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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.
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Differential Analysis
o Managerial decision making involves choosing
between alternative courses of action.
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Differential Analysis
o Managerial Decision Making
Step 1: Identify the
objective of
the decision
Step 5: Review, analyze, and
assess the results 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
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Differential Analysis
o Bryant Restaurants, Inc.
Step 1: Increase
Identify the
its
objective of
income.
the decision
Step 5: Review, analyze, and
assess the results of
the decision
Step 2: Replace
Identify
the
Use
floorthe
space
alternative
tables
with a
for existing
courses
of
salad
bar.
tables,
or…
action
Tablesrelevant
Salad Bar
Step 3: Gather
Revenues information
$100,000 and
$120,000
perform
Costs
60,000differential
65,000
Income analysis.
$ 40,000 $ 55,000
Step 4: Make a
decision
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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.
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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.
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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.
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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.
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DIFFERENTIAL
ANALYSIS
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
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
Less accumulated depreciation
Book value
Lease Option:
Total revenue for five-year lease
Total estimated repair, insurance, and
property tax expenses during life of lease
Residual value at end of 5th year of lease
Sell Option:
Sales price
Commission on sales
$200,000
120,000
$ 80,000
160,000
35,000
0
$100,000
6%
(continued)
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LEASE OR SELL
Marcus Company uses
differential analysis to
make the decision.
Exhibit 2 (next slide)
provides key
information for making
this decision.
(continued)
LEASE OR SELL
Lease the
equipment
(continued)
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.
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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.
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
DISCONTINUE A
SEGMENT OR
PRODUCT
Don’t discontinue Bran Flakes!
DISCONTINUE A
SEGMENT OR
PRODUCT
MAKE OR BUY
Companies often
manufacture products
made up of components
that are assembled into
a final product. Should
they make or buy the
parts?
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
Direct labor
Variable factory overhead
Fixed factory overhead
Total estimated cost per unit
$ 80
80
52
68
$280
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MAKE OR BUY
Replace Equipment
o On November 28, 2014, a business is
considering replacing the following machine:
Old Machine:
Book value
Estimated annual variable
manufacturing costs
Estimated selling price
Estimated remaining useful life
$100,000
225,000
25,000
5 years
(continued)
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Replace Equipment
o The business is considering replacing the old
machine with a new one, as shown below:
Book value
Cost of new machine
Estimated annual variable
manufacturing costs
Estimated selling price
Estimated residual value
Estimated remaining useful life
Old
$100,000
New
$250,000
225,000
25,000
5 years
150,000
0
5 years
(continued)
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REPLACE
EQUIPMENT
replace old
machine
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.
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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.
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PROCESS OR SELL
A business produces
kerosene as follows:
Batch size
4,000 gallons
Cost of producing kerosene $2,400 per batch
Selling price
$2.50 per gallon
(continued)
Process or Sell
o The kerosene can be processed further to
yield gasoline as follows:
Input batch size
Less evaporation (20%)
Output batch size
Cost of producing
gasoline
Selling price
4,000 gallons
800 (4,000 x 20%)
3,200
$3,050 per batch
$3.50 per gallon
(continued)
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PROCESS OR SELL
process
further
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.
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Accept Business at a Special Price
o B-Ball Inc. manufactures basketballs as follows:
Monthly productive capacity
Current monthly sales
Normal (domestic) selling price
Manufacturing costs:
Variable costs
Fixed costs
Total
12,500 basketballs
10,000 basketballs
$30.00 per basketball
$12.50 per basketball
7.50
$20.00 per basketball
(continued)
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ACCEPT BUSINESS AT A SPECIAL PRICE
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.
(continued)
ACCEPT BUSINESS
AT A SPECIAL PRICE
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Setting Normal Product Selling Prices
o The basic approaches to setting prices are:
 Market methods
• Demand-based concept
• Competition-based concept
 Cost-Plus Methods
• Total cost concept
• Product cost concept
• Variable cost concept
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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.
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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.
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
Step 1: Estimate the total product costs as
follows:
Product costs:
Direct materials
Direct labor
Factory overhead
Total product cost
$XXX
XXX
XXX
$XXX
Product Cost Concept
Step 2: Estimate the total selling and
administrative expenses.
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.
Product Cost per unit =
Total Product Cost
Estimated Units Produced
and Sold
Product Cost Concept
Step 4: Compute the markup percentage as
follows:
Markup Percentage =
Desired Profit + Total Selling
and Administrative Expenses
Total Product Cost
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
Product Cost Concept
Step 6: Determine the normal selling price by
adding the markup per unit to the product cost
per unit as follows:
Total product cost per unit
Markup per unit
Normal selling price per unit
$XXX
XXX
$XXX
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:
Manufacturing costs:
Direct materials ($3.00 x 100,000)
Direct labor ($10.00 x 100,000)
Factory overhead
Total Manufacturing costs
Selling and administrative expenses
Total cost
Total assets
Desired rate of return
$ 300,000
1,000,000
200,000
$1,500,000
170,000
$1,670,000
$800,000
20%
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Product Cost Concept
Step 1: Estimate the total product cost as follows:
Product costs:
Direct materials
Direct labor
Factory overhead
Total product cost
$ XXXXX
XXXXX
XXX
$1,500,000
Product Cost Concept
Step 2: Estimate the total selling and
administrative expenses.
