs
Helpful in deciding whether a particular venture will at least return the cash expenditures
Sunk Costs
Irrecoverable costs
Not included in differential cost analysis