Accounting 203 – Management Accounting
Chapter 12: Differential Analysis: The Key to Decision Making
Cost Concepts
Define
Example
Relevant Costs
Relevant Benefits
Avoidable costs
Sunk Cost (ch 2)
An Example:
Automobile Costs (based on 10,000 miles driven per year)
Annual Cost of
Fixed Items
1
Annual straight-line depreciation on car
2
Cost of gasoline ($4.50/gallon ÷ 30 miles per gallon)
3
Annual cost of auto insurance and license
4
Maintenance and repairs
5
Parking fees at school
6
Total average cost
$
2,800
Cost per Mile
$
0.280
0.150
1,380
0.138
0.065
360
0.036
$
0.669
Some Additional Information
7
Reduction in resale value of car per mile of wear
$ 0.026
8
Round-tip train fare
$
9
Benefits of relaxing on train trip
104
????
10
Cost of putting dog in kennel while gone
11
Benefit of having car in New York
????
12
Hassle of parking car in New York
Per day cost of parking car in New York - in an inconvenient location far away from
????
13
anywhere convenient. Hence, the low cost ….
$
$
40
25
Cost of Driving to NY (show calcs)
Cost of Train Ticket:
Decision:
Presenting a Case
Define
Warning!
Presentation is EVERYTHING!
Total Cost Approach
Differential Cost
Approach
Practice: Katniss Corporation is considering two alternatives that are code-named Mocking and Jay.
Costs associated with the alternatives are listed below:
Material
Labor
Electricity
Quality Control
$
$
$
$
$
Mocking
25,000
25,000
16,000
7,500
73,500
Jay
$ 30,000
$ 32,000
$ 16,000
$ 9,000
$ 87,000
Required:
a. Which costs are relevant and which are not relevant in the choice between these two alternatives?
b. What is the differential cost between these two alternatives?
EXAMPLE: DROP OR KEEP A SEGMENT?
Lovell Company - Segment Income Statement
Digital Watches
Sales
$ 500,000
Less: variable expenses
Variable manufacturing
costs
$ 120,000
Variable shipping costs
5,000
Commissions
75,000
Contribution margin
200,000
$ 300,000
Less: fixed expenses
General factory overhead
Salary of line manager
Depreciation of equipment
$ 60,000
90,000
50,000
Advertising - direct
100,000
Rent - factory space
70,000
General admin. expenses
30,000
Net operating loss
400,000
$ (100,000)
Investigation has revealed that total fixed general factory overhead and general
& administrative expenses would not be affected if the digital watch line is dropped. The fixed general
factory overhead and general administrative expenses assigned to this product would be reallocated to
other product lines. The equipment used to manufacture digital watches has no resale value or
alternative use. Should Lovell retain or drop the digital watch segment?
Is there a LOST benefit? How much?
Are there avoidable costs?
Net Advantage (Disadvantage) of dropping
the segment
Practice: The most recent monthly income statement for Bullseye Stores is given below:
Sales
Variable expenses
Contribution Margin
Traceable Fixed Costs
Store segment margin
Common fixed expenses
Net Operating income
Total
$
1,850,000
1,055,000
795,000
538,500
256,500
50,000
$
206,500
Factoria
$
800,000
320,000
480,000
192,000
288,000
20,000
$
268,000
Northgate
$ 1,050,000
735,000
315,000
346,500
(31,500)
30,000
$
(61,500)
Due to its poor showing, consideration is being given to closing the Northgate Store. Studies show that
if the Northgate Store is closed, one-fourth of its traceable fixed expenses will continue unchanged. The
studies also show that closing the Northgate Store would result in a 10 percent decrease in sales in the
Factoria Store. The company allocates common fixed expenses to the stores on the basis of sales
dollars.
Required: Compute the overall increase/decrease in the store’s operating income if the Northgate
Store is closed.
EXAMPLE: MAKE OR BUY DECISION
Essex manufactures part 4A that is used in one of its products.
The unit product cost of this part is:
Direct materials
$
9
Direct labor
5
Variable overhead
1
Depreciation of special equip.
