1. Differential Analysis and Product Pricing
Chapter 24
Differential Analysis and Product Pricing
Accounting, 21st Edition
Warren Reeve Fess
© Copyright 2004 South-Western, a division of Thomson Learning. All rights reserved.
Task Force Image Gallery clip art included in this electronic presentation is used with the permission of NVTech Inc.
PowerPoint Presentation by Douglas Cloud Professor Emeritus of Accounting Pepperdine University

2. Some of the action has been automated, so click the mouse when you see this lightning bolt in the lower right-hand corner of the screen. You can point and click anywhere on the screen.

3. After studying this chapter, you should be able to:
Objectives
1. 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, or accepting additional business at a special price.
After studying this chapter, you should be able to:

4. Objectives
2. Determine the selling price of a product, using the total cost, product cost, and variable cost concepts.
3. Calculate the relative profitability of products in bottleneck production environments.

5. Differential Analysis
Differential analysis is used for analyzing:
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.

6. Differential Analysis
Decisions
Alternative A
Differential revenue
– Differential costs or
Differential income or loss
Alternative B

7. Lease or Sell Equipment
Marcus Company
Marcus Company is considering disposing of equipment that cost $200,000 and that has $120,000 of accumulated depreciation.

8. Lease or Sell Equipment
Marcus Company
The equipment can be sold through a broker for $100,000, less a 6% commission.
Sell equipment to
Broker

9. Lease or Sell Equipment
Marcus Company
Potamkin Company, the lessee, has offered to lease the equipment for five years for a total consideration of $160,000.
Lease equipment to OR
Potamkin Company

10. Lease or Sell Equipment
Marcus Company
At the end of the fifth year, the equipment is expected to have no residual value. During the period of the lease, Marcus Company expects to incur repair, insurance, and property taxes estimated at $35,000.

11. Proposal to Lease or Sell Equipment
June 22, 2006
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 ,000
Differential cost of lease ,000
Net differential income from the lease alternative $31,000
Lease the equipment!

12. OR

13. Proposal to Lease or Sell Equipment
June 22, 2006
Lease alternative:
Revenue from lease $160,000 Depreciation expense for remaining 5 years $80,000 Repairs, insurance, and property tax expense 35, ,000 Net gain $45,000
Sell alternative:
Sales price $100,000 Book value of equipment $80,000 Commission expense 6, , Net gain ,000
Net differential income from the lease alternative $31,000
This is the traditional analysis. The differential income is the same.

14. Discontinue a Segment or Product

15. Condensed Income Statement For the Year Ended August 31, 2006
Battle Creek Cereal Co.
Condensed Income Statement
For the Year Ended August 31, 2006
Bran Flakes
Other Cereals
Differential items
Total
Sales $100,000 $900,000 $1,000,000
Cost of goods sold:
Variable costs $ 60,000 $420,000 $ 480,000
Fixed costs , , ,000
Total cost of goods sold $ 80,000 $620,000 $ 700,000
Gross profit $ 20,000 $280,000 $ 300,000
Operating expenses:
Variable expenses $ 25,000 $155,000 $ 180,000
Fixed expenses , , ,000
Total operating expenses $ 31,000 $200,000 $ 231,000
Income (loss) from operations $ (11,000) $ 80,000 $ 69,000
Sales $100,000
Variable cost $ 60,000
Variable expenses $ 25,000
Should Bran Flakes be discontinued?

16. Condensed Income Statement For the Year Ended August 31, 2006
Battle Creek Cereal Co.
Condensed Income Statement
For the Year Ended August 31, 2006
Bran Flakes
Other Cereals
Differential items
Total
Sales $100,000 $900,000 $1,000,000
Cost of goods sold:
Variable costs $ 60,000 $420,000 $ 480,000
Fixed costs , , ,000
Total cost of goods sold $ 80,000 $620,000 $ 700,000
Gross profit $ 20,000 $280,000 $ 300,000
Operating expenses:
Variable expenses $ 25,000 $155,000 $ 180,000
Fixed expenses , , ,000
Total operating expenses $ 31,000 $200,000 $ 231,000
Income (loss) from operations $ (11,000) $ 80,000 $ 69,000
Sales $100,000
Variable cost $ 60,000
Variable expenses $ 25,000
If Bran Flakes is discontinued, net income will decrease by $15,000.

