Differential Analysis, Product Pricing, and Activity-Based Costing PRINCIPLES OF ACCOUNTING 24e ACCOUNTING PRINCIPLES Using excel for Success 2e Chapter 25 Prepared by: C. Douglas Cloud Professor Emeritus of Accounting Pepperdine University These slides should be viewed using the presentation mode (click the icon to start presentation). Reeve Warren Duchac © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Learning Objective 1 Prepare differential analysis reports for a variety of managerial decisions.

Managerial Decision Making LO 1 Differential Analysis Managerial Decision Making Step 2: Identify the alternative courses of action Step 1: Identify the objective of the decision Step 3: Gather relevant information and perform differential analysis. Step 5: Review, analyze, and assess the results of the decision Step 4: Make a decision

Bryant Restaurants, Inc. LO 1 Differential Analysis Bryant Restaurants, Inc. Step 2: Identify the alternative courses of action Use floor space for existing tables, or… replace the tables with a salad bar. Step 1: Identify the objective of the decision Increase its income. Tables Salad Bar Revenues $100,000 $120,000 Costs 60,000 65,000 Income $ 40,000 $ 55,000 Step 3: Gather relevant information and perform differential analysis. Step 5: Review, analyze, and assess the results of the decision Step 4: Make a decision Replace tables with salad bar

Differential Analysis LO 1 Differential Analysis Differential analysis, sometimes called incremental analysis, analyzes differential revenues and costs to determine the differential impact on income of two alternative courses of action. Differential revenue is the amount of increase or decrease in revenue that is expected from a course of action as compared to an alternative.

Differential Analysis LO 1 Differential Analysis 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 the differential costs.

LO 1 Lease or Sell The $80,000 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.

Discontinue a Segment or Product LO 1 Discontinue a Segment or Product Management may consider discontinuing a product or segment of a business that is generating losses. The management of Battle Creek Cereal Co. is considering discontinuing Bran Flakes.

LO 1 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?

LO 1 Make or Buy 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 $ 80 Direct labor 80 Variable factory overhead 52 Fixed factory overhead 68 Total estimated cost per unit $280

LO 1 Replace Equipment The revenue that is forgone from an alternative use of an asset, such as cash, is called an opportunity cost. Although the opportunity cost is not recorded in the accounting records, it is useful in analyzing alternative courses of action.

LO 1 Process or Sell In some cases, a product can be sold at an intermediate stage of production, or it can be processed further and then sold.

Accept Business at a Special Price LO 1 Accept Business at a Special Price 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.

Learning Objective 2 Prepare differential analysis reports for a variety of managerial decisions. Determine the selling price of a product, using the product cost concept.

Setting Normal Product Selling Prices LO 2 Setting Normal Product Selling Prices 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

Setting Normal Product Selling Prices LO 2 Setting Normal Product Selling Prices The demand-based concept sets the price according to the demand for the product. The competition-based concept sets the price according to the price offered by competitors.

LO 2 Product Cost Concept 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.

LO 2 Product Cost Concept Step 1: Estimate the total product costs as follows: Product costs: Direct materials $XXX Direct labor XXX Factory overhead XXX Total product cost $XXX

LO 2 Product Cost Concept Step 2: Estimate the total selling and administrative expenses.

Estimated Units Produced and Sold LO 2 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

Desired Profit + Total Selling and Administrative Expenses LO 2 Product Cost Concept Step 4. Compute the markup percentage as follows: Markup Percentage = Desired Profit + Total Selling and Administrative Expenses Total Product Cost

LO 2 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

LO 2 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 $XXX Markup per unit XXX Normal selling price per unit $XXX

LO 2 Product Cost Concept 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) $ 300,000 Direct labor ($10.00 x 100,000) 1,000,000 Factory overhead 200,000 Total Manufacturing costs $1,500,000 Selling and administrative expenses 170,000 Total cost $1,670,000 Total assets $800,000 Desired rate of return 20%

LO 2 Product Cost Concept Step 1: Estimate the total product cost as follows: Product costs: Direct materials $ XXXXX Direct labor XXXXX Factory overhead XXX Total product cost $1,500,000

LO 2 Product Cost Concept Step 2: Estimate the total selling and administrative expenses. Management expects total selling and administrative expenses to be $170,000.

