chapter 24 differential analysis and product pricing accounting, 21 st edition warren reeve fess...

Chapter Chapter 2424Differential Analysis and Differential Analysis and

Product PricingProduct PricingAccounting, 21st Edition

Warren Reeve Fess

PowerPoint Presentation by Douglas CloudProfessor Emeritus of AccountingPepperdine University

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1. Prepare a differential analysis report for decisions involving leasing or selling equipment, discontinuing an unprofitable segment, manufacturing or purchasing a needed part, replacing usable fixed assets, processing further or selling an intermediate product, or accepting additional business at a special price.

ObjectivesObjectivesObjectivesObjectives

After studying this After studying this chapter, you should chapter, you should

be able to:be able to:

After studying this After studying this chapter, you should chapter, you should

be able to:be able to:

2. Determine the selling price of a product, using the total cost, product cost, and variable cost concepts.

ObjectivesObjectivesObjectivesObjectives

3. Calculate the relative profitability of products in bottleneck production environments.

Differential AnalysisDifferential AnalysisDifferential AnalysisDifferential Analysis

Leasing or selling equipment. Discontinuing an unprofitable segment. Manufacturing or purchasing a needed part. Replacing usable fixed assets. Processing further or selling an intermediate

product. Accepting additional business at a special price.

Differential analysis is used for analyzing:

Differential AnalysisDifferential AnalysisDifferential AnalysisDifferential Analysis

DecisionsDecisionsDifferential Differential

AnalysisAnalysis

Alternative AAlternative A

oror

Alternative BAlternative B

Differential revenueDifferential revenue

–– Differential costs Differential costs

Differential income or lossDifferential income or loss

Lease or Sell Equipment

Marcus Company

Marcus Company is considering disposing of equipment that cost

$200,000 and that has $120,000 of accumulated depreciation.

Lease or Sell Equipment

Marcus Company

Sell equipment Sell equipment toto

Sell equipment Sell equipment toto

Broker

The equipment can be sold through a broker for $100,000, less a 6%

commission.

Lease or Sell Equipment

Marcus Company

Lease Lease equipment toequipment to

Lease Lease equipment toequipment to

Potamkin Company

ORPotamkin Company, the lessee, has offered to lease the equipment

for five years for a total consideration of

$160,000.

Lease or Sell Equipment

Marcus Company

At the end of the fifth year, the equipment is expected to have no residual value. During the period of the lease, Marcus Company

expects to incur repair, insurance, and property taxes estimated at $35,000.

Proposal to Lease or Sell EquipmentJune 22, 2006

Differential revenue from alternatives:Revenue from lease $160,000Revenue from sales 100,000 Differential revenue from lease $60,000

Lease the equipment!

Differential cost of alternatives:Repairs, insurance, taxes $ 35,000Commission expense on sale 6,000 Differential cost of lease 29,000

Net differential income from the leasealternative $31,000

OR

Proposal to Lease or Sell EquipmentJune 22, 2006

Lease alternative:Revenue from lease $160,000Depreciation expense for remaining 5 years $80,000Repairs, insurance, and property tax expense 35,000 115,000

Net gain $45,000

This is the traditional analysis. The differential income is the same.

This is the traditional analysis. The differential income is the same.

Sell alternative:Sales price $100,000Book value of equipment $80,000Commission expense 6,000 86,000

Net gain 14,000

Net differential income from the lease alternative $31,000

Discontinue a Segment or Product

Sales $100,000 $900,000 $1,000,000Cost of goods sold:

Variable costs $ 60,000 $420,000 $ 480,000Fixed costs 20,000 200,000 220,000 Total cost of goods sold $ 80,000 $620,000 $ 700,000

Gross profit $ 20,000 $280,000 $ 300,000Operating expenses:

Variable expenses $ 25,000 $155,000 $ 180,000Fixed expenses 6,000 45,000 51,000 Total operating expenses $ 31,000 $200,000 $ 231,000

Income (loss) from operations $ (11,000) $ 80,000 $ 69,000

Battle Creek Cereal Co.Condensed Income Statement

For the Year Ended August 31, 2006

Should Bran Flakes be discontinued?Should Bran Flakes be discontinued?