3
Supervisor's salary
2
General factory overhead
Unit product cost
10
$ 30
The special equipment used to manufacture part 4A has no resale value. The total amount of general
factory overhead, which is allocated on the basis of direct labor hours, would be unaffected by this
decision. The $30 unit product cost is based on 20,000 parts produced each year. An outside supplier has
offered to provide the 20,000 parts at a cost of $25 per part. Should we accept the supplier’s offer?
Cost
Per
Unit
Essex Company:
Cost of 20,000 Units
Make
Outside purchase price
$ 25
Direct materials
$
9
Direct labor
5
Variable overhead
1
Depreciation of equip.
3
Supervisor's salary
2
General factory overhead
Total cost
Buy
10
$ 30
Net Advantage (Disadvantage) of BUYING
Part 4A.
Practice: Peeta Company makes 50,000 units per year of a part it uses in the products it
manufactures. The unit product cost of this part is computed as follows:
Direct Materials
Direct Labor
Variable Manufacturing Overhead
Fixed Manufacturing Overhead
$
53.20
22.00
5.25
15.40
Unit product Cost
$
95.85
An outside supplier has offered to sell the company all of these parts it needs for $88.50 a unit. If the
company accepts this offer, the facilities now being used to make the part could be used to make more
units of a product that is in high demand. The additional contribution margin on this other product
would be $225,000 per year.
If the part were purchased from the outside supplier, $10.00 of the fixed manufacturing overhead cost
being applied to the part would continue. This fixed manufacturing overhead cost would be applied to
the company's remaining products.
Required:
a. How much of the unit product cost of $95.85 is relevant in the decision of whether to make or buy
the part?
b. What is the net total dollar advantage (disadvantage) of purchasing the part rather than making it?
c. What is the maximum amount the company should be willing to pay an outside supplier per unit for
the part if the supplier commits to supplying all 40,000 units required each year?
EXAMPLE: SPECIAL ORDERS
Jet, Inc. makes a single product whose normal selling price is $20 per unit. A foreign distributor
offers to purchase 3,000 units for $10 per unit. This is a one-time order that would not affect the
company’s regular business. Annual capacity is 10,000 units, but Jet, Inc. is currently producing and
selling only 5,000 units.
Should Jet accept the offer?
Jet, Inc.
Contribution Income Statement – at 5,000 units
Revenue (5,000 × $20)
$100,000
Variable costs:
Direct materials
Direct labor
Manufacturing
overhead
Marketing costs
$ 20,000
5,000
10,000
5,000
Total variable costs
40,000
Contribution margin
60,000
Fixed costs:
Manufacturing
overhead
Marketing costs
$ 28,000
20,000
Total fixed costs
Net operating income
48,000
$ 12,000
Practice: Gale Company produces a single product. The cost of producing and selling a single unit of
this product at the company's normal activity level of 40,000 units per month is as follows:
Direct Materials
Direct Labor
Variable Manufacturing Overhead
Fixed Manufacturing Overhead
Variable selling/admin expense
Fixed selling/admin expense
$ 25.40
$ 8.00
$ 1.40
$ 13.20
$ 2.50
$ 9.10
The normal selling price of the product is $65.10 per unit.
An order has been received from an overseas customer for 2,500 units to be delivered this month at a
special discounted price. This order would have no effect on the company's normal sales and would not
change the total amount of the company's fixed costs. The variable selling and administrative expense
would be $1.00 less per unit on this order than on normal sales.
Direct labor is a variable cost in this company.
Required:
a. Suppose there is ample idle capacity to produce the units required by the overseas customer and the
special discounted price on the special order is $55.25 per unit. By how much would this special order
increase (decrease) the company's net operating income for the month?
b. Suppose the company is already operating at capacity when the special order is received from the
overseas customer. What would be the opportunity cost of each unit delivered to the overseas
customer?
c. Suppose there is not enough idle capacity to produce all of the units for the overseas customer and
accepting the special order would require cutting back on production of 1,200 units for regular
customers. What would be the minimum acceptable price per unit for the special order?
