12-1 Electronic Presentation by Douglas Cloud Pepperdine University Carl S.Warren Survey of Accounting

12-2 Task Force Clip Art included in this electronic presentation is used with the permission of New Vision Technology of Nepean Ontario, Canada.

12-3 Differential Analysis and Product Pricing Chapter 12

Prepare a differential analysis report for decisions involving  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. Learning Objectives After studying this chapter, you should be able to: ContinuedContinued

Determine the selling price of a product using the total cost concept. 3.Calculate the relative profitability of products in bottleneck production environments. Learning Objectives

Learning Objective Prepare a differential analysis report.

12-7 Differential Analysis 1.Leasing or selling equipment 2.Discontinuing an unprofitable segment 3.Manufacturing or purchasing a needed part 4.Replacing usable fixed assets 5.Processing further or selling an intermediate product 6.Accepting additional business at a special price Differential analysis is used for analyzing:

12-8 Proposal to Lease or Sell Equipment June 22, 2006 Differential revenue from alternatives: Revenue from lease$160,000 Revenue from sales100,000 Differential revenue from lease$60,000 Differential cost of alternatives: Repairs, insurance, taxes$ 35,000 Commission expense on sale6,000 Differential cost of lease29,000 Net differential income from leasing$31,000

12-9 Proposal to Lease or Sell Equipment June 22, 2006 Revenue from lease$160,000 Revenue from sales100,000 Repairs, insurance, taxes(35,000) Commission expense on sale(6,000) Totals$125,000 $94,000 LeaseSell This alternative format separates the two options into columns. The net benefit is the same.

12-10 Proposal to Lease or Sell Equipment June 22, 2006 LeaseSell Revenue from lease$160,000 Revenue from sales100,000 Repairs, insurance, taxes(35,000) Commission expense on sale(6,000) Totals$125,000 $94,000 Net benefit from leasing$31,000 This analysis indicates that it would be better to lease the equipment rather then sell it. What other factors should be considered?

12-11 Battle Creek Cereal Co. Condensed Income Statement For the Year Ended August 31, 2006 Bran Corn Toasted Total Flakes Flakes Oats Sales$100,000 $500,000$400,000$1,000,000 Cost of goods sold: Variable costs$ 60,000 $220,000$200,000$ 480,000 Fixed costs20, ,00080,000220,000 Total cost of goods sold$ 80,000 $340,000$280,000$ 700,000 Gross profit$ 20,000 $160,000$120,000$ 300,000 Operating expenses: Variable expenses $ 25,000 $ 95,000$ 60,000$ 180,000 Fixed expenses6,000 25,00020,00051,000 Total operating expenses $31,000 $120,000$ 80,000$ 231,000 Income (loss) from operations$ (11,000)$ 40,000$ 40,000$ 69,000 Should Bran Flakes be discontinued?

12-12 Battle Creek Cereal Co. Condensed Income Statement For the Year Ended August 31, 2006 Bran Corn Toasted Total Flakes Flakes Oats Differential items Should Bran Flakes be discontinued? Sales$100,000 Sales$100,000 $500,000$400,000$1,000,000 Cost of goods sold: Variable costs$ 60,000 $220,000$200,000$ 480,000 Fixed costs20, ,00080,000220,000 Total cost of goods sold$ 80,000 $340,000$280,000$ 700,000 Gross profit$ 20,000 $160,000$120,000$ 300,000 Operating expenses: Variable expenses $ 25,000 $ 95,000$ 60,000$ 180,000 Fixed expenses6,000 25,00020,00051,000 Total operating expenses $31,000 $120,000$ 80,000$ 231,000 Income (loss) from operations$ (11,000)$ 40,000$ 40,000$ 69,000