Differential itemsDifferential items

Variable cost $ 60,000Variable cost $ 60,000

Sales $100,000Sales $100,000

Variable expenses $ 25,000Variable expenses $ 25,000

Bran Flakes

Other Cereals Total

Battle Creek Cereal Co.Condensed Income Statement

For the Year Ended August 31, 2006

Differential itemsDifferential items

Sales $100,000 $900,000 $1,000,000Cost of goods sold:

Variable costs $ 60,000 $420,000 $ 480,000Fixed costs 20,000 200,000 220,000 Total cost of goods sold $ 80,000 $620,000 $ 700,000

Gross profit $ 20,000 $280,000 $ 300,000Operating expenses:

Variable expenses $ 25,000 $155,000 $ 180,000Fixed expenses 6,000 45,000 51,000 Total operating expenses $ 31,000 $200,000 $ 231,000

Income (loss) from operations $ (11,000) $ 80,000 $ 69,000

Variable cost $ 60,000Variable cost $ 60,000

Sales $100,000Sales $100,000

Variable expenses $ 25,000Variable expenses $ 25,000

Bran Flakes

Other Cereals Total

If Bran Flakes is discontinued, net income will decrease by $15,000.

If Bran Flakes is discontinued, net income will decrease by $15,000.

Proposal to Discontinue Bran FlakesSeptember 29, 2006

Differential revenue from annual sales of Bran Flakes:

Revenue from sales $100,000Differential cost of annual sales of Brian Flakes:

Variable cost goods sold $60,000Variable operating expenses 25,000 85,000

Annual differential income from sales ofBran Flakes $15,000

Don’t discontinue!

or

Currently, a firm manufactures the dashboards that it uses in making automobiles. The cost of

manufacturing this part is summarized below. An outside supplier has offered to provide the part for

$240. Should the car manufacturer accept the offer?

Direct materialsDirect materials $ 80$ 80Direct laborDirect labor 8080Variable factory overheadVariable factory overhead 5252Fixed factory overheadFixed factory overhead 68 68Total cost per unitTotal cost per unit $280$280

INITIAL REACTION—DON’T MAKE INTERNALLY

Proposal to Manufacture Automobile PartFebruary 15, 2006

Purchase price of part $240.00Differential cost to manufacture:

Direct materials $80.00Direct labor 80.00Variable factory overhead 52.00 212.00

Cost savings from manufacturing part $ 28.00

The fixed factory overhead is excluded because it is not relevant—so continue

making the part.

The fixed factory overhead is excluded because it is not relevant—so continue

making the part.

Replace Equipment

Assume that a business is considering the disposal of several identical machines having a total book value of $100,000 and an estimated remaining life of five years. The old machines can be sold for $25,000.

They can be replaced by a single high-speed machine at a cost $250,000. The new machine has a n

estimated useful life of five years and no residual value. Analyses indicate an estimated annual

reduction in variable manufacturing costs from $225,000 with the old machine to $150,000 with the

new machine. No other changes in the manufacturing costs or the operating expenses are expected. Should

the new machine be purchased?

Annual variable costs—present equipment $225,000Annual variable costs—new equipment 150,000Annual differential decrease in cost $ 75,000Number of years applicable x 5Total differential decrease in cost $375,000Proceeds from sale of present equipment 5,000 $400,000Cost of new equipment 250,000Net differential decrease in cost, 5-years $150,000

Annual net differential—new equipment $ 30,000

Proposal to Replace EquipmentNovember 28, 2006

Buy the new equipment!Buy the new equipment!Buy the new equipment!Buy the new equipment!

Process or SellProcess or SellProcess or SellProcess or Sell

A refinery produces kerosene in batches of 4,000 gallons at a

processing cost of $0.60 per gallon. Kerosene can be sold without further processing for

$0.80 per gallon or further processed to yield gasoline, which can be sold for $1.25 per gallon. The additional processing cost $650 per

batch, and 20% of the gallons of kerosene will evaporate

during production.

