1. Chapter 24 Differential Analysis and Product Pricing Student Version
Principles of Financial and Managerial Accounting
11e
Principles of Managerial Accounting
11e
Chapter 24
Principles of Financial and Managerial Accounting
Using excel for Success
Student Version
These slides should be viewed using the presentation mode (left click your mouse on the icon).
Prepared by: C. Douglas Cloud
Professor Emeritus of Accounting
Pepperdine University
© 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.
Reeve Warren Duchac

2. Learning Objective 1
Prepare differential analysis reports for a variety of managerial decisions.

3. Managerial Decision Making
LO 1
Differential Analysis
Managerial Decision Making
Step 2: Identify the alternative courses of action
Step 1: Identify the objective of the decision
Step 3: Gather relevant information and perform differential analysis.
Step 5: Review, analyze, and assess the results of the decision
Step 4: Make a decision

4. Differential Analysis
LO 1
Differential Analysis
Differential analysis, sometimes called incremental analysis, analyzes differential revenues and costs to determine the differential impact on income of two alternative courses of action.
Differential revenue is the amount of increase or decrease in revenue that is expected from a course of action as compared to an alternative.

5. Differential Analysis
LO 1
Differential Analysis
Differential cost is the amount of increase or decrease in cost that is expected from a course of action as compared to an alternative.

6. Differential Analysis
LO 1
Differential Analysis
Differential income (loss) is the difference between the differential revenue and the differential costs.
Differential income indicates that a particular decision is expected to be profitable, while a differential loss indicates that the decision is expected to decrease income.

7. LO 1
Lease or Sell
On June 22, 2012, Marcus Company is considering leasing or disposing of the following equipment:
Cost of equipment $200,000
Less accumulated depreciation 120,000
Book value $ 80,000
Lease Option:
Total revenue for five-year lease 160,000
Total estimated repair, insurance, and
property tax expenses during life of lease 35,000
Residual value at end of 5th year of lease 0
Sell Option:
Sales price $100,000
Commission on sales 6%
(continued)

8. LO 1
Lease or Sell
Lease the equipment

9. LO 1
Lease or Sell
The book value of equipment is a sunk cost and is not considered in the differential analysis.
Sunk costs are costs that have been incurred in the past, cannot be recouped, and are not relevant to future decisions.

10. Discontinue a Segment or Product
LO 1
Discontinue a Segment or Product B
attle C
reek

11. LO 1
Make or Buy
An automobile manufacturer has been purchasing instrument panels for $240 a unit. The factory currently operates at 80% of capacity. The cost per unit of manufacturing a panel internally is estimated as follows:
Direct materials $ 80
Direct labor 80
Variable factory overhead 52
Fixed factory overhead
Total estimated cost per unit $280

12. LO 1
Replace Equipment
On November 28, 2012, a business is considering replacing the following machine:
Old Machine:
Book value $100,000
Estimated annual variable
manufacturing costs 225,000
Estimated selling price 25,000
Estimated remaining useful life 5 years
(continued)

13. LO 1
Replace Equipment
The business is considering replacing the old machine with a new one, as shown below:
Old New
Book value $100,000
Cost of new machine $250,000
Estimated annual variable
manufacturing costs 225, ,000
Estimated selling price 25,000
Estimated residual value 0
Estimated remaining useful life 5 years 5 years
(continued)

14. LO 1
Replace Equipment
replace old machine

15. LO 1
Replace Equipment
The revenue that is forgone from an alternative use of an asset, such as cash, is called an opportunity cost.
Although the opportunity cost is not recorded in the accounting records, it is useful in analyzing alternative courses of action.