17. Proposal to Discontinue Bran Flakes
September 29, 2006
Differential revenue from annual sales of Bran Flakes:
Revenue from sales $100,000
Differential cost of annual sales of Brian Flakes:
Variable cost goods sold $60,000 Variable operating expenses 25, ,000
Annual differential income from sales of Bran Flakes $15,000
Don’t discontinue!

18. MAKE or
BUY

19. Currently, a firm manufactures the dashboards that it uses in making automobiles. The cost of manufacturing this part is summarized below. An outside supplier has offered to provide the part for $240. Should the car manufacturer accept the offer?
Direct materials $ 80
Direct labor 80
Variable factory overhead 52
Fixed factory overhead
Total cost per unit $280
INITIAL REACTION—DON’T MAKE INTERNALLY

20. Proposal to Manufacture Automobile Part
February 15, 2006
Purchase price of part $240.00
Differential cost to manufacture:
Direct materials $80.00
Direct labor 80.00
Variable factory overhead
Cost savings from manufacturing part $
The fixed factory overhead is excluded because it is not relevant—so continue making the part.

21. Replace Equipment

22. Assume that a business is considering the disposal of several identical machines having a total book value of $100,000 and an estimated remaining life of five years. The old machines can be sold for $25,000. They can be replaced by a single high-speed machine at a cost $250,000. The new machine has a n estimated useful life of five years and no residual value. Analyses indicate an estimated annual reduction in variable manufacturing costs from $225,000 with the old machine to $150,000 with the new machine. No other changes in the manufacturing costs or the operating expenses are expected. Should the new machine be purchased?

23. Proposal to Replace Equipment
November 28, 2006
Annual variable costs—present equipment $225,000
Annual variable costs—new equipment 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 ,000 $400,000
Cost of new equipment ,000
Net differential decrease in cost, 5-years $150,000
Annual net differential—new equipment $ 30,000
Buy the new equipment!

24. Process or Sell

25. A refinery produces kerosene in batches of 4,000 gallons at a processing cost of $0.60 per gallon. Kerosene can be sold without further processing for $0.80 per gallon or further processed to yield gasoline, which can be sold for $1.25 per gallon. The additional processing cost $650 per batch, and 20% of the gallons of kerosene will evaporate during production.

26. Proposal to Process Kerosene Further
October 1, 2006
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 gasoline
Differential income from further processing gasoline per batch $150
Process further!

27. Accept Business at a Special Price

28. The monthly capacity of a sporting goods business is 12,500 basketballs. Current sales and production are averaging 10,000 basketballs per month. The current manufacturing cost is $20 (variable, $12.50; fixed, $7.50). The domestic selling price is $30.

29. Should the offer be accepted or rejected?
The manufacturer 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. Domestic sales would not be affected.
Should the offer be accepted or rejected?

30. Proposal to Sell Basketballs to Exporter
March 10, 2006
Differential revenue from accepting offer: Revenue from sale of 5,000 additional units at $18 $90,000
Differential cost of accepting offer: Variable cost of 5,000 additional units at $ ,500
Differential income from accepting offer $27,500
Accept the offer!

31. Setting Normal Product Selling Prices

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

33. Market Methods
Demand-based methods set the price according to the demand for the product.

34. Market Methods
Competition-based methods set the price according to the price offered by the competitors.

35. Using the Total cost concept, all cost of manufacturing a product...
Manufacturing Cost

36. Total Cost Concept …plus the selling and administrative expenses...
Selling Expenses
Manufacturing Cost

37. Total Cost Concept
…are included in the cost to which the markup is added.
Desired Profit
Administrative Expenses
Total cost
Selling Expenses
Manufacturing Cost

38. Total Cost Concept The company’s desired profit is $160,000.
Desired selling price
Desired Profit
Manufacturing Cost
Selling Expenses
Administrative Expenses

39. Cost Structure Example (100,000 units)
Total Cost Concept
Cost Structure Example (100,000 units)
Per Unit Total
Cost Cost
Variable Costs (per unit):
Direct materials $ $ 300,000
Direct labor ,000,000
Factory overhead ,000
Selling and administrative ,000
Total variable costs $16.00 $1,600,000
Fixed Costs:
Factory overhead ,000
Selling and administrative ,000
Total fixed costs ,000
Total costs $16.70 $1,670,000

40. Only the desired profit is covered in the markup.
Total Cost Concept
Markup Percentage:
Desired profit $160,000
Total costs $1,670,000 =
= 9.6%
Total cost per calculator $16.70
Markup ($16.70 x 9.6%)
Selling price $18.30
Only the desired profit is covered in the markup.

