Differential Analysis and Product Pricing 9 Differential Analysis and Product Pricing

Differential Analysis 9-1 Differential Analysis 9-1 11

Differential analysis is used for analyzing: Uses of Differential Analysis 9-1 Differential analysis is used for analyzing: Leasing or selling equipment. Discontinuing an unprofitable segment. Manufacturing or purchasing a needed part. Replacing usable fixed assets. Processing further or selling an intermediate product. Accepting additional business at a special price. 12

Lease or Sell 9-1 Marcus Company is considering disposing of equipment that cost $200,000 and that has $120,000 of accumulated depreciation. The equipment can be sold through a broker for $100,000, less a 6% commission.

9-1 Potamkin Company, the lessee, has offered to lease the equipment for five years for a total consideration of $160,000.

9-1 At the end of the fifth year of the lease, the equipment is expected to have no residual value. During the period of the lease, Marcus Company expects to incur repair, insurance, and property taxes estimated at $35,000.

Differential Analysis Report—Lease or Sell 9-1 Differential Analysis Report—Lease or Sell 9-1 16

9-1 Example Exercise 9-1 Office space with a cost of $100,000 and accumulated depreciation of $30,000 can be sold for $150,000 less a 6% broker commission. Alternatively, the office space can be leased for ten years for a total of $170,000 at the end of which there is no salvage value. In addition, repair, insurance, and property tax on the rented office space would total $24,000 over the ten years. Determine the differential income or loss from the lease alternative. 18

Differential revenue from alternatives: Revenue from lease $170,000 9-1 Follow My Example 9-1 Differential revenue from alternatives: Revenue from lease $170,000 Revenue from sale 150,000 Differential revenue from lease $20,000 Differential cost of alternatives: Repairs, insurance, and property tax expense $ 24,000 Commission expense 9,000 Differential cost of lease 15,000 Net differential income from lease alternative $ 5,000 19 For Practice: PE9-1A, PE9-1B

9-1 4 Income (Loss) by Product 20

Discontinue a Segment or Product 9-1 Based on the information contained in the condensed income statement , management of Battle Creek Cereal Co. is considering discontinuing Bran Flakes.

Proposal to Discontinue Bran Flakes Don’t discontinue Bran Flakes! Differential Analysis Report—Discontinue an Unprofitable Segment 9-1 Proposal to Discontinue Bran Flakes September 29, 2008 Differential revenue from annual sales of Bran Flakes: Revenue from sales $100,000 Differential cost of annual sales of Bran Flakes: Variable cost goods sold $60,000 Variable operating expenses 25,000 85,000 Annual differential income from sales of Bran Flakes $15,000 Don’t discontinue Bran Flakes! 22

a. Determine the differential income or loss from sales of Product A. 9-1 Example Exercise 9-2 Product A has revenue of $65,000, variable cost of goods sold of $50,000, variable selling expenses of $12,000, and fixed costs of $25,000, creating a loss from operations of $22,000. a. Determine the differential income or loss from sales of Product A. b. Should Product A be discontinued? 24

Differential revenue from sales of Product A: a. Product A 9-1 Follow My Example 9-2 Differential revenue from sales of Product A: a. Product A Revenue from sales $65,000 Differential costs of Product A: Variable cost of goods sold $50,000 Variable selling expenses 12,000 62,000 Annual differential income from Product A $ 3,000 b. Product A should not be discontinued. 25 For Practice: PE9-2A, PE9-2B

Variable factory overhead 52 Fixed factory overhead 68 Make or Buy 9-1 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 labor 80 Variable factory overhead 52 Fixed factory overhead 68 Total estimated cost per unit $280 26

Proposal to Manufacture Instrument Panels Differential Analysis Report—Make or Buy 9-1 Proposal to Manufacture Instrument Panels February 15, 2008 Purchase price of instrument panel $240.00 Differential cost to manufacture: Direct materials $80.00 Direct labor 80.00 Variable factory overhead 52.00 212.00 Cost savings from manufacturing instrument panel $ 28.00 27

