Chapter 12
Differential Analysis and
Product Pricing
DIFFERENTIAL COSTS AND REVENUES
Bill is currently employed as a lifeguard, but he has been offered a
job in an auto service center in the same town. The differential
revenues and costs between the two jobs are listed below:
Lifeguard
Monthly salary
Auto
Service
Center
Differential
costs and
revenues
$1,200
$1,500
$300
30
90
60
Meals
150
150
0
Apartment rent
450
450
0
0
50
50
10
0
640
740
100
$ 560
$ 760
$200
Monthly expenses:
Commuting
Uniform rental
Union dues
Total monthly expenses
Net monthly income
(10)
Identifying Relevant Costs
Automobile Costs (based on 10,000 miles driven per year)
1
2
3
4
5
6
Annual straight-line depreciation on car
Cost of gasoline
Annual cost of auto insurance and license
Maintenance and repairs
Parking fees at school
Total average cost
7
8
9
10
11
12
13
Annual Cost
of Fixed Items
$
2,800
1,380
360
Cost per
Mile
$
0.280
0.050
0.138
0.065
0.036
$
0.569
Some Additional Information
Reduction in resale value of car per mile of wear
Round-trip train fare
Cost of hotel in New York
Cost of putting dog in kennel while gone
Benefit of having car in New York
Hassle of parking car in New York
Per day cost of parking car in New York
$ 0.026
$
104
$
200
$
40
????
????
$
25
Lease versus Sell
Harbold Construction Company is considering selling excess
machinery with a book value of $210,000 (original cost of
$320,000 less accumulated depreciation of $110,000) for
$180,000 less a 5% brokerage commission. Alternatively, the
machinery can be leased for a total of $200,000 for 5 years,
after which it is expected to have no residual value. During the
period of the lease, Harbold Construction Company’s costs of
repair, insurance and property tax expenses are expected to be
$24,000.
Prepare a differential analysis to determine whether Harbold
should sell or lease the machinery.
Make versus Buy
Grayson Enterprises currently manufactures part A-14, one of
the component parts used to assemble the company’s main
product. Specialty Parts has offered to make part A-14 for $12.50
per unit.
Grayson’s per-unit cost to make part A-14 is $14.30,
as follows:
Direct Materials
$ 4.55
Direct Labor
6.00
Variable Overhead
1.75
Fixed Overhead
2.00
Make versus Buy (cont.)
1. None of Grayson’s fixed overhead costs will be eliminated if
the part is purchased. Assuming that Grayson needs 100,000
parts per year, should the company continue to make part A14 or buy it from Specialty Parts?
2. Now, let’s assume that the plant space currently used to
manufacture part A-14 can be leased to another company for
$30,000 per year. Should Grayson continue to make part A-14
or but it from Specialty Parts?
Pop Quiz
Konrade’s Engine Company manufactures part TE456 used in several of its engine
models. Monthly production costs for 1,000 units are as follows:
Direct materials
$ 40,000
Direct labor
10,000
Variable overhead costs
30,000
Fixed overhead costs
20,000
Total costs
$100,000
It is estimated that 10% of the fixed overhead costs assigned to TE456 will no
longer be incurred if the company purchases TE456 from the outside supplier.
Konrade’s Engine Company has the option of purchasing the part from an
outside supplier at $85 per unit.
The maximum price that Konrade’s Engine Company should be willing to pay the
outside supplier is:
a.
$80 per TE456 part.
b.
$82 per TE456 part.
c.
$98 per TE456 part.
d.
$100 per TE456 part.
Sell versus Process Further
Apple Valley Orchards sells apples for $15.00 per
bushel. Its costs for picking and packing the apples is
$13.00 per bushel. The company has considered
processing some of its apples into apple butter. Each
bushel of apples will yield two dozen jars of apple
butter, which can be sold for $1.50 per jar. The
additional cost to process the apples into apple butter is
$0.75 per jar. Use differential analysis to determine
whether Apple Valley Orchards should make the apple
butter.
Accept Business at Special Price
Gooding Foods makes Goody-Goody brand peanut butter. The cost to
make each jar is $2.05 and consists of the following:
Direct Materials
$ 1.00
Direct Labor
0.25
Variable Overhead
0.30
Fixed Overhead
0.50
1. A grocery store chain wants to purchase a generic brand peanut
butter from Gooding and is willing to pay $1.50 per jar. The generic
peanut butter will be made using a different recipe, lowering the
direct materials cost to $0.80 per jar. Gooding can produce this
special order using excess capacity; therefore, fixed costs will not
increase. Use differential analysis to determine whether Gooding
should accept this special order.
