CHAPTER 25 Differential Analysis, Product Pricing, and Activity-Based Costing Warren Reeve Duchac human/iStock/360/Getty Images Accounting 26e Differential Analysis (slide 1 of 4) • • Managerial decision making involves choosing between alternative courses of action. Although the managerial decision-making process varies by the type of decision, it normally involves the following steps: o o o o o Step 1. Identify the objective of the decision, which is normally maximizing income. Step 2. Identify alternative courses of action. Step 3. Gather information and perform a differential analysis. Step 4. Make a decision. Step 5. Review, analyze, and assess the results of the decision. ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Differential Analysis (slide 2 of 4) • Differential analysis, sometimes called incremental analysis, analyzes differential revenues and costs in order to determine the differential impact on income of two alternative courses of action. o o o Differential revenue is the amount of increase or decrease in revenue that is expected from a course of action compared to an alternative. Differential cost is the amount of increase or decrease in cost that is expected from a course of action as compared to an alternative. Differential income (loss) is the difference between the differential revenue and differential costs. Differential income indicates that a decision is expected to increase income. A differential loss indicates that a decision is expected to decrease income. ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Differential Analysis (slide 3 of 4) • The differential analysis is prepared in three columns, where positive amounts indicate the effect is to increase income and negative amounts indicate the effect is to decrease income. o o o The first column is the revenues, costs, and income for maintaining floor space for tables (Alternative 1). The second column is the revenues, costs, and income for using that floor space for a salad bar (Alternative 2). The third column is the difference between the revenue, costs, and income of one alternative over the other. ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Differential Analysis (slide 4 of 4) • In this chapter, differential analysis is illustrated for the following common decisions: o o o o o o Leasing or selling equipment Discontinuing an unprofitable segment Manufacturing or purchasing a needed part Replacing fixed assets Selling a product or processing further Accepting additional business at a special price ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Lease or Sell • • • Management may lease or sell a piece of equipment that is no longer needed. In making a decision, differential analysis can be used. Only the differential revenues and differential costs associated with the lease-or-sell decision are included in the differential analysis. o The book value of the equipment is a sunk cost and is not considered in the differential analysis. Sunk costs are costs that have been incurred in the past, cannot be recouped, and are not relevant to future decisions. ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Discontinuing a Segment or Product • • • A product, department, branch, territory, or other segment of a business may be generating losses. As a result, management may consider discontinuing (eliminating) the product or segment. Discontinuing the product or segment usually eliminates all of the product’s or segment’s variable costs such as direct materials direct labor, variable factory overhead, and sales commissions. However, fixed costs such as depreciation, insurance, and property taxes may not be eliminated. o Thus, it is possible for total company income to decrease rather than increase if the unprofitable product or segment is discontinued. ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Make or Buy • • Companies that manufacture products made up of components that are assembled into a final product, such as automobile manufacturers, must decide whether to make a part or purchase it from a supplier. Differential analysis can be used to decide whether to make or buy a part. ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Replace Equipment • • The usefulness of a fixed asset may decrease before it is worn out as it may be less efficient. Differential analysis can be used for decisions to replace fixed assets such as equipment and machinery. o The analysis normally focuses on the costs of continuing to use the old equipment versus replacing the equipment. The book value of the old equipment is a sunk cost and, thus, is irrelevant. • The revenue that is forgone from an alternative use of an asset, such as cash, is called an opportunity cost. It is useful in analyzing alternative courses of action. ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Process or Sell • • During manufacturing, a product normally progresses through various stages or processes. In some cases, a product can be sold at an intermediate stage of production, or it can be processed further and then sold. Differential analysis can be used to describe whether to sell a product at an intermediate stage or to process it further. o o In doing so, the differential revenues and costs from further processing are compared. The costs of producing the intermediate product do not change, regardless of whether the intermediate product is sold or processed further. ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Accept Business at a Special Price • A company may be offered the opportunity to sell its products at prices other than normal prices. o • For example, an exporter may offer to sell a company’s products overseas at special discount prices. Differential analysis can be used to decide whether to accept business at a special price. o The differential revenue from accepting the additional business is compared to the differential costs of producing and delivering the product to the customer. o If the company is operating at less than full capacity, then the additional production does not increase fixed manufacturing costs. – However, selling and administrative expenses may change because of the additional business. ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Setting Normal Product Selling Prices (slide 1 of 3) • • The normal selling price is the target selling price to be achieved in the long term. The normal selling price must be set high enough to cover all costs and expenses (fixed and variable) and provide a reasonable profit. ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Setting Normal Product Selling Prices (slide 2 of 3) • Managers can use one of two market methods to determine selling price: o Demand-based concept The demand-based concept sets the price according to the demand for the product. – If there is high demand for the product, then the price is set high. – Likewise, if there is low demand for the product, then the price is set low. o Competition-based concept The competition-based concept sets the price according to the price offered by competitors. ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Setting Normal Product Selling Prices (slide 3 of 3) • Managers can also use one of three cost-plus methods to determine the selling price: o o o Product cost concept Total cost concept Variable cost concept ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Product Cost Concept (slide 1 of 3) • Cost-plus methods determine the normal selling price by estimating a cost amount per unit and adding a markup, computed as follows: • 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. o o Estimated selling expenses, administrative expenses, and desired profit are included in the markup. The markup per unit is then computed and added to the product cost per unit to determine the normal selling price. ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Product Cost Concept (slide 2 of 3) • Step 1. Estimate the total product costs as follows: • Step 2. Estimate the total selling and administrative expenses. 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, computed as follows: • ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Product Cost Concept (slide 3 of 3) • Step 4. Compute the markup percentage as follows: o The desired profit is normally computed based on a rate of return on assets as follows: • Step 5. Determine the markup per unit by multiplying the markup percentage times the product cost per unit as follows: • Step 6. Determine the normal selling price by adding the markup per unit to the product cost per unit as follows: ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Target Costing • • • • Target costing is a method of setting prices that combines market-based pricing with a cost-reduction emphasis. Under target costing, a future selling price is anticipated, using the demand-based or the competition-based methods. The target cost is then determined by subtracting a desired profit from the expected selling price, computed as follows: Target costing tries to reduce costs. ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Production Bottlenecks • • • 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. The theory of constraints (TOC) is a manufacturing strategy that focuses on reducing the influence of bottlenecks on production processes. When a company has a production bottleneck in its production process, it should attempt to maximize its profits, subject to the production bottleneck. o In doing so, the unit contribution margin of each product per production bottleneck constraint is used. ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Activity-Based Costing Method • • • Activity-based costing (ABC) identifies and traces costs and expenses to activities and then to specific products. The ABC method is an alternative approach for allocating factory overhead when there are diverse products and processes. ABC uses multiple factory overhead rates based on activities. o o Activities are the types of work, or actions, involved in a manufacturing process or service activity. ABC initially assigns estimated factory overhead costs to activities, resulting in estimated activity costs. ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Activity Rates • • The estimated activity costs are allocated to products using an activity rate. Activity rates are determined as follows: Estimated Activity Cost Activity Rate = Estimated Activity-Base Usage o o The activity base is a measure of physical activity for each activity. The activity-base usage is the number of setups estimated to be used by the operations. ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Dangers of Product Cost Distortion • • The allocation of factory overhead affects the accuracy of product costs. In turn, product costs are used for decisions such as establishing product price and determining whether to discontinue a product line. Using an inappropriate factory overhead allocation method can lead to distorted product costs. ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Appendix: Total Cost Concept (slide 1 of 3) • • 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. ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Appendix: Total Cost Concept (slide 2 of 3) • Step 1. Estimate the total manufacturing cost as follows: • Step 2. Estimate the total selling and administrative expenses. • Step 3. Estimate the total cost as follows: • Step 4. Divide the total cost by the number of units expected to be produced and sold to determine the total cost per unit, as follows: ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Appendix: Total Cost Concept (slide 3 of 3) • Step 5. Compute the markup percentage as follows: o The desired profit is normally computed based on a rate of return on assets as follows: • Step 6. Determine the markup per unit by multiplying the markup percentage times the cost per unit as follows: • Step 7. Determine the normal selling price by adding the markup per unit to the cost per unit as follows: ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Appendix: Variable Cost Concept (slide 1 of 3) • • • • Under the variable cost concept, only variable costs are included in the cost amount per unit to which the markup is added. All variable manufacturing costs as well as variable selling and administrative expenses, are included in the cost amount. Fixed manufacturing costs, fixed selling and administrative expenses, and desired profit are included in the markup. The markup per unit is then added to the variable cost per unit to determine the normal selling price. ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Appendix: Variable Cost Concept (slide 2 of 3) • Step 1. Estimate the total variable product cost as follows: • Step 2. Estimate the total variable selling and administrative expenses. • Step 3. Determine the total variable cost as follows: • Step 4. Compute the variable cost per unit as follows: ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Appendix: Variable Cost Concept (slide 3 of 3) • Step 5. Compute the markup percentage as follows: o The desired profit is normally computed based on a rate of return on assets as follows: • Step 6. Determine the markup per unit by multiplying the markup percentage times the variable cost per unit as follows: • Step 7. Determine the normal selling price by adding the markup per unit to the variable cost per unit as follows: ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.