9-1 Example Exercise 9-3 A company manufactures a subcomponent of an assembly for $80 per unit, including fixed costs of $25 per unit. A proposal is offered to purchase the subcomponent from an outside source for $60 per unit, plus $5 per unit freight. Provide a differential analysis of the outside purchase proposal. 28

Differential cost to purchase: Purchase price of the subcomponent $60 9-1 Follow My Example 9-3 Differential cost to purchase: Purchase price of the subcomponent $60 Freight for subcomponent 5 $65 Differential cost to manufacture: Variable manufacturing costs ($80 – $25 fixed cost) 55 Cost savings from manufacturing sub- component $10 29 For Practice: PE9-3A, PE9-3B

Replace Equipment 9-1 A business is considering the disposal of several identical machines having a total book value of $100,000 and an estimated remaining life of five years.

9-1 The old machines can be sold for $25,000. They can be replaced by a single high-speed machine at a cost of $250,000. The new machine has an estimated useful life of five years and no residual value.

Proposal to Replace Equipment Differential Analysis Report—Replace Equipment 9-1 Proposal to Replace Equipment November 28, 2008 Annual variable costs—present equipment $225,000 Annual variable costs—new equipment 150,000 Annual differential decrease in cost $ 75,000 Number of years applicable x 5 Total differential decrease in cost $375,000 Proceeds from sale of present equipment 25,000 $400,000 Cost of new equipment 250,000 Net differential decrease in cost, 5-years $150,000 Annual net differential decrease in cost—new equipment $ 30,000

Opportunity Cost 9-1 The amount of income that is foregone from an alternative use of an asset, such as cash, is called an opportunity cost.

9-1 Example Exercise 9-4 A machine with a book value of $32,000 has an estimated four-year life. A proposal is offered to sell the old machine for $10,000 and replace it with a new machine at a cost of $45,000. The new machine has a four-year life with no salvage value. The new machine would reduce annual direct labor costs by $15,000. Provide a differential analysis on the proposal to replace the machine. 34

Annual direct labor cost reduction $15,000 9-1 Follow My Example 9-4 Annual direct labor cost reduction $15,000 Number of years applicable x 4 Total differential decrease in cost $60,000 Proceeds from sale of old equipment 10,000 $70,000 Cost of new equipment 45,000 Net differential decrease in cost from replacing equipment, 4-year total $ 25,000 35 For Practice: PE9-4A, PE9-4B

Accept Business at a Special Price 9-1 The monthly capacity of a sporting goods business is 12,500 basketballs. Current sales and production are averaging 10,000 basketballs per month. The current manufacturing cost is $20 per unit (variable, $12.50; fixed, $7.50). The domestic unit selling price is $30.

9-1 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.

Proposal to Sell Basketballs to Exporter Differential Analysis Report—Sell at Special Price 9-1 Differential revenue from accepting offer: Revenue from sale of 5,000 additional units at $18 $90,000 Differential cost of accepting offer: Variable cost of 5,000 additional units at $12.50 62,500 Differential income from accepting offer $27,500 Proposal to Sell Basketballs to Exporter March 10, 2008 43

9-1 Example Exercise 9-6 Product D is normally sold for $4.40 per unit. A special price of $3.60 is offered for the export market. The variable production cost is $3.00 per unit. An additional export tariff of 10% of revenue will be required to be paid for all export products. Determine the differential income or loss per unit from selling Product D for export. 44

Differential revenue from export: 9-1 Follow My Example 9-6 Differential revenue from export: Revenue per unit from export sale $3.60 Differential cost from export: Variable manufacturing costs $3.00 Export tariff (10% x $3.60) 0.36 3.36 Differential income from accepting export sale $0.24 45 For Practice: PE9-6A, PE9-6B