Differential revenue from further processingper batch:

Revenue from sale of gasoline [(4,000 gallons –800 gallons evaporation) x $1.25] $4,000

Revenue from sale of kerosene (4,000 gallons x $0.80) 3,200 Differential revenue $800

Differential cost per batch:Additional cost of producing gasoline 650

Differential income from further processinggasoline per batch $150

Proposal to Process Kerosene FurtherOctober 1, 2006

Process further!Process further!

Accept Business at a Special Price

The monthly capacity of a sporting goods business is

12,500 basketballs. Current sales and production are

averaging 10,000 basketballs per month. The current

manufacturing cost is $20 (variable, $12.50; fixed,

$7.50). The domestic selling price is $30.

The manufacturer 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. Domestic sales would not be affected.

Should the offer be accepted or Should the offer be accepted or rejected?rejected?

Should the offer be accepted or Should the offer be accepted or rejected?rejected?

Differential revenue from accepting offer:Revenue from sale of 5,000 additional units at $18 $90,000

Differential cost of accepting offer:Variable cost of 5,000 additional units at $12.50 62,500

Differential income from accepting offer $27,500

Proposal to Sell Basketballs to ExporterMarch 10, 2006

Accept the offer!Accept the offer!

Setting Normal Product Selling Prices

Setting Normal Product Setting Normal Product Selling PricesSelling Prices

Setting Normal Product Setting Normal Product Selling PricesSelling Prices

1. Demand-based methods2. Competition-based methods

Cost-Plus MethodsCost-Plus Methods

Market MethodsMarket Methods

1. Total cost concept

2. Product cost concept

3. Variable cost concept

Market MethodsMarket MethodsMarket MethodsMarket Methods

Demand-based methods set the price according to the demand for the product.

Demand-based methods set the price according to the demand for the product.

Market MethodsMarket MethodsMarket MethodsMarket Methods

Competition-based methods set the price according to the price

offered by the competitors.

Competition-based methods set the price according to the price

offered by the competitors.

Using the Total cost concept, all cost of

manufacturing a product...

Using the Total cost concept, all cost of

manufacturing a product...

Manufacturing Manufacturing CostCost

Total Cost ConceptTotal Cost Concept

…plus the selling and administrative

expenses...

…plus the selling and administrative

expenses...

Manufacturing Manufacturing CostCost

Selling ExpensesSelling Expenses

Administrative Administrative ExpensesExpenses

Total Cost ConceptTotal Cost Concept

…are included in the cost to which the markup is added.

…are included in the cost to which the markup is added.

Manufacturing Manufacturing CostCost

Selling ExpensesSelling Expenses

Administrative Administrative ExpensesExpenses

Total cost

Desired ProfitDesired Profit

Total Cost ConceptTotal Cost Concept

The company’s desired profit is

$160,000.

The company’s desired profit is

$160,000.

Manufacturing Manufacturing CostCost

Selling ExpensesSelling Expenses

Administrative Administrative ExpensesExpenses

Desired ProfitDesired Profit

Desired selling price

Total Cost ConceptTotal Cost Concept

Per Unit TotalCost Cost

Cost Structure Example (100,000 units)

Variable Costs (per unit):Direct materials $ 3.00 $ 300,000Direct labor 10.00 1,000,000Factory overhead 1.50 150,000Selling and administrative 1.50 150,000 Total variable costs $16.00 $1,600,000

Fixed Costs:Factory overhead .50 50,000Selling and administrative .20 20,000 Total fixed costs . 70 70,000

Total costs $16.70 $1,670,000

Total Cost ConceptTotal Cost Concept

Only the desired profit is covered in the markup.

Only the desired profit is covered in the markup.

