©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publically accessible website, in whole or in part. Differential Analysis and Product Pricing CHAPTER 12

©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publically accessible website, in whole or in part. Learning Objectives After studying this chapter, you should be able to: Prepare differential analysis reports for a variety of managerial decisions Determine the selling price of a product, using the total cost, product cost, and variable cost concepts Compute the relative profitability of products in bottleneck production processes

©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publically accessible website, in whole or in part. Prepare differential analysis reports for a variety of managerial decisions Learning Objective 1

©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publically accessible website, in whole or in part. Differential Analysis Step 1. Identify the objective of the decision Step 2. Identify the __________________ Step 3. _____________ __________________ Step 4. _____________ __________________ Step 5. _____________ ___________ of the decision

©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publically accessible website, in whole or in part. Differential Analysis Looks at the effects of different alternatives Uses ________ revenues and costs Focuses on relevant ______ and _______ Ignores _____________ – those costs that have occurred in the past and are irrelevant for future decision making

©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publically accessible website, in whole or in part. Differential Analysis in Six Situations Leasing or selling equipment Discontinuing ___________ segment Manufacturing or purchasing a needed part Replacing _____ assets Processing further or selling an intermediate product Accepting additional business at a __________

©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publically accessible website, in whole or in part. Lease or Sell Karnes Company has equipment to dispose. The equipment originally cost $200,000, and accumulated depreciation is $120,000 Two alternatives: Lease the equipment for $160,000 less $35,000 in repairs, taxes, etc Sell the equipment for $100,000 less 6% commission

©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publically accessible website, in whole or in part. Lease or Sell NOTE: The $80,000 book value is a _______ and is ignored in differential analysis Decision: Leasing the equipment would _________ overall income by $31,000

©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publically accessible website, in whole or in part. Discontinue a Segment or Product Montana Wheat Cereal Co. produces and sells three kinds of cereal. Bran Flakes exhibits an operating loss so the company is considering discontinuing production and sale of the product If fixed costs remain the same, is this the right decision?

©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publically accessible website, in whole or in part. Discontinue a Segment or Product Decision: Discontinuing Bran Flakes would ______ overall profit by $15,000 because that is the amount that Bran Flakes contributes to covering _________

©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publically accessible website, in whole or in part. Make or Buy An automobile company has been buying a part for $240 per unit. It is considering making the part at the following cost: $80 in direct materials $80 in direct labor $52 in variable overhead $68 in fixed overhead 80% capacity Should the company make or buy the part?

©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publically accessible website, in whole or in part. Focus the analysis on differential costs Since the automobile company has excess factory capacity, fixed costs will not change and hence they are _______ to the decision Decision: Making the instrumental panels will provide a cost saving of $28 per unit because _________ will not change Make or Buy

©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publically accessible website, in whole or in part. Replace Equipment A manufacturer is considering replacing several old machines with a new one Total book value of the old machines: $100,000 Total remaining useful life of the old machines is 5 years New machine cost $250,000; 5-year useful life The old equipment can be sold for $25,000 The new machine will reduce annual variable costs from $225,000 to $150,000 Should the company buy the new machine?

©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publically accessible website, in whole or in part. Focus the analysis on relevant costs The book value of the equipment ($100,000) is a ________ and is not considered. ____________ include the cost savings of more efficient equipment, product quality, etc Replace Equipment Decision: Replacing the old equipment with the new equipment will provide an annual _________ in cost of $30,000

©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publically accessible website, in whole or in part. Opportunity Cost Measures the amount of revenue that is foregone from ____________________ Assume that the $250,000 for the new equipment less the $25,000 sale proceeds could be invested to yield a 15% return The annual opportunity cost of the new equipment is $33,750 ($225,000 × 15%) It is not beneficial to replace the equipment for an annual cost savings of $30,000

©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publically accessible website, in whole or in part. Process or Sell A 4,000 gallon batch of kerosene sells at $0.80 per gallon; produced from 4,000 gallons of raw material costing $0.60 per gallon Alternatively, could continue processing these raw material into gasoline selling at $1.25 per gallon for an additional cost of $650 per batch; 20% of the gallons of kerosene will evaporate during production Should the company sell or process further?

©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publically accessible website, in whole or in part. Process or Sell Initial raw material cost will be incurred in both alternatives and is not considered The ___________ revenue and the cost________ ___________ further will be the focus

©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publically accessible website, in whole or in part. Accept Business at a Special Price A company currently produces an average of 10,000 basketballs per month; factory has a monthly capacity of 12,500 basketballs Variable costs are $12.50 per ball Fixed costs are $7.50 per ball The domestic selling price is $30 per ball The company received an offer for 5,000 additional basketballs at $18 each from a foreign buyer and the balls can be produced over 3 months Should the company accept the offer?