41. For the Year Ended December 31, 2006
Total Cost Concept
Proof that a sale of 100,000 computers at $18.30 each will generate a desired profit of $160,000.
Sales (100,000 units x $18.30) $1,830,000
Expenses: Variable (100,000 units x $16.00) $1,600,000
Fixed ($50,000 + $20,000) , ,670,000
Income from operations $ 160,000
Digital Solutions Inc.
Income Statement
For the Year Ended December 31, 2006

42. Product Cost Concept
Using the product cost concept only the manufacturing costs are included in the amount to which the markup is applied.

43. Cost Structure Example (100,000 units)
Product Cost Concept
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 administrative ,000
Total variable costs $16.00 $1,600,000
Fixed Costs:
Factory overhead ,000
Selling and administrative ,000
Total fixed costs ,000
Total costs $16.70 $1,670,000
Product Cost = $15 per unit

44. Administrative Expense
Product Cost Concept
Desired Selling Price
Administrative Expense +
Selling Expense
Desired Profit
Markup
Manufacturing Cost
Product Cost

45. Product Cost Concept = Total selling and administrative expenses
Markup percentage
Desired profit +
Total manufacturing costs =
Total selling and administrative expenses

46. Product Cost Concept = = 22% $160,000 + $170,000 Markup percentage
$1,500,000
DM ($3 x 100,000) $ 300,000
DL ($10 x 100,000) 1,000,000
Factory overhead:
Variable ($1.50 x 100,000) 150,000
Fixed ,000
Total manufacturing costs $1,500,000
Markup percentage =
22%

47. Product Cost Concept Manufacturing cost per calculator $15.00
Markup ($15 x 22%)
Selling price $18.30

48. Variable Cost Concept
The variable cost concept uses total of the variable manufacturing costs and the variable selling and administrative expenses as the amount to apply a markup.

49. Total Fixed Costs + Desired Profit
Variable Cost Concept
Desired Selling Price
Markup
Total Fixed Costs + Desired Profit
Variable Manufacturing Cost +
Variable Administrative and Selling Expenses
Product Cost

50. Variable Cost Concept = Desired profit + Total fixed costs
Markup percentage
Desired profit +
Total variable costs =
Total fixed costs

51. Variable Cost Concept Markup percentage $160,000 + $50,000 + $20,000 =
$1,600,000
Direct materials ($3 x 100,000) $ 300,000
Direct labor ($10 x 100,000) 1,000,000
Variable factory overhead ($1.50 x 100,000) 150,000
Variable selling and administrative expenses ($1.50 x 100,000) ,000
Total variable costs $1,600,000
Markup percentage =
14.4%

52. Variable Cost Concept Variable cost per calculator $16.00
Markup ($16 x 14.4%)
Selling price $18.30

53. Required cost reduction
Target Costing
Using target costing the cost is determined by subtracting a desired profit from the selling price.
Present Market Price
Profit
Expected Market Price
Profit
Drift
Actual Cost
Required cost reduction
Target Cost
Present
Future

54. Bottlenecks

55. Product Profitability Under Production Bottlenecks
Small Medium Large
Wrench Wrench Wrench
Sales price $130 $140 $160
Variable cost
Contribution margin $ 90 $100 $120
Bottleneck hours
The number of heat treatment hours per unit for each product.

56. Product Profitability Under Production Bottlenecks
Small Medium Large
Wrench Wrench Wrench
Sales price $130 $140 $160
Variable cost
Contribution margin $ 90 $100 $120
Bottleneck hours ÷ ÷ ÷ 8
Bottleneck contribution $ 90 $ 25 $ 15
Largest contribution margin per bottleneck hour

57. Product Profitability Under Production Bottlenecks
How much should the firm charge for the large wrench in order to deliver the same contribution as the small wrench?

58. Product Profitability Under Production Bottlenecks
Contribution margin per bottleneck hour per small wrench =
Revised price of large wrench
Variable cost per large wrench –
Bottleneck hours per large wrench
$90 =
Revised price of large wrench – 8
$40
$720 = Revised price of large wrench – $40
$760 = Revised price of large wrench

59. Product Profitability Under Production Bottlenecks
Revised price of large wrench per formula on the previous slide $760
Less: Variable cost per unit of large wrench
Contribution margin per unit of large wrench $720
Bottleneck hours per unit of large wrench ÷ 8
Revised contribution margin per bottleneck hour $ 90

60. Chapter 24
The End