1. Power Notes Chapter 23 Differential Analysis and Product Pricing
Learning Objectives
1. Differential Analysis
2. Setting Normal Product Selling Prices
3. Product Profitability and Pricing
Under Production Bottlenecks
C23

2. Power Notes Chapter 23 Differential Analysis and Product Pricing
Slide # Power Note Topics 3 16 20 27
Differential Analysis Decisions
Setting Normal Product Selling Prices
Cost-Plus Methods of Product Pricing
Production Bottlenecks
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3. Differential Analysis
Differential analysis is used for analyzing:
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

4. Proposal to Lease or Sell Equipment
June 22, 2003
Differential revenue from alternatives:
Revenue from lease $160,000
Revenue from sales 100,000
Differential revenue from lease $60,000
Differential cost of alternatives:
Repairs, insurance, taxes $ 35,000
Commission expense on sale 6,000
Differential cost of lease 29,000
Net differential income from leasing $31,000

5. Proposal to Lease or Sell Equipment
June 22, 2003
Lease Sell
Revenue from lease $160,000
Revenue from sales 100,000
Repairs, insurance, taxes (35,000)
Commission expense on sale (6,000)
Totals $125,000 $94,000
This alternative format separates the two options into columns. The net benefit is the same.

6. Proposal to Lease or Sell Equipment
June 22, 2003
Lease Sell
Revenue from lease $160,000
Revenue from sales 100,000
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?

7. Condensed Income Statement For the Year Ended August 31, 2003
Battle Creek Cereal Co.
Condensed Income Statement
For the Year Ended August 31, 2003
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 costs 20, ,000 80, ,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 expenses 6, ,000 20,000 51,000
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?

8. Condensed Income Statement For the Year Ended August 31, 2003
Battle Creek Cereal Co.
Condensed Income Statement
For the Year Ended August 31, 2003
Bran Corn Toasted Total Flakes Flakes Oats
Differential items
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 costs 20, ,000 80, ,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 expenses 6, ,000 20,000 51,000
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?

9. Condensed Income Statement For the Year Ended August 31, 2003
Battle Creek Cereal Co.
Condensed Income Statement
For the Year Ended August 31, 2003
Bran Corn Toasted Total Flakes Flakes Oats
Differential items
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 costs 20, ,000 80, ,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 expenses 6, ,000 20,000 51,000
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?

10. Condensed Income Statement For the Year Ended August 31, 2003
Battle Creek Cereal Co.
Condensed Income Statement
For the Year Ended August 31, 2003
Bran Corn Toasted Total Flakes Flakes Oats
Differential items
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 costs 20, ,000 80, ,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 expenses 6, ,000 20,000 51,000
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?

11. Condensed Income Statement For the Year Ended August 31, 2003
Battle Creek Cereal Co.
Condensed Income Statement
For the Year Ended August 31, 2003
Bran Corn Toasted Total Flakes Flakes Oats
Differential items
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 costs 20, ,000 80, ,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 expenses 6, ,000 20,000 51,000
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. Proposal to Replace Equipment
November 28, 2003
Annual variable costs—present $225,000
Annual variable costs—new equip. 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—new equipment $ 30,000

13. Proposal to Replace Equipment
November 28, 2003
Present New
Equipment Equipment
Annual variable costs $ 225,000 $150,000
Number of years applicable x 5 x 5
Total variable costs $1,125,000 $750,000
Cost of new equipment 250,000
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
This analysis indicates that it would be better to replace the existing equipment. What other factors should be considered?

14. Proposal to Process Kerosene Further
October 1, 2003
Differential revenue from further processing per batch:
Revenue from sale of gasoline [(4,000 gallons -
800 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 gasoline 650
Differential income from further processing gasoline per batch $150

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

16. Cost Structure Example (100,000 units)
Per Unit Total
Cost Cost
Variable Costs:
Direct materials $ $ 300,000
Direct labor ,000,000
Factory overhead ,000
Selling and admin ,000
Fixed Costs:
Factory overhead ,000
Selling and admin ,000
Total costs $16.70 $1,670,000
Product costs $15.00 $1,500,000
Variable costs $16.00 $1,600,000

17. Cost Structure Example (100,000 units)
Per Unit Total
Cost Cost
Variable Costs:
Direct materials $ $ 300,000
Direct labor ,000,000
Factory overhead ,000
Selling and admin ,000
Fixed Costs:
Factory overhead ,000
Selling and admin ,000
Total costs $16.70 $1,670,000
Product costs $15.00 $1,500,000
Variable costs $16.00 $1,600,000

