1 24 Differential Analysis and Product Pricing Student Version

Prepare differential analysis reports for a variety of managerial decisions. 24-2

Sunk Costs Costs that have been incurred in the past are not relevant to the decision. These costs are called sunk costs. 1

Differential revenue is the amount of increase or decrease in revenue that is expected from a course of action as compared with an alternative action. Differential Revenue 1

Differential cost is the amount of increase or decrease in cost that is expected from a course of action as compared with an alternative action. Differential Cost 1

Differential income (or loss) is the difference between the differential revenue and the differential costs. Differential income indicates that a particular decision is expected to be profitable, while a differential loss indicates the opposite. Differential Income or Loss 1

Marcus Company is considering leasing or disposing of the following equipment: Lease or Sell Cost of equipment$200,000 Less accumulated depreciation 120,000 Book value$ 80,000 Lease Option: Total revenue for five-year lease 160,000 Total estimated repair, insurance, and property tax expenses during life of lease35,000 Sell Option: Sales price$100,000 Commission on sale6% 1

Differential Analysis Report—Lease or SellExhibit 2 1

Management may consider discontinuing the product or segment of a business that is generating losses. Based on the information contained in the condensed income statement (Slide 10), management of Battle Creek Cereal Co. is considering discontinuing Bran Flakes. Discontinue a Segment or Product 1

Income (Loss) by ProductExhibit 4 1

Differential Analysis Report—Discontinue an Unprofitable Segment Don’t discontinue Bran Flakes! Exhibit 5 1

Make or Buy An automobile manufacturer has been purchasing instrument panels for $240 a unit. The factory currently operates at 80% of capacity. The cost per unit is estimated as follows: Direct materials$ 80 Direct labor80 Variable factory overhead52 Fixed factory overhead 68 Total estimated cost per unit$280 1

Differential Analysis Report—Make or BuyExhibit 7 1

The amount of income that is foregone from an alternative use of an asset, such as cash, is called an opportunity cost. Opportunity Cost 1

A business produces kerosene as follows: Process or Sell Batch size4,000gallons Cost of producing kerosene$2,400per batch Selling price$0.80per gallon (continued) 1

The kerosene can be processed further to yield gasoline as follows: Process or Sell Input batch size4,000gallons Less evaporation (20%) 800(4,000 × 20%) Output batch size3,200 Additional processing costs$650per batch Selling price$1.25per gallon 1 (continued)

Differential Analysis Report—Process or Sell Exhibit 9 1

Accept Business at a Special Price B-Ball Inc. manufactures basketballs as follows: Monthly productive capacity12,500basketballs Current monthly sales10,000basketballs Normal (domestic) selling price$30.00per basketball Manufacturing costs: Variable costs$12.50 per basketball Fixed costs 7.50 Total$20.00per basketball 1

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. Accept Business at a Special Price 1

Differential Analysis Report— Sell at Special Price Exhibit 10 1

Determine the selling price of a product using the total cost, product cost, and variable cost concepts

Markup Using the cost-plus methods, managers add to the cost an amount called a markup. This allows for all costs plus a profit to be included in the selling price. 2

Manufacturing Cost Selling Expenses Administrative Expenses The markup is determined by applying the following formula: Markup percentage = Desired profit Total costs Desired selling price Desired Profit 2

Manufacturing costs: Direct materials ($3.00 × 100,000)$ 300,000 Direct labor ($10.00 × 100,000)1,000,000 Factory overhead: Variable costs ($1.50 × 100,000) $150,000 Fixed costs 50, ,000 Total manufacturing costs$1,500,000 Selling and administrative expenses: Variable expenses ($1.50 × 100,000)$150,000 Fixed costs 20,000 Total selling and administrative expenses 170,000 Total cost$1,670,000 2

Only the desired profit is covered in the markup. Desired profit Total costs = 9.6% = Total cost per calculator$16.70 Markup ($16.70 × 9.6%) 1.60 Selling price$18.30 $160,000 $1,670,000 Markup Percentage 2

Using the product cost concept, only the costs of manufacturing the product are included in the cost amount to which the markup is added. The markup percentage is computed as follows: Product Cost Concept Markup Percentage = Desired Profit + Total Selling and Administrative Expenses Total Product Cost 2

Manufacturing costs: Direct materials ($3.00 × 100,000)$ 300,000 Direct labor ($10.00 × 100,000)1,000,000 Factory overhead: Variable costs ($1.50 × 100,000) $150,000 Fixed costs 50, ,000 Total manufacturing costs$1,500,000 Selling and administrative expenses: Variable expenses ($1.50 × 100,000)$150,000 Fixed costs 20,000 Total selling and administrative expenses 170,000 Total cost$1,670,000 2

Manufacturing Cost Product Cost Markup Administrative Expense + Selling Expense + Desired Profit Desired Selling Price 2

Markup Percentage Desired Profit + = Total Selling and Administrative Expenses Total Manufacturing Costs Calculating the Markup Percentage Markup Percentage $160,000 + $170,000 = $1,500,000 Markup Percentage = 22% 2

Digital Solutions Inc. would price each calculator at $18.30 per unit, as shown below: 2 Manufacturing cost per calculator$15.00 Markup ($15.00 × 22%) 3.30 Selling price$18.30

Variable Cost Concept The variable cost concept emphasizes the distinction between variable and fixed costs in product pricing. Only variable costs are include in the cost amount to which the markup is added. 2

Product Cost Markup Variable Manufacturing Cost + Variable Administrative and Selling Expenses Total Fixed Costs + Desired Profit Desired Selling Price 2

Markup Percentage Desired Profit + = Total Fixed Costs Total Variable Costs Markup Percentage $160,000 + $50,000 + $20,000 = $1,600,000 Direct materials ($3 × 100,000)$ 300,000 Direct labor ($10 × 100,000)1,000,000 Variable factory overhead ($1.50 × 100,000)150,000 Variable selling and administrative expenses ($1.50 × 100,000) 150,000 Total variable costs$1,600,000 2

Markup Percentage Desired Profit + = Total Fixed Costs Total Variable Costs Markup Percentage $160,000 + $50,000 + $20,000 = $1,600,000 Markup Percentage = $230,000 $1,600,000 = 14.4% 2

Variable cost per calculator $16.00 Markup ($16.00 × 14.4%) 2.30 Selling price $18.30 Digital Solutions Inc. would price each calculator at $18.30 per unit, as shown below: 2

Target Costing Target costing is a method of setting prices that combines market-based pricing with a cost reductive emphasis. A future price is anticipated, using the demand-based methods or the competition-based methods. Target Cost = Expected Selling Price – Desired Profit 2

Compute the relative profitability of products in bottleneck production processes

Production Bottlenecks and Profits A production bottleneck (or constraint) occurs at the point in the process where the demand for the company’s product exceeds the ability to produce the product. 3

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

Unit Contribution Margin per Bottleneck Hour = Unit Contribution Margin Heat Treatment Hours per Unit Small Wrenches Unit Contribution Margin per Bottleneck Hour = $90 1 hr. = $90 per hour Medium Wrenches Unit Contribution Margin per Bottleneck Hour = $100 4 hrs. = $25 per hour Large Wrenches Unit Contribution Margin per Bottleneck Hour = $120 8 hrs. = $15 per hour 3

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

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 3