16. LO 1
Process or Sell
In some cases, a product can be sold at an intermediate stage of production, or it can be processed further and then sold.
A business produces kerosene as follows:
Batch size 4,000 gallons
Cost of producing kerosene $2,400 per batch
Selling price $2.50 per gallon
(continued)

17. LO 1
Process or Sell
The kerosene can be processed further to yield gasoline as follows:
Input batch size 4,000 gallons
Less evaporation (20%) (4,000 x 20%)
Output batch size 3,200
Cost of producing
gasoline $3,050 per batch
Selling price $3.50 per gallon
(continued)

18. LO 1
Process or Sell
process further

19. Accept Business at a Special Price
LO 1
Accept Business at a Special Price
The differential costs of accepting additional business depend on whether the company is operating at full capacity.
If the company is operating at full capacity, any additional production increases fixed and variable manufacturing costs.
If the company is operating below full capacity, any additional production does not increase fixed manufacturing costs.

20. Accept Business at a Special Price
LO 1
Accept Business at a Special Price
B-Ball Inc. manufactures basketballs as follows:
Monthly productive capacity 12,500 basketballs
Current monthly sales 10,000 basketballs
Normal (domestic) selling price $30.00 per basketball
Manufacturing costs:
Variable costs $ per basketball
Fixed costs
Total $20.00 per basketball
(continued)

21. Accept Business at a Special Price
LO 1
Accept Business at a Special Price
On March 10, 2012, B-Ball Inc. receives an offer from an exporter for 5,000 basketballs at $18 each. Production can be spread over three months, so these basketballs can be manufactured using normal capacity. The domestic market will not be affected.
(continued)

22. Accept Business at a Special Price
LO 1
Accept Business at a Special Price

23. Learning Objective 2
Determine the selling price of a product, using the product cost concept.

24. Setting Normal Product Selling Prices
LO 2
Setting Normal Product Selling Prices
The basic approaches to setting prices are:
Market methods
Demand-based concept
Competition-based concept
Cost-plus methods
Total cost concept
Product cost concept
Variable cost concept

25. LO 2
Product Cost Concept
Under the product cost concept, only the costs of manufacturing the product, termed the product costs, are included in the cost amount per unit to which the markup is added.

26. LO 2
Product Cost Concept
Step 1: Estimate the total product costs as follows:
Product costs:
Direct materials $XXX
Direct labor XXX
Factory overhead XXX
Total product cost $XXX

27. Estimated Units Produced and Sold
LO 2
Product Cost Concept
Step 2: Estimate the total selling and administrative expenses.
Step 3: Divide the total product cost by the number of units expected to be produced and sold to determine the total product cost per unit, as shown below.
Product Cost per unit =
Total Product Cost
Estimated Units Produced and Sold

28. Desired Profit + Total Selling and Administrative Expenses
LO 2
Product Cost Concept
Step 4. Compute the markup percentage as follows:
Markup Percentage =
Desired Profit + Total Selling and Administrative Expenses
Total Product Cost

29. Desired Profit + Total Selling and Administrative Expenses
LO 2
Product Cost Concept
Step 4. Compute the markup percentage as follows:
Markup Percentage =
Desired Profit + Total Selling and Administrative Expenses
Total Product Cost
Step 5. Determine the markup per unit by multiplying the markup percentage times the product cost per unit as follows:
Markup per Unit = Markup Percentage x Product Cost per Unit

30. LO 2
Product Cost Concept
Step 6. Determine the normal selling price by adding the markup per unit to the product cost per unit as follows:
Total product cost per unit $XXX
Markup per unit XXX
Normal selling price per unit $XXX

31. LO 2
Product Cost Concept
Assume the following data for 100,000 calculators that Digital Solutions Inc. expects to produce and sell during the current year:
Manufacturing costs:
Direct materials ($3.00 x 100,000) $ 300,000
Direct labor ($10.00 x 100,000) 1,000,000
Factory overhead ,000
Total Manufacturing costs $1,500,000
Selling and administrative expenses ,000
Total cost $1,670,000
Total assets $800,000
Desired rate of return 20%

32. LO 2
Product Cost Concept
Step 1: Estimate the total product cost. These costs are estimated at $1,500,000.
Step 2: Estimate the total selling and administrative expenses. These expenses are estimated at $170,000.