Markup Percentage:Desired profit $160,000 Total costs $1,670,000

= 9.6%=

Total cost per calculator $16.70Markup ($16.70 x 9.6%) 1.60Selling price $18.30

Total Cost ConceptTotal Cost Concept

Proof that a sale of 100,000 computers at $18.30 each will generate a desired profit of $160,000.

Proof that a sale of 100,000 computers at $18.30 each will generate a desired profit of $160,000.

Sales (100,000 units x $18.30) $1,830,000Expenses:Variable (100,000 units x $16.00) $1,600,000

Fixed ($50,000 + $20,000) 70,000 1,670,000Income from operations $ 160,000

Digital Solutions Inc.Income Statement

For the Year Ended December 31, 2006

Total Cost ConceptTotal Cost Concept

Product Cost ConceptProduct Cost ConceptProduct Cost ConceptProduct Cost Concept

Using the product cost concept only the manufacturing costs are included in the amount to which

the markup is applied.

Using the product cost concept only the manufacturing costs are included in the amount to which

the markup is applied.

Per Unit TotalCost Cost

Cost Structure Example (100,000 units)

Variable Costs:Direct materials $ 3.00 $ 300,000Direct labor 10.00 1,000,000Factory overhead 1.50 150,000Selling and administrative 1.50 150,000 Total variable costs $16.00 $1,600,000

Fixed Costs:Factory overhead .50 50,000Selling and administrative .20 20,000 Total fixed costs .70 70,000

Total costs $16.70 $1,670,000

Product Cost = $15 per unitProduct Cost = $15 per unit

Product Cost ConceptProduct Cost ConceptProduct Cost ConceptProduct Cost Concept

Manufacturing Manufacturing CostCost

Product Cost

Markup

Product Cost ConceptProduct Cost ConceptProduct Cost ConceptProduct Cost Concept

Administrative Administrative ExpenseExpense

++

Selling ExpenseSelling Expense

++

Desired ProfitDesired Profit

Desired Selling

Price

Product Cost ConceptProduct Cost ConceptProduct Cost ConceptProduct Cost Concept

Markup percentage

Desired profit +

Total manufacturing costs=

Total selling and administrative expenses

Markup percentage

= 22%

Markup percentage

=$160,000 + $170,000

$1,500,000

Product Cost ConceptProduct Cost ConceptProduct Cost ConceptProduct Cost Concept

DM ($3 x 100,000) $ 300,000DL ($10 x 100,000) 1,000,000Factory overhead:

Variable ($1.50 x 100,000) 150,000Fixed 50,000

Total manufacturing costs $1,500,000

DM ($3 x 100,000) $ 300,000DL ($10 x 100,000) 1,000,000Factory overhead:

Variable ($1.50 x 100,000) 150,000Fixed 50,000

Total manufacturing costs $1,500,000

Manufacturing cost per calculator Manufacturing cost per calculator $15.00 $15.00Markup ($15 x 22%) Markup ($15 x 22%) 3.30 3.30Selling priceSelling price $18.30 $18.30

Manufacturing cost per calculator Manufacturing cost per calculator $15.00 $15.00Markup ($15 x 22%) Markup ($15 x 22%) 3.30 3.30Selling priceSelling price $18.30 $18.30

Product Cost ConceptProduct Cost ConceptProduct Cost ConceptProduct Cost Concept

Variable Cost ConceptVariable Cost ConceptVariable Cost ConceptVariable Cost Concept

The variable cost concept uses total of the variable manufacturing costs and the variable selling and administrative

expenses as the amount to apply a markup.

The variable cost concept uses total of the variable manufacturing costs and the variable selling and administrative

expenses as the amount to apply a markup.