©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publically accessible website, in whole or in part. Accept Business at a Special Price The company has excess capacity and can produce additional product without incurring additional _____________ Whether differential revenue covers _________ and produces _______ is the issue

©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publically accessible website, in whole or in part. Determine the selling price of a product, using the total cost, product cost, and variable cost concepts Learning Objective 2

©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publically accessible website, in whole or in part. Setting Normal Product Selling Prices In the long run, the normal selling price must be enough to _______________ and _______ ________ Approaches for setting prices: ______________

©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publically accessible website, in whole or in part. Market Methods _____________ concept – set the selling price according to demand for the product _____________ concept – set the price according to the price offered by competitors

©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publically accessible website, in whole or in part. Cost-Plus Methods Managers price the product in order to achieve a ________. The price covers all costs plus a profit ________ Concept Markup added to all costs (including selling & administrative) Product Cost Concept Markup added to ________ Variable Cost Concept Markup added to ________

©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publically accessible website, in whole or in part. Cost-Plus Examples We’ll use these facts to illustrate the three cost-plus methods UNIT VARIABLE COSTS Direct materials$ 3.00 Direct labor10.00 Factory overhead1.50 Selling & admin. exp.1.50 Total$ FIXED COSTS Factory overhead$50,000 Selling & admin. exp.20,000

©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publically accessible website, in whole or in part. Assuming 100,000 units, the total cost per unit is as follows: After adding the markup to the total cost the selling price per unit is: Nebular Inc. desires a profit equal to 20% of total assets. If total assets are $800,000, the desired profit is $160,000, or $1.60 per unit, assuming 100,000 units. Markup % = ___________ Total Cost Concept

©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publically accessible website, in whole or in part. Total Cost Concept Markup % = $16.70 total cost/unit × = $18.30 _____________ _________ = _____% $1,670,000 =

©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publically accessible website, in whole or in part. Product Cost Concept _____________ + ______________ ________________ The product cost concept applies the markup to the manufacturing cost per unit. Assuming 100,000 units, the manufacturing cost per unit is as follows: Markup % =

©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publically accessible website, in whole or in part. Markup % = $15.00 Manufacturing Cost/Unit × 22% = $3.30 Markup = ____% $160,000+ $170,000 $1,500,000 ____________ + Total Selling and Administrative Expenses Total Product Cost Product Cost Concept

©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publically accessible website, in whole or in part. Variable Cost Concept ______________ + ____________________ ______________________ The variable cost concept applies the markup to the variable cost per unit. Assuming 100,000 units, the variable cost per unit is as follows: Markup % =

©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publically accessible website, in whole or in part. Variable Cost Concept Markup % = $16.00 Variable Cost/Unit × ___% = $2.30 Markup = 14.4% $160,000+ $50,000 + $20,000 $1,600,000 Desired Profit + Total Fixed Costs and Expenses ___________________

©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publically accessible website, in whole or in part. Choosing a Cost-Plus Approach Cost Concept Normal Selling Price = Cost Amount per Unit + Markup Cost Amount per Unit = Cost Amount Estimated Units Produced and Sold Markup = Cost Amount per Unit × Markup Percentage Cost-Plus Concept Cost Amount Markup Percentages Total cost Manufacturing (product) costs: Direct materials Direct labor Factory overhead Selling and administrative expenses Product cost Manufacturing (product) costs: ____________ + ____________ Variable cost Variable manufacturing (product) costs: ____________ + ____________ ____________________ Each method requires different estimates of costs and expenses Things to consider when choosing a method: ______________

©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publically accessible website, in whole or in part. Other Cost Concepts Activity-Based Costing ____________________________________ Target Costing Combines ____________ pricing with _________

©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publically accessible website, in whole or in part. Compute the relative profitability of products in bottleneck production processes Learning Objective 3

©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publically accessible website, in whole or in part. Production Bottleneck Occurs at the point in the process where the _______ for the product exceeds the ability to produce the product The theory of constraints focuses on reducing the influence of __________ on a process

©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publically accessible website, in whole or in part. Analyzing a Bottleneck The contribution margin per unit suggests that the ___________ is the most profitable However…

©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publically accessible website, in whole or in part. Analyzing a Bottleneck …the contribution margin per unit of constrained resource suggests the __________ is the most profitable

©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publically accessible website, in whole or in part. Production Bottlenecks and Pricing The _____________________ of scarce resource can be used to set product prices Products that use a large amount of the constrained resource require a ______ contribution margin

©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publically accessible website, in whole or in part. Production Bottlenecks and Pricing Assume that for Rapidan Tool company, the variable cost per unit and the heat treatment hours for the large wrench cannot be decreased. In this case, it might be able to increase the selling price of the large wrenches The price of the large wrench that would make it as profitable as the small wrench is determined as follows: Unit Contribution Margin Revised Price of _____ − ______ for Large Wrench per Bottleneck = Hour for Small Wrench Bottleneck Hours per Unit for ___________

©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publically accessible website, in whole or in part. End of Chapter 12