12-13 Battle Creek Cereal Co. Condensed Income Statement For the Year Ended August 31, 2006 Should Bran Flakes be discontinued? Bran Corn Toasted Total Flakes Flakes Oats Differential items Sales$100,000 Sales$100,000 $500,000$400,000$1,000,000 Cost of goods sold: Variable costs$ 60,000 Variable costs$ 60,000 $220,000$200,000$ 480,000 Fixed costs20, ,00080,000220,000 Total cost of goods sold$ 80,000 $340,000$280,000$ 700,000 Gross profit$ 20,000 $160,000$120,000$ 300,000 Operating expenses: Variable expenses $ 25,000 $ 95,000$ 60,000$ 180,000 Fixed expenses6,000 25,00020,00051,000 Total operating expenses $31,000 $120,000$ 80,000$ 231,000 Income (loss) from operations$ (11,000)$ 40,000$ 40,000$ 69,000

12-14 Battle Creek Cereal Co. Condensed Income Statement For the Year Ended August 31, 2006 Bran Corn Toasted Total Flakes Flakes Oats Differential items Sales$100,000 Sales$100,000 $500,000$400,000$1,000,000 Cost of goods sold: Variable costs$ 60,000 Variable costs$ 60,000 $220,000$200,000$ 480,000 Fixed costs20, ,00080,000220,000 Total cost of goods sold$ 80,000 $340,000$280,000$ 700,000 Gross profit$ 20,000 $160,000$120,000$ 300,000 Operating expenses: Variable expenses $ 25,000 Variable expenses $ 25,000 $ 95,000$ 60,000$ 180,000 Fixed expenses6,000 25,00020,00051,000 Total operating expenses $31,000 $120,000$ 80,000$ 231,000 Income (loss) from operations$ (11,000)$ 40,000$ 40,000$ 69,000 If Bran Flakes are discontinued, how would net income be affected?

12-15 Battle Creek Cereal Co. Condensed Income Statement For the Year Ended August 31, 2006 Differential items Bran Corn Toasted Total Flakes Flakes Oats Sales$100,000 Sales$100,000 $500,000$400,000$1,000,000 Cost of goods sold: Variable costs$ 60,000 Variable costs$ 60,000 $220,000$200,000$ 480,000 Fixed costs20, ,00080,000220,000 Total cost of goods sold$ 80,000 $340,000$280,000$ 700,000 Gross profit$ 20,000 $160,000$120,000$ 300,000 Operating expenses: Variable expenses $ 25,000 Variable expenses $ 25,000 $ 95,000$ 60,000$ 180,000 Fixed expenses6,000 25,00020,00051,000 Total operating expenses $31,000 $120,000$ 80,000$ 231,000 Income (loss) from operations$ (11,000)$ 40,000$ 40,000$ 69,000 If Bran Flakes are discontinued, $15,000 of net income will be lost and overall net income would be reduced to $54,000.

12-16 Annual variable costs—present$225,000 Annual variable costs—new equip.150,000 Annual differential decrease in cost$ 75,000 Number of years applicablex 5 Total differential decrease in cost$375,000 Proceeds from sale of present equipment25,000$400,000 Cost of new equipment250,000 Net differential decrease in cost, 5-years$150,000 Annual net differential—new equipment$ 30,000 Proposal to Replace Equipment November 28, 2006

12-17 Proposal to Replace Equipment November 28, 2006 PresentNewEquipment This analysis indicates that it would be better to replace the existing equipment. What other factors should be considered? Annual variable costs$ 225,000$150,000 Number of years applicablex 5x 5 Total variable costs$1,125,000$750,000 Cost of new equipment250,000 Less proceeds from sale(25,000) Total costs$1,125,000$975,000 Net total benefit to replace $150,000 Net annual benefit to replace$ 30,000

12-18 Differential revenue from further processing per batch: Revenue from sale of gasoline [(4,000 gallons gallons evaporation) x $1.25]$4,000 Revenue from sale of kerosene (4,000 gallons x $0.80)3,200 Differential revenue$800 Differential cost per batch: Additional cost of producing gasoline650 Differential income from further processing gasoline per batch$150 Proposal to Process Kerosene Further October 1, 2006