Estimated Units Produced and Sold LO 2 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. Total Product Cost Estimated Units Produced and Sold Product Cost per Unit = Product Cost per Unit = $1,500,000 100,000 units = $15.00 per unit

Desired Profit + Total Selling and Administrative Expenses LO 2 Product Cost Concept Step 4. Compute the markup percentage as follows: Markup Percentage = Desired Profit + Total Selling and Administrative Expenses Total Product Cost Desired Rate of Return x Total Assets Markup Percentage = $160,000 + $170,000 $1,500,000 0.20 x $800,000 $330,000 $1,500,000 = 22% Markup Percentage =

LO 2 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

LO 2 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 $15.00 Markup per unit 3.30 Normal selling price per unit $18.30

LO 2 Target Costing 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

LO 2 Target Costing 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

Learning Objective 3 Prepare differential analysis reports for a variety of managerial decisions. Determine the selling price of a product, using the product cost concept. Compute the relative profitability of products in bottleneck production processes.

Production Bottlenecks, Pricing, and Profits LO 3 Production Bottlenecks, Pricing, and Profits 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.

Production Bottlenecks, Pricing, and Profits LO 3 Production Bottlenecks, Pricing, and Profits The theory of constraints (TOC) is a manufacturing strategy that focuses on reducing the influence of bottlenecks on production processes.

Production Bottlenecks and Profits LO 3 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 LO 3 Production Bottlenecks and Profits The product unit contribution margin and the number of hours of heat treatment used by each type of wrench are as follows: Small Medium Large Wrench Wrench Wrench Sales price per unit $130 $140 $160 Variable cost per unit 40 40 40 Contribution margin per unit $ 90 $100 $120 Heat treatment hours per unit 1 hr. 4 hrs. 8 hrs. (continued)

Unit Contribution Margin Heat Treatment Hours per Unit LO 3 Production Bottlenecks and Profits Unit Contribution Margin Heat Treatment Hours per Unit Unit Contribution Margin per Production Bottleneck Hour = Small Wrenches Unit Contribution Margin per Production Bottleneck Hour = $90 1 hr. = $90 per hour $90 per hour The small wrench is the most profitable product per bottleneck hour. Medium Wrenches Unit Contribution Margin per Production Bottleneck Hour = $100 4 hrs. = $25 per hour Large Wrenches Unit Contribution Margin per Production Bottleneck Hour = $120 8 hrs. = $15 per hour

Production Bottlenecks and Pricing LO 3 Production Bottlenecks and Pricing 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.

Production Bottlenecks and Pricing LO 3 Production Bottlenecks and Pricing How much should PrideCraft Tool Co. charge for the large wrench in order to deliver the same contribution margin of $90 that is being provided by the small wrench?

Production Bottlenecks and Pricing LO 3 Production Bottlenecks and Pricing Contribution Margin (per unit) per Bottleneck Hour for Small Wrench Revised Price of Large Wrench Variable Cost per Unit for Large Wrench – = Bottleneck Hours per Unit for Large Wrench $90 = Revised Price of Large Wrench – $40 8 $720 = Revised Price of Large Wrench – $40 $760 = Revised Price of Large Wrench

Learning Objective 4 Prepare differential analysis reports for a variety of managerial decisions. Determine the selling price of a product, using the product cost concept. Compute the relative profitability of products in bottleneck production processes. Allocate product costs using activity-based costing.

Activity-Based Costing Method LO 4 Activity-Based Costing Method Activity-based costing (ABC) identifies and traces costs and expenses to activities and then to specific products. Activities are the types of work, or actions, involved in a manufacturing process or service activity.

Estimated Activity Costs LO 4 Estimated Activity Costs 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 (p. 1164 of your textbook). Setup consists of changing tooling in machines in preparation for making a new product.

Estimated Activity Costs LO 4 Estimated Activity Costs 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 consists of processing changes in design or process specifications for a product.

Estimated Activity Cost Estimated Activity- Base Usage LO 4 Activity Rates The estimated activity costs are allocated to products using an activity rate. Activity rates are determined as follows: Activity Rate = Estimated Activity Cost Estimated Activity- Base Usage

LO 4 Activity Rates 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.

Dangers of Product Cost Distortion LO 4 Dangers of Product Cost Distortion Using an inappropriate factory overhead allocation method can lead to distorted product costs.

Estimated Total Factory Overhead Costs Estimated Activity Base LO 4 Dangers of Product Cost Distortion 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: Predetermined Factory Overhead Rate Estimated Total Factory Overhead Costs Estimated Activity Base = Predetermined Factory Overhead Rate $1,600,000 20,000 direct labor hours = = $80

Dangers of Product Cost Distortion LO 4 Dangers of Product Cost Distortion 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 single-rate method can distort costs.

Differential Analysis, Product Pricing, and Activity-Based Costing The End