Management expects total selling and
administrative expenses to be $170,000.
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.
Product Cost per Unit =
Product Cost per Unit =
Total Product Cost
Estimated Units Produced
and Sold
$1,500,000
= $15.00 per unit
100,000 units
Product Cost Concept
Step 4: Compute the markup percentage as
follows:
Desired Profit + Total Selling
and Administrative Expenses
Markup Percentage =
Total Product Cost
Desired Rate of
Return
x Total
$160,000
+ $170,000
Markup Percentage =
Assets
$1,500,000
$330,000
Markup Percentage =0.20 x $800,000
$1,500,000
= 22%
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
Markup per Unit = 22% x $15.00 = $3.30 per unit
Product Cost Concept
Step 6: Determine the normal selling price by
adding the markup per unit to the product cost
per unit as follows:
Total product cost per unit
Markup per unit
Normal selling price per unit
$15.00
3.30
$18.30
Product Cost Concept
Markup
Product Cost
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
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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
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TARGET COSTING
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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.
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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.
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PRODUCTION BOTTLENECKS AND
PROFITS
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.
(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:
Sales price per unit
Variable cost per unit
Contribution margin per unit
Heat treatment hours per unit
Small
Wrench
Medium
Wrench
$130
40
$ 90
1 hr.
$140
40
$100
4 hrs.
Large
Wrench
$160
40
$120
8 hrs.
(continued)
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Production Bottlenecks and Profits
Unit Contribution Margin
Unit Contribution Margin per =
Production Bottleneck Hour
Heat Treatment Hours per Unit
Small Wrenches
Unit Contribution Margin per
$90 = $90
$90per
perhour
hour
=
Production Bottleneck Hour
1 hr.
Medium Wrenches
$100 The small wrench is the
Unit Contribution Margin per
= $25 per hour
=
most
profitable product
Production Bottleneck Hour
4 hrs.
Large Wrenches
per bottleneck hour.
$120
Unit Contribution Margin per
= $15 per hour
=
Production Bottleneck Hour
8 hrs.
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.
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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.
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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 consists of changing tooling in machines
in preparation for making a new product.
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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.
Engineering changes consist of processing changes in
design or process specifications for a product.
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Activity Rates
o The estimated activity costs are allocated to
products using an activity rate. Activity rates
are determined as follows:
Estimated Activity Cost
Activity Rate =
Estimated ActivityBase Usage
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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.
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ACTIVITY RATES
ACTIVITY RATES
OVERHEAD
ALLOCATION
OVERHEAD
ALLOCATION
Dangers of Product Cost Distortion
o Using an inappropriate factory overhead
allocation method can lead to distorted
product costs.
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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:
Estimated Total Factory
Overhead Costs
Predetermined Factory
=
Overhead Rate
Estimated Activity Base
Predetermined Factory
Overhead Rate =
$1,600,000
= $80
20,000 direct labor hours
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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 singlerate method can distort costs.
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.
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
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.
Selling Expense
Administrative
Expense
Manufacturing
Cost
Total cost
TOTAL COST CONCEPT
The markup percentage
is determined by
applying the following
formula:
Selling Expense
Administrative
Expense
Manufacturing
Cost
Markup
Desired profit
percentage = Total cost
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.
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Total Cost Concept
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
Desired profit
Total cost
= $160,000 = 9.6%
$1,670,000
Total cost per calculator
Markup ($16.70 x 9.6%)
Selling price
Only the desired profit is
covered in the markup.
$16.70
1.60
$18.30
TOTAL COST
CONCEPT
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.
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.
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VARIABLE COST CONCEPT
Markup
Product
Cost
Variable Cost Concept
Markup
Percentage =
Desired Profit + Total Fixed Costs and Expenses
Markup
Percentage =
$160,000 + $50,000 + $20,000
Total Variable Cost
$1,600,000
Direct materials ($3 x 100,000)
Direct labor ($10 x 100,000)
Variable factory overhead
($1.50 x 100,000)
Variable selling and
administrative expenses
($1.50 x 100,000)
Total variable costs
$ 300,000
1,000,000
150,000
150,000
$1,600,000
Variable Cost Concept
Markup
Percentage =
Desired Profit + Total Fixed Costs and Expenses
Markup
Percentage =
$160,000 + $50,000 + $20,000
Total Variable Cost
$1,600,000
$230,000
Markup
Percentage = $1,600,000
= 14.4%
Variable Cost Concept
o Digital Solutions Inc. would price each
calculator at $18.30 per unit, as shown below:
Variable cost per calculator
Markup ($16.00 x 14.4%)
Selling price
$16.00
2.30
$18.30
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.
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.