Differential Analysis and Product Pricing

1. 24 Differential Analysis and Product Pricing Student Version

2. 1 1 Prepare differential analysis reports for a variety of managerial decisions. 24-2

3. 1 Sunk Costs Costs that have been incurred in the past are not relevant to the decision. These costs are called sunk costs.

4. 1 Differential Revenue Differential revenue is the amount of increase or decrease in revenue that is expected from a course of action as compared with an alternative action.

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

6. 1 Differential Income or Loss Differential income (or 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 the opposite.

7. 1 Lease or Sell 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 Sell Option: Sales price $100,000 Commission on sale 6%

8. Exhibit 2 1 Differential Analysis Report—Lease or Sell

9. 1 Discontinue a Segment or Product Management may consider discontinuing the product or segment of a business that is generating losses. Based on the information contained in the condensed income statement (Slide 10), management of Battle Creek Cereal Co. is considering discontinuing Bran Flakes.

10. Exhibit 4 1 Income (Loss) by Product

11. Exhibit 5 1 Differential Analysis Report—Discontinue an Unprofitable Segment Don’t discontinue Bran Flakes!

12. 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 is estimated as follows: Direct materials $ 80 Direct labor 80 Variable factory overhead 52 Fixed factory overhead 68 Total estimated cost per unit $280

13. Exhibit 7 1 Differential Analysis Report—Make or Buy

14. 1 Opportunity Cost The amount of income that is foregone from an alternative use of an asset, such as cash, is called an opportunity cost.

15. 1 Process or Sell A business produces kerosene as follows: Batch size 4,000 gallons Cost of producing kerosene $2,400 per batch Selling price $0.80 per gallon (continued)

16. 1 Process or Sell The kerosene can be processed further to yield gasoline as follows: Input batch size 4,000 gallons Less evaporation (20%) 800 (4,000 × 20%) Output batch size 3,200 Additional processing costs $650 per batch Selling price $1.25 per gallon (continued)

17. Exhibit 9 1 Differential Analysis Report—Process or Sell

18. 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 $12.50 per basketball Fixed costs 7.50 Total $20.00 per basketball

19. 1 Accept Business at a Special Price 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.

20. Exhibit 10 1 Differential Analysis Report—Sell at Special Price

21. 1 2 Determine the selling price of a product using the total cost, product cost, and variable cost concepts. 24-21

22. 2 Markup Using the cost-plus methods, managers add to the cost an amount called a markup. This allows for all costs plus a profit to be included in the selling price.

23. Desired selling price Administrative Expenses Selling Expenses Markup percentage Desired profit Total costs = Manufacturing Cost 2 The markup is determined by applying the following formula: Desired Profit

24. 2 