18. Cost Structure Example (100,000 units)
Per Unit Total
Cost Cost
Variable Costs:
Direct materials $ $ 300,000
Direct labor ,000,000
Factory overhead ,000
Selling and admin ,000
Fixed Costs:
Factory overhead ,000
Selling and admin ,000
Total costs $16.70 $1,670,000
Product costs $15.00 $1,500,000
Variable costs $16.00 $1,600,000

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

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

21. Product Cost Concept Selling Price: Desired profit $ 1.60 $ 160,000
Per Unit Total
Selling Price:
Desired profit $ $ 160,000
Selling and admin ,000
Total to markup $ $ 330,000
Total product costs ,500,000 Selling price $18.30 $1,830,000
Markup Percentage:
Markup amount $3.30
Product costs $15.00 =
= 22.0%
The desired profit and selling and administrative costs are covered in the markup.

22. Product Cost Concept Selling Price: Desired profit $ 1.60 $ 160,000
Per Unit Total
Selling Price:
Desired profit $ $ 160,000
Selling and admin ,000
Total to markup $ $ 330,000
Total product costs ,500,000 Selling price $18.30 $1,830,000
Markup Percentage:
Markup amount $3.30
Product costs $15.00
Markup on product cost =
= 22.0%

23. Variable Cost Concept Selling Price: Desired profit $ 1.60 $ 160,000
Per Unit Total
Selling Price:
Desired profit $ $ 160,000
Fixed costs ,000
Total to markup $ $ 230,000
Total variable costs ,600,000 Selling price $18.30 $1,830,000
Markup Percentage:
Markup amount $2.30
Variable costs $16.00 =
= 14.4%
The desired profit and total fixed costs are covered in the markup.

24. Variable Cost Concept Selling Price: Desired profit $ 1.60 $ 160,000
Per Unit Total
Selling Price:
Desired profit $ $ 160,000
Fixed costs ,000
Total to markup $ $ 230,000
Total variable costs ,600,000 Selling price $18.30 $1,830,000
Markup Percentage:
Markup amount $2.30
Variable costs $16.00
Markup on variable cost =
= 14.4%

25. Product Pricing Using a Cost-Plus Approach
Total Product Variable
Cost Cost Cost
Cost amount per unit $16.70 $ $16.00
Markup percentage x 9.6% x 22.0% x 14.4%
Markup amount $ $ $ 2.30
Selling price $18.30 $18.30 $18.30
The most common method

26. Profitability Under Production Bottlenecks
Products—Unit Analysis
Small Medium Large
Wrench Wrench Wrench
Sales price $130 $140 $160
Variable cost
Contribution margin $ 90 $100 $120
The process is currently operating at full capacity and is a production bottleneck.

27. Profitability Under Production Bottlenecks
Products—Unit Analysis
Small Medium Large
Wrench Wrench Wrench
Sales price $130 $140 $160
Variable cost
Contribution margin $ 90 $100 $120
Bottleneck hours
The number of hours per unit for each product.

28. Profitability Under Production Bottlenecks
Products—Unit Analysis
Small Medium Large
Wrench Wrench Wrench
Sales price $130 $140 $160
Variable cost
Contribution margin $ 90 $100 $120
Bottleneck hours
Bottleneck contribution $ 90 $ 25 $ 15
Contribution after dividing by the bottleneck hours.

29. Profitability Under Production Bottlenecks
Products—Unit Analysis
Small Medium Large
Wrench Wrench Wrench
Sales price $130 $140 $160
Variable cost
Contribution margin $ 90 $100 $120
Bottleneck hours
Bottleneck contribution $ 90 $ 25 $ 15
What price for Product C would equate its profitability to Product A?

30. Profitability Under Production Bottlenecks
Products—Unit Analysis
Small Medium Large
Wrench Wrench Wrench
Sales price $130 $140 $160 $760
Variable cost
Contribution margin $ 90 $100 $120 $720
Bottleneck hours
Bottleneck contribution $ 90 $ 25 $ 15 $ 90
A price of $760 will provide the same contribution as Product A.

31. Power Notes This is the last slide in Chapter 23. Chapter 23
Differential Analysis and Product Pricing
This is the last slide in Chapter 23.
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