Differential Cost Analysis Chapter 25

Management decisions Accepting/Rejecting certain orders Reducing the price of a single order Making a price cut in a competitive market Evaluating Make-or-buy alternatives Expanding or reducing plant capacity Increasing, curtailing or stopping production Replacing present equipment Spending additional amounts for sales promotion

Differential Cost Difference between cost of alternative choices Marginal/Incremental cost Deals with determination of incremental revenue, costs and margins Variable costs are significant Fixed costs might be included

Example Total cost at 60,000 units = $324,250 Calculate total differential cost Calculate differential cost/unit

Solution Differential cost = 423,400 – 324,250 = $99,150 Differential cost/unit = 99,150/20,000 = $4.96

Accepting Additional Orders Differential cost must be considered involving a change in output Difference between the cost of producing present smaller output and that of the planned larger output Possibility of selling additional output at a figure lower or greater than the existing average unit cost New or additional business can be accepted as long as the variable cost is recovered

Example Maximum capacity=100,000 units Normal capacity = 80,000 units Variable cost per unit = $5 Fixed cost= $100,000 Sales price per unit= $9 Profit at 80,000 and 81,000 units?

Solution Present business Additional business Total Sales $720,000 $9,000 $729,000 Variable cost 400,000 5,000 405,000 Contribution Margin 320,000 4,000 324,000 Fixed cost 100,000 _-0-____ 100,000 Profit 320,000 4,000 224,000

Reducing the Price of a Special Order At what minimum price the firm can afford to sell additional goods

Example Company manufactures 450,000 units using 90% of its capacity Fixed factory overhead is $335,000 Variable factory overhead = $0.50/unit Direct materials = $1.80/unit Direct labor = $1.40/unit Each unit sells for $5

Example Sales $2,250,000 Cost of goods sold: Direct materials(450,000*1.80) 810,000 Direct labor(450,000*1.40) 630,000 Variable factory overheads(450,000*0.50) 225,000 Fixed factory overheads(450,000*0.67) 301,500 1,966,500 Income from operations 283,500 Unabsorbed fixed factory overheads(500,000-450,000)*0.67] 33,500 Income from operations (adjusted) 250,000

Special Order Additional fixed cost if special order of 100,000 units is accepted = $10,000 Sales price of a special order=$4.25

Solution Sales (100,000 units@4.25) $425,000 Cost of goods sold: Direct materials(100,000units @1.80) 180,000 Direct labor (100,000units @ 1.40) 140,000 Variable factory overheads (100,000 units @0.50) 50,000 Additional fixed cost 10,000 380,000 Gain on the order $45,000

Exercise The wood River plant of the Union Company has a normal capacity 0f 90,000 units per month. Monthly production costs are $12 variable cost per unit and $240,000 fixed. By increasing the fixed cost $10,000 a month, the plant can produce 95,000 units. Differential cost of the production between 80% and 90% of normal capacity. Differential cost of producing the 5,000 units above the normal capacity. Per unit total production cost of the 95,000 units Per unit differential production cost of the 5,000 units.

Solution Differential cost of the production between 80% and 90% of normal capacity. 90,000 units *90% 81,000 units 90,000 units *80% 72,000 units 9,000 units 9,000 units *$12 = $108,000

Solution Differential cost of producing the 5,000 units above the normal capacity. 5,000 units *12 $60,000 Differential Fixed cost 10,000 70,000

Solution Per unit total production cost of the 5,000 units Fixed costs(240,000+10,000) 250,000 1,390,000

Solution Per unit differential production cost of the 5,000 units. = $14

Make-Or-Buy Decisions Compare the cost of making the parts with the cost of buying them Costs for each of the alternatives must be based on the identical product specifications, quantities and quality standards

Decisions to Shut Down Facilities In the short run, a firm seems to be better off operating than not operating if revenue > variable costs Shutting down of facilities Does not eliminate all costs Loss of investment spent on training employees Recruiting and training costs after reopening Loss of losing established markets & customers

Decisions to Shut Down Facilities If operations are continued Certain expenses connected with the shutting down of the facilities can be saved Costs that would have to be incurred when a closed facility is reopened will be saved

Decisions to Discontinue Products Requires careful analysis of relevant differential cost and revenue data Following benefits can be achieved with the correct decision: Expanded sales Increased profits Reduced inventory levels Resources made available for more promising projects

Decisions to Discontinue Products Not only the profitability of the products being analyzed be considered but also the extent to which sales of other products will be affected when one product is removed should be evaluated

Decisions to Discontinue Products Management needs following signals to identify troubled products: Declining sales volume Decreasing market share Malfunctioning of the product or introduction of a superior competitive product Expected future sales and market potential not favorable Return on investment below minimum acceptable level Variable costs approaching or exceeding revenue Price required to be constantly lowered to maintain sales

Other Cost Concepts Opportunity costs Imputed costs Measurable value of an opportunity bypassed by rejecting an alternative use to resources Measurement of sacrifices associated with alternatives Imputed costs Hypothetical costs representing the cost/value of a resource measured by its use value Interest on invested capital, rental value of company-owned properties, salaries of owners of sole proprietors Do not involve actual cash flows

Other Cost Concepts Out-Of-Pocket Costs Sunk Costs Involves cash outlays Often identified as variable costs Helpful in deciding whether a particular venture will at least return the cash expenditures Sunk Costs Irrecoverable costs Not included in differential cost analysis