Product Cost

Markup

Variable Cost ConceptVariable Cost ConceptVariable Cost ConceptVariable Cost Concept

Variable Manufacturing

Cost

+Variable

Administrative and Selling Expenses

Total Fixed Total Fixed Costs + Costs + Desired Desired ProfitProfit

Desired Selling

Price

Variable Cost ConceptVariable Cost ConceptVariable Cost ConceptVariable Cost Concept

Markup percentage

Desired profit +

Total variable costs=

Total fixed costs

Markup percentage =

$160,000 + $50,000 + $20,000

$1,600,000

Markup percentage

= 14.4%

Direct materials ($3 x 100,000) $ 300,000Direct labor ($10 x 100,000) 1,000,000Variable factory overhead

($1.50 x 100,000) 150,000Variable selling and administrative

expenses ($1.50 x 100,000) 150,000Total variable costs $1,600,000

Direct materials ($3 x 100,000) $ 300,000Direct labor ($10 x 100,000) 1,000,000Variable factory overhead

($1.50 x 100,000) 150,000Variable selling and administrative

expenses ($1.50 x 100,000) 150,000Total variable costs $1,600,000

Variable Cost ConceptVariable Cost ConceptVariable Cost ConceptVariable Cost Concept

Variable cost per calculatorVariable cost per calculator $16.00$16.00Markup ($16 x 14.4%) Markup ($16 x 14.4%) 2.30 2.30Selling priceSelling price $18.30$18.30

Variable cost per calculatorVariable cost per calculator $16.00$16.00Markup ($16 x 14.4%) Markup ($16 x 14.4%) 2.30 2.30Selling priceSelling price $18.30$18.30

Variable Cost ConceptVariable Cost ConceptVariable Cost ConceptVariable Cost Concept

Target CostingTarget CostingTarget CostingTarget Costing

Using target costing the cost is determined by subtracting a desired profit from the selling price.

Using target costing the cost is determined by subtracting a desired profit from the selling price.

Present Future

Actual Cost

Target Cost

ProfitProfit

Present Market Price

Required cost

reduction

Expected Market PriceDrift

Drift

BottlenecksBottlenecks

Sales price $130 $140 $160

Variable cost 40 40 40

Contribution margin $ 90 $100 $120

Bottleneck hours 1 4 8

Small Medium LargeWrench Wrench Wrench

Product Profitability Under Production BottlenecksProduct Profitability Under Production BottlenecksProduct Profitability Under Production BottlenecksProduct Profitability Under Production Bottlenecks

The number of heat treatment The number of heat treatment hours per unit for each product.hours per unit for each product.The number of heat treatment The number of heat treatment

hours per unit for each product.hours per unit for each product.

Sales price $130 $140 $160

Variable cost 40 40 40

Contribution margin $ 90 $100 $120

Bottleneck hours ÷ 1 ÷ 4 ÷ 8

Bottleneck contribution $ 90 $ 25 $ 15

Small Medium LargeWrench Wrench Wrench

Largest contribution margin per

bottleneck hour

Largest contribution margin per

bottleneck hour

Product Profitability Under Production BottlenecksProduct Profitability Under Production BottlenecksProduct Profitability Under Production BottlenecksProduct Profitability Under Production Bottlenecks

How much should the firm charge for the large wrench in order to deliver the same contribution as

the small wrench?

Product Profitability Under Production BottlenecksProduct Profitability Under Production BottlenecksProduct Profitability Under Production BottlenecksProduct Profitability Under Production Bottlenecks

Contribution margin per

bottleneck hour per small wrench

=

Revised price of large wrench

Variable cost per large wrench–

Bottleneck hours per large wrench

$90 =

Revised price of large wrench –

8

$40

$720 = Revised price of large wrench – $40 $760 = Revised price of large wrench

Product Profitability Under Production BottlenecksProduct Profitability Under Production BottlenecksProduct Profitability Under Production BottlenecksProduct Profitability Under Production Bottlenecks

Revised price of large wrench per formulaon the previous slide $760

Less: Variable cost per unit of large wrench 40

Contribution margin per unit of large wrench $720

Bottleneck hours per unit of large wrench ÷ 8

Revised contribution margin per bottleneck hour $ 90

Product Profitability Under Production BottlenecksProduct Profitability Under Production BottlenecksProduct Profitability Under Production BottlenecksProduct Profitability Under Production Bottlenecks

The EndThe End

Chapter 24Chapter 24