1 Differential Cost Analysis for Operating Decisions CHAPTER 7 © 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. PowerPointPresentation by PowerPoint Presentation by LuAnn Bean Professor of Accounting Florida Institute of Technology Managerial Accounting 11E Maher/Stickney/Weil

2 CHAPTER GOAL This chapter explains how managers can use differential analysis to examine the effects on profits. Differential analysis helps managers answer relevant questions such as:  What activities differ between the alternatives?  How does that difference affect costs and profits? ☼☼

3 DIFFERENTIAL ANALYSIS: Definition Is the analysis of differences among particular alternative actions. LO 1

4 EXAMPLE: Ullman Educational Media Ullman Educational Media (UEM) is a company that produces tutorial videos for primary and preschool use. UEM developed the following estimates: LO 1 Continued Units made and sold800 per month Maximum production and sales capacity1,200 units per month Selling price$ 30 UEMUEM

5 ACTIVITY & COSTS Ullman Educational Media provides the following information about activities and costs: LO 1 Continued VC per unitFC per month Manufacturing$ 17$ 3,060 Marketing and Administrative51,740 Total costs$ 22$4,800 UEMUEM

6 LO 1 EXHIBIT 7.2 UEMUEM Profit decreases by $1,000.

7 CASH FLOW Differential analysis focuses on cash flow because  Cash is the medium of exchange in business  Cash is a common objective measure of the costs and benefits of alternatives LO 1

8 Pricing Decisions LO 2 Customer Demands Competitors’ Actions Cost of Products Will raising prices lose customers to a competitor or cause them to substitute cheaper goods? MANAGERS WANT TO KNOW! Managers must consider competitors actions both nationally and internationally. Internal focus on continuous improvements is key to cutting costs.

9 SPECIAL ORDERS Ullman has an opportunity for a one-time only special order to sell 100 units at $25 each. The regular price is $28. Should they accept the special order? LO 2 MANAGERS WANT TO KNOW! UEMUEM Continued

10 LO 2 EXHIBIT 7.3 Yes! Since normal operations should be used to cover FC, not special orders, this special order adds $300 to the bottom line. UEMUEM

11 LO 2 EXHIBIT 7.5 Full cost, used for long run decisions, is the total cost of producing and selling a unit. UEMUEM

12 PRICING DECISIONS Use of full cost in pricing decisions is justified because  In the long run, prices must cover all costs to survive  Long term contractual agreements must cover all costs  Prices in regulated industries are often based on full cost  Although full cost + profit may be used initially, short term adjustments may reflect market conditions. LO 2

13 PRODUCT LIFE CYCLE: Definition Covers the time from initial research and development to time support to customer is withdrawn. LO 2

14 Predatory pricing: Definition Is when a business deliberately prices below its costs to drive out competitors. LO 2 Dumping: Definition Occurs when a foreign company sells a product in the U.S. at a price below the market value in the country of its creation.

15 What is target cost? Target cost is the target price less the target profit. LO 3

16 LO 3 EXHIBIT 7.5 Value engineering is a systematic evaluation of all aspects of the business.

17 Customer cost Activities Cost to acquire customerPromote product; campaign to win lost customers; run advertising campaign Cost to provide goods and servicesProcess order; deliver product; process returns Cost to maintain customersBill customers; process payments; issue refunds Cost to retain customersFollow-up calls USING ACTIVITY-BASED COSTING: Analyze Profitability LO 4

18 THEORY OF CONSTRAINTS The theory of constraints (TOC) acknowledges that businesses often have constraints or limits on what can be done. TOC encourages managers to identify where constraints arise and to develop methods to manage them. Three factors predominate: 1.Throughput contribution 2.Investments 3.Other operating costs LO 6

19 BOTTLENECK: Definition Is an operation in which the work to be performed equals or exceeds the available capacity. LO 6

20 MANAGING THE BOTTLENECK  Recognize that the bottleneck resource determines throughput contribution of product  Search for, find bottleneck  Resource with large quantities of inventory waiting to be worked on  Subordinate all non-bottleneck resources to the bottleneck resource  Increase bottleneck efficiency, capacity  Repeat 4 steps for any new bottleneck LO 6

21 MAKE-OR-BUY The make-or-buy decision is one where the firm must decide whether to meet its needs internally or to acquire goods or services externally. Both cost and non- quantitative factors are considered. LO 7

22 JOINT PRODUCTS In some circumstances, multiple products can be produced from a single production process. The question for management is: What is the effect of additional processing/production on profits? LO 8 MANAGERS WANT TO KNOW!

23 SPLITOFF POINT: Definition Is the point up to which all costs are joint and after which additional processing costs are identified with other products. LO 8

24 ADD OR DROP Managers must decide when to add or drop products; when to open or abandon sales territories. The differential principle involved can be stated: If differential revenue from selling exceeds differential costs of product, the product is profitable and the firm should continue production. LO 9 MANAGERS WANT TO KNOW! Click the button to skip Example

25 INVENTORY MANAGEMENT Inventory has a direct affect on profit and must be carefully managed. Key questions for managers are: 1.How many units should be on hand for use or sale? 2.How often should the firm order an item and what is the optimal order size? LO 10 MANAGERS WANT TO KNOW!

26 JUST-IN-TIME (JIT) JIT is a philosophy, not a tool, that dovetails with total quality management (TQM) in that TQM requires reliable processing systems and disallows defective units. Flexible manufacturing that reduces both setup and inventory levels also enhances JIT. LO 10

27 LINEAR PROGRAMMING  Linear programming: (a) finds the product mix that will maximize profits given the constraints, (b) provides opportunity costs of constraints, and (c) allows for sensitivity analysis. LO 11

28 ECONOMIC ORDER QUANTITY (EOQ)  The economic order quantity (EOQ) model is a mathematical model that gives the optimal amount of goods to order when demand reduces inventory to a level called the “reorder point.” LO 12

29 End of CHAPTER 7