12-19 Determine the selling price of a product using the total cost concept. 2 Learning Objective

12-20 Setting Normal Product Selling Prices 1.Demand-based methods 2.Competition-based methods 1.Total cost concept 2.Product cost concept 3.Variable cost concept Cost-Plus Methods Cost-Plus Methods Market Methods Market Methods

12-21 Per UnitTotalCost Cost Structure Example (100,000 units) Variable Costs: Direct materials$ 3.00$ 300,000 Direct labor10.001,000,000 Factory overhead ,000 Selling and admin ,000 Fixed Costs: Factory overhead.5050,000 Selling and admin..2020,000 Total costs$16.70$1,670,000 Product costs$15.00$1,500,000 Variable costs$16.00$1,600,000

12-22 Per UnitTotalCost Cost Structure Example (100,000 units) Variable Costs: Direct materials$ 3.00$ 300,000 Direct labor10.001,000,000 Factory overhead ,000 Selling and admin ,000 Fixed Costs: Factory overhead.5050,000 Selling and admin..2020,000 Total costs$16.70$1,670,000 Product costs$15.00$1,500,000 Variable costs$16.00$1,600,000

12-23 Per UnitTotalCost Cost Structure Example (100,000 units) Variable Costs: Direct materials$ 3.00$ 300,000 Direct labor10.001,000,000 Factory overhead ,000 Selling and admin ,000 Fixed Costs: Factory overhead.5050,000 Selling and admin..2020,000 Total costs$16.70$1,670,000 Product costs$15.00$1,500,000 Variable costs$16.00$1,600,000

12-24 Selling Price: Desired profit$ 1.60$ 160,000 Total to markup $ 1.60$ 160,000 Total costs16.701,670,000 Selling price$18.30$1,830,000 Markup Percentage: Markup amount$1.60 Total costs$16.70 Per UnitTotal Total Cost Concept = 9.6% Only the desired profit is covered in the markup. =

12-25 Per UnitTotal Selling Price: Desired profit$ 1.60$ 160,000 Total to markup $ 1.60$ 160,000 Total costs16.701,670,000 Selling price$18.30$1,830,000 Markup Percentage: Markup amount$1.60 Total costs$16.70 Total Cost Concept = 9.6% Markup on total cost =

12-26 Calculate the relative profitability of products in bottleneck production environments. 3 Learning Objective

12-27 Products—Unit Analysis SmallMediumLarge WrenchWrenchWrench Sales price$130$140$160 Variable cost Contribution margin$ 90$100$120 Profitability Under Production Bottlenecks The process is currently operating at full capacity and is a production bottleneck.

12-28 Sales price$130$140$160 Variable cost Contribution margin$ 90$100$120 Bottleneck hours Products—Unit Analysis SmallMediumLarge WrenchWrenchWrench Profitability Under Production Bottlenecks The number of hours per unit for each product.

12-29 Products—Unit Analysis SmallMediumLarge WrenchWrenchWrench Profitability Under Production Bottlenecks Contribution after dividing by the bottleneck hours. Sales price$130$140$160 Variable cost Contribution margin$ 90$100$120 Bottleneck hours Bottleneck contribution$ 90$ 25$ 15

12-30 Products—Unit Analysis SmallMediumLarge WrenchWrenchWrench Sales price$130$140$160 Variable cost Contribution margin$ 90$100$120 Bottleneck hours Bottleneck contribution$ 90$ 25$ 15 Profitability Under Production Bottlenecks What price for Product C would equate its profitability to Product A?

12-31 Products—Unit Analysis SmallMediumLarge WrenchWrenchWrench Sales price$130$140$160$760 Variable cost Contribution margin$ 90$100$120$720 Bottleneck hours Bottleneck contribution$ 90$ 25$ 15$ 90 Profitability Under Production Bottlenecks A price of $760 will provide the same contribution as Product A.

12-32 The End Chapter 12

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