Financial and Managerial Accounting
8th Edition
Warren Reeve Fess
PowerPoint Presentation by Douglas Cloud
Professor Emeritus of Accounting
Pepperdine University
© Copyright 2004 South-Western, a division of Thomson Learning. All rights reserved.
Task Force Image Gallery clip art included in this electronic presentation is used with the permission of
NVTech Inc.

Some of the action has been automated, so click the mouse when you see this lightning bolt in the lower right-hand corner of the screen. You can point and click anywhere on the screen.

1.
Prepare a differential analysis report for decisions involving leasing or selling 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.

2.
Determine the selling price of a product, using the total cost, product cost, and variable cost concepts.
3.
Calculate the relative profitability of products in bottleneck production environments.

Differential analysis is used for analyzing:
 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.

Decisions
Alternative A or
Alternative B
Differential
Analysis
Differential revenue
– Differential costs
Differential 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 to
The equipment can be sold through a broker for
$100,000, less a 6% commission.
Broker

Lease or Sell Equipment
Marcus
Company
Potamkin Company, the lessee, has offered to lease the equipment for five years for a total consideration of
$160,000.
OR
Lease equipment to
Potamkin
Company

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 Equipment
June 22, 2006
Differential revenue from alternatives:
Revenue from lease
Revenue from sales
Differential revenue from lease
Differential cost of alternatives:
Repairs, insurance, taxes
Commission expense on sale
Differential cost of lease
Net differential income from the lease alternative
$160,000
100,000
$ 35,000
6,000
$60,000
29,000
$31,000
Lease the equipment!

Proposal to Lease or Sell Equipment
June 22, 2006
Lease alternative:
Revenue from lease
Depreciation expense for remaining 5 years $80,000
$160,000
Repairs, insurance, and property tax expense 35,000 115,000
Net gain
Sell alternative:
Sales price
Book value of equipment
Commission expense
Net gain
$80,000
$100,000
6,000 86,000
Net differential income from the lease alternative
$45,000
14,000
$31,000
This is the traditional analysis. The differential income is the same.

Battle Creek Cereal Co.
Condensed Income Statement
For the Year Ended August 31, 2006
Differential items
Bran
Flakes
Other
Cereals Total
$100,000 $900,000 $1,000,000
Cost of goods sold:
Fixed costs
Total cost of goods sold
Gross profit
Operating expenses:
$ 60,000 $420,000 $ 480,000
20,000 200,000 220,000
$ 80,000 $620,000 $ 700,000
$ 20,000 $280,000 $ 300,000
Fixed expenses
Total operating expenses
Income (loss) from operations
$ 25,000 $155,000 $ 180,000
6,000 45,000 51,000
$ 31,000 $200,000 $ 231,000
$ (11,000) $ 80,000 $ 69,000
Should Bran Flakes be discontinued?

Battle Creek Cereal Co.
Condensed Income Statement
For the Year Ended August 31, 2006
Differential items
Bran
Flakes
Other
Cereals Total
$100,000 $900,000 $1,000,000
Cost of goods sold:
Fixed costs
Total cost of goods sold
$ 60,000 $420,000 $ 480,000
20,000 200,000 220,000
$ 80,000 $620,000 $ 700,000
Gross profit
Operating expenses:
$ 20,000 $280,000 $ 300,000
Fixed expenses
Total operating expenses
$ 25,000 $155,000 $ 180,000
6,000 45,000 51,000
$ 31,000 $200,000 $ 231,000
Income (loss) from operations $ (11,000) $ 80,000 $ 69,000
If Bran Flakes is discontinued, net income will decrease by $15,000.

Proposal to Discontinue Bran Flakes
September 29, 2006
Differential revenue from annual sales of Bran Flakes:
Revenue from sales
Differential cost of annual sales of Brian Flakes:
Variable cost goods sold
Variable operating expenses
$100,000
$60,000
25,000 85,000
Annual differential income from sales of
Bran Flakes $15,000

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 materials
Direct labor
Variable factory overhead
Fixed factory overhead
Total cost per unit
$ 80
80
52
68
$280
INITIAL REACTION—DON’T MAKE
INTERNALLY

Proposal to Manufacture Automobile Part
February 15, 2006
$240.00
Purchase price of part
Differential cost to manufacture:
Direct materials
Direct labor
Variable factory overhead
Cost savings from manufacturing part
$80.00
80.00
52.00
212.00
$ 28.00
The fixed factory overhead is excluded because it is not relevant—so continue making the part.

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?

Proposal to Replace Equipment
November 28, 2006
Annual variable costs—present equipment
Annual variable costs—new equipment
Annual differential decrease in cost
Number of years applicable
Total differential decrease in cost
Proceeds from sale of present equipment
Cost of new equipment
Net differential decrease in cost, 5-years
Annual net differential—new equipment
$225,000
150,000
$ 75,000 x 5
$375,000
5,000 $400,000
250,000
$150,000
$ 30,000

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.

Proposal to Process Kerosene Further
October 1, 2006
Differential revenue from further processing per batch:
Revenue from sale of gasoline [(4,000 gallons –
800 gallons evaporation) x $1.25]
Revenue from sale of kerosene (4,000 gallons x $0.80)
Differential revenue
Differential cost per batch:
Additional cost of producing gasoline
Differential income from further processing gasoline per batch
$4,000
3,200
$800
650
$150

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 rejected?

Proposal to Sell Basketballs to Exporter
March 10, 2006
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
Accept the offer!

Market Methods
1. Demand-based methods
2. Competition-based methods
Cost-Plus Methods
1. Total cost concept
2. Product cost concept
3. Variable cost concept

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

Market Methods
Competition-based methods set the price according to the price offered by the competitors.

Total Cost Concept
Using the Total cost concept , all cost of manufacturing a product...
Manufacturing
Cost

Administrative
Expenses
Selling Expenses
Manufacturing
Cost
Total Cost Concept
…plus the selling and administrative expenses...

Desired Profit
Administrative
Expenses
Selling Expenses
Manufacturing
Cost
Total Cost Concept
…are included in the cost to which the markup is added.
Total cost

Total Cost Concept
Desired selling price
The company’s desired profit is
$160,000.
Desired Profit
Administrative
Expenses
Selling Expenses
Manufacturing
Cost

Total Cost Concept
Cost Structure Example (100,000 units)
Variable Costs (per unit):
Direct materials
Direct labor
Factory overhead
Per Unit
Cost
$ 3.00
10.00
1.50
Selling and administrative 1.50
Total variable costs $16.00
Fixed Costs:
Factory overhead .50
Selling and administrative .20
Total fixed costs
Total costs
. 70
$16.70
Total
Cost
$ 300,000
1,000,000
150,000
150,000
$1,600,000
50,000
20,000
70,000
$1,670,000

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

Total Cost Concept
Proof that a sale of 100,000 computers at $18.30 each will generate a desired profit of $160,000.
Digital Solutions Inc.
Income Statement
For the Year Ended December 31, 2006
Sales (100,000 units x $18.30)
Expenses:
Variable (100,000 units x $16.00) $1,600,000
Fixed ($50,000 + $20,000)
Income from operations
$1,830,000
70,000 1,670,000
$ 160,000

Product Cost Concept
Using the product cost concept only the manufacturing costs are included in the amount to which the markup is applied.

Product Cost Concept
Cost Structure Example (100,000 units)
Variable Costs:
Per Unit
Cost
Total
Cost
Direct materials $ 3.00
$ 300,000
Direct labor
Factory overhead
10.00
1.50
Selling and administrative 1.50
Total variable costs $16.00
Fixed Costs:
Factory overhead .50
Selling and administrative .20
Total fixed costs
Total costs
.70
$16.70
1,000,000
150,000
150,000
$1,600,000
50,000
20,000
70,000
$1,670,000
Product Cost = $15 per unit

Product Cost Concept
Administrative
Expense
+
Selling Expense
+
Desired Profit
Manufacturing
Cost
Markup
Product Cost

Product Cost Concept
Total selling and
Markup percentage
=
Desired profit + administrative expenses
Total manufacturing costs

Product Cost Concept
Markup percentage
=
$160,000 + $170,000
$1,500,000
Markup
= 22%
DL ($10 x 100,000)
Factory overhead:
Variable ($1.50 x 100,000)
Fixed
Total manufacturing costs
$ 300,000
1,000,000
150,000
50,000
$1,500,000

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

Variable 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.

Variable Cost Concept
Markup
Total Fixed
Costs +
Desired
Profit
Variable
Manufacturing
Cost
+
Variable
Administrative and Selling
Expenses
Product Cost

Variable Cost Concept
Markup percentage
=
Desired profit + Total fixed costs
Total variable costs

Variable Cost Concept
Markup percentage
=
$160,000 + $50,000 + $20,000
$1,600,000
Markup
= 14.4% percentage
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
Variable cost per calculator
Markup ($16 x 14.4%)
Selling price
$16.00
2.30
$18.30

Target Costing
Using target costing the cost is determined by subtracting a desired profit from the selling price.
Profit
Present Market Price
Expected
Market Price
Profit
Actual
Cost
Required cost reduction
Target
Cost
Present Future

Product Profitability Under Production Bottlenecks
Sales price
Variable cost
Contribution margin
Bottleneck hours
Small Medium Large
Wrench Wrench Wrench
$130 $140 $160
40 40 40
$ 90 $100 $120
1 4 8
The number of heat treatment hours per unit for each product.

Product Profitability Under Production Bottlenecks
Small Medium Large
Wrench Wrench Wrench
Sales price
Variable cost
$130 $140 $160
40 40 40
Contribution margin
Bottleneck hours
$ 90 $100 $120
÷ 1 ÷ 4 ÷ 8
Bottleneck contribution $ 90 $ 25 $ 15
Largest contribution margin per bottleneck hour

Product 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 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 Bottlenecks
Revised price of large wrench per formula on the previous slide
Less: Variable cost per unit of large wrench
Contribution margin per unit of large wrench
Bottleneck hours per unit of large wrench
$760
40
$720
÷ 8
Revised contribution margin per bottleneck hour $ 90