2. Now assume that the grocery chain wants to purchase the standard
(original) brand of peanut butter at $1.50 per jar. Should Gooding
accept this order?
Add or Drop a Product Line
Discount Drug Company has three major product lines. What can be done
to improve the company’s overall performance?
Total
250,000
Drug
125,000
Product Line
Cosmetics
75,000
105,000
145,000
50,000
75,000
25,000
50,000
Less: Fixed Expenses
Salaries
Advertising
Utilities
Depreciation – fixtures
Rent
Insurance
Administrative
Total
50,000
15,000
2,000
5,000
20,000
3,000
30,000
125,000
29,500
1,000
500
1,000
10,000
2,000
15,000
59,000
12,500
7,500
500
2,000
6,000
500
9,000
38,000
8,000
6,500
1,000
2,000
4,000
500
6,000
28,000
Net Op Income (Loss)
20,000
16,000
12,000
(8,000)
Sales
Less:
Variable Expenses
Contribution Margin
Housewares
50,000
30,000
20,000
Add or Drop a Product Line
Which fixed expenses in Housewares will Discount Drug be able to
avoid?
Total
Unavoidable
Avoidable
Salaries
8,000
8,000
Advertising
6,500
6,500
Utilities
1,000
1,000
Depreciation - fixtures
2,000
2,000
Rent
4,000
4,000
Insurance
General Administrative
Total Fixed Expenses
500
500
6,000
6,000
28,000
13,000
15,000
Add or Drop a Product Line
• Contribution margin lost if housewares
line is discontinued
$
• Less fixed costs that can be avoided if the
housewares line is discontinued
$
• Inc/(Dec) in overall company net operating inc.
$
DECISION RULE:
• The Housewares Line should be dropped only if the fixed
cost savings exceed the lost contribution margin.
Equipment Replacement Decision
A manager at White Co. wants to replace an old machine with a new, more
efficient machine:
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Equipment Replacement Decision
White’s sales are $200,000 per year
Fixed expenses, other than depreciation, are $70,000 per year
Should the manager purchase the new machine?
More Efficient Analysis
Relevant Cost Analysis
Savings in variable expenses
provided by the new machine
($20,000 × 5 yrs.)
Cost of the new machine
Disposal value of old machine
Net effect
Scarce Resource Constraint
A company has two products: a plain cellular
phone and a fancier cellular phone with many
special features:
Selling price
Variable costs
Contribution margin
Contribution-margin ratio
Plain
Phone
$ 80
64
$ 16
20%
Fancy
Phone
$ 120
84
$ 36
30%
Scarce Resource Constraint
Suppose annual demand for phones of both types is more than
the company can produce in the next year.
Only 10,000 hours of capacity are available
If in one hour plant workers can make either three plain
phones or one fancy phone, which phone is more profitable?
Scarce Resource Constraint
1. Units per hour
2. Contribution margin per unit
Contribution margin per hour
Total contribution for
10,000 hours
Plain
Phone
3
Fancy
Phone
1
$16
$36
Scarce Resource Constraint
Additional Question:
At what price for the fancy phone would the company be
indifferent between producing and selling the plain phone
or the fancy phone?
Pop Quiz 
Colonial Heritage makes reproduction colonial
furniture from select hardwoods.
Chairs
Selling price per unit
$80
Variable cost per unit
$30
Board feet per unit
2
Monthly demand
600
Tables
$400
$200
10
100
The company’s supplier of hardwood will only be
able to supply 2,000 board feet this month. Is this
enough hardwood to satisfy demand?
a. Yes
b. No
Pop Quiz 
Chairs
Selling price per unit
$80
Variable cost per unit
$30
Board feet per unit
2
Monthly demand
600
Tables
$400
$200
10
100
The company’s supplier of hardwood will only be able to
supply 2,000 board feet this month. What plan would
maximize profits?
a. 500 chairs and 100 tables
b. 600 chairs and 80 tables
c. 500 chairs and 80 tables
d. 600 chairs and 100 tables
Determining A Product’s Selling Price
The following costs were incurred to make 10,000 units of a
product.
Variable manufacturing costs ………………..$5 per unit
Variable selling and administrative expenses ..$2 per unit
Fixed factory overhead costs ………………..$80,000
Fixed selling and administrative expenses …..$30,000
This company wishes to price its product so it will make a profit
20% return on assets if all 10,000 units are sold. $135,000 of
assets are devoted to producing the above product.
Determine the selling price of the product using the Total Cost
Concept.