33. Estimated Units Produced and Sold
LO 2
Product Cost Concept
Step 3: Divide the total product cost by the number of units expected to be produced and sold to determine the total product cost per unit, as shown below.
Total Product Cost
Estimated Units Produced and Sold
Product Cost per Unit = =
$1,500,000
100,000 units
= $15.00 per unit

34. Product Cost Concept Step 4. Compute the markup percentage as follows:
Desired Profit + Total Selling and Administrative Expenses
Total Product Cost
Desired Rate of Return x Total Assets
Markup Percentage =
Markup Percentage =
$160,000 + $170,000
$1,500,000
0.20 x $800,000
Markup Percentage =
$330,000
$1,500,000
= 22%

35. LO 2
Product Cost Concept
Step 5. Determine the markup per unit by multiplying the markup percentage times the product cost per unit as follows:
Markup per Unit = Markup Percentage x Product Cost per Unit
Markup per Unit = 22% x $15.00 = $3.30 per unit

36. LO 2
Product Cost Concept
Step 6. Determine the normal selling price by adding the markup per unit to the product cost per unit as follows:
Total product cost per unit $15.00
Markup per unit
Normal selling price per unit $18.30

37. LO 2
Target Costing
Target costing is a method of setting prices that combines market-based pricing with a cost-reduction emphasis. A future selling price is anticipated, using the demand-based or the competition-based methods.
Target Cost = Expected Selling Price – Desired Profit

38. Learning Objective 3
Compute the relative profitability of products in bottleneck production processes.

39. Production Bottlenecks, Pricing, and Profits
LO 3
Production Bottlenecks, Pricing, and Profits
A production bottleneck (or constraint) is a point in the manufacturing process where the demand for the company’s product exceeds the ability to produce the product.
The theory of constraints (TOC) is a manufacturing strategy that focuses on reducing the influence of bottlenecks on production processes.

40. Production Bottlenecks and Profits
LO 3
Production Bottlenecks and Profits P
PrideCraft Tool Company makes three types of wrenches: small, medium, and large. All three products are processed through a heat treatment operation, which hardens the steel tools. PrideCraft Tool’s heat treatment process is operating at full capacity and is a production bottleneck.
(continued)

41. Production Bottlenecks and Profits
LO 3
Production Bottlenecks and Profits P
The product unit contribution margin and the number of hours of heat treatment used by each type of wrench are as follows:
Small Medium Large
Wrench Wrench Wrench
Sales price per unit $130 $140 $160
Variable cost per unit
Contribution margin per unit $ 90 $100 $120
Heat treatment hours per unit 1 hr. 4 hrs. 8 hrs.
(continued)

42. Unit Contribution Margin Heat Treatment Hours per Unit
LO 3
Production Bottlenecks and Profits P
Unit Contribution Margin
Heat Treatment Hours per Unit
Unit Contribution Margin per Production Bottleneck Hour =
Small Wrenches
Unit Contribution Margin per Production Bottleneck Hour =
$90
1 hr.
= $90 per hour
$90 per hour
The small wrench is the most profitable product per bottleneck hour.
Medium Wrenches
Unit Contribution Margin per Production Bottleneck Hour =
$100
4 hrs.
= $25 per hour
Large Wrenches
Unit Contribution Margin per Production Bottleneck Hour =
$120
8 hrs.
= $15 per hour

43. Production Bottlenecks and Pricing
LO 3
Production Bottlenecks and Pricing P
PrideCraft Tool Company can improve the profitability of producing the large wrenches by any combination of the following:
Increase the selling price of the large wrenches.
Decrease the variable cost per unit of the large wrenches.
Decrease the heat treatment hours required for the large wrenches.

44. Production Bottlenecks and Pricing
LO 3
Production Bottlenecks and Pricing P
Contribution Margin (per unit) per Bottleneck Hour for Small Wrench
Revised Price of Large Wrench
Variable Cost per Unit for Large Wrench – =
Bottleneck Hours per Unit for Large Wrench
$90 =
Revised Price of Large Wrench
– $40 8
$720 = Revised Price of Large Wrench – $40
$760 = Revised Price of Large Wrench

45. Differential Analysis and Product Pricing
The End