EXAMPLE: MANAGING CONSTRAINTS
Machine A1 is the constrained resource at Ensign Company
ENSIGN COMPANY
Product
Selling price per unit
Prod 1
Prod 2
$
$
Less variable expenses per unit
60
36
Contribution margin per unit
$
Current demand per week (units)
24
$
2,000
Contribution margin ratio
50
35
15
2,200
40%
30%
Processing time required
on Machine A1 per unit
1.00
min.
0.50
min.
Machine A1 is the constrained resource and is being used at 100% of its capacity.
There is excess capacity on all other machines.
Machine A1 has a capacity of 2,400 minutes per week.
Product 1 or 2?
Should Ensign focus its efforts on
PRODUCT 1
PRODUCT 2
How many units of each
product can be processed
through Machine A1 in one
minute?
What generates more profit
for the company, using one
minute of machine A1 to
process Product 1 or using one
minute of machine A1 to
process Product 2?
What is the Contribution
Margin per MINUTE?
CM per unit
Time per unit
CM per minute (or unit of time)
Assume weekly demand for Product 1 = 2,200 units
Allotting Our Constrained Resource (Machine A1)
Weekly demand for Product 2
Time required per unit
2,200
×
units
min.
Total time required to make
Product 2
min.
Total time available
min.
Time used to make Product 2
min.
Time available for Product 1
Time required per unit
Production of Product 1
min.
÷
min.
units
Practice:
Haymitch Company makes three products in a single facility. These products have the following unit
product costs:
Direct Materials
Direct Labor
Variable Manufacturing Overhead
Fixed Manufacturing Overhead
UNIT/COST
Product A
$
14.90
13.30
2.50
19.50
$
50.20
Product B
$
15.60
17.10
2.80
27.70
$
63.20
Product C
$
16.70
15.70
3.10
21.00
$
56.50
Product A
2.25
$
45.50
$
2.00
1,200
Product B
1.25
$
65.00
$
1.30
2,500
Product C
1.50
$
55.00
$
2.80
2,500
Additional information:
Mixing minutes per unit
Selling price per unit
Variable selling costs per unit
Monthly demand in units
The mixing machines are potentially the constraint in the production facility. A total of 9,150 minutes
are available per month on these machines.
Direct labor is a variable cost in this company.
Required:
a. From high to low, which product is most profitable?
b. How many minutes of mixing machine time would be required to satisfy demand for all four
products?
c. How much of each product should be produced to maximize net operating income? (Round off to the
nearest whole unit.)
d. Up to how much should the company be willing to pay for one additional hour of mixing machine
time if the company has made the best use of the existing mixing machine capacity? (Round off to the
nearest whole cent.)
EXAMPLE: JOINT PRODUCTS – Sell or Process Further?
•
•
•
Sawmill, Inc. cuts logs from which unfinished lumber and sawdust are the immediate joint products.
Unfinished lumber is sold “as is” or processed further into finished lumber.
Sawdust can also be sold “as is” to gardening wholesalers or processed further into “presto-logs.”
Per Log
Lumber
Sales value at the split-off
point
Sales value after further
processing
Allocated joint product costs
Cost of further processing
$
140
Sawdust
$
40
270
176
50
50
24
20
Analysis of Sell or Process Further
Per Log
Lumber
Sawdust
Sales value after further processing
Sales value at the split-off point
Incremental revenue
Cost of further processing
Profit (loss) from further processing
Practice:
Cinna Corp. manufactures three products from a common input in a joint processing operation. Joint
processing costs up to the split-off point total $500,000 per year. The company allocates these costs to
the joint products on the basis of their total sales value at the split-off point.
Each product may be sold at the split-off point or processed further. The additional processing costs
and sales value after further processing for each product (on an annual basis) are:
Sales Value at
Split-off
Further costs
Sales Value
after further
processing
Product X
$
609,000
$
135,000
$
375,000
Product Y
$
525,000
$
235,000
$
350,000
Product Z
$
435,000
$
145,000
$
270,000
The "Further Processing Costs" consist of variable and avoidable fixed costs.
Required:
Which product or products should be sold at the split-off point, and which product or products should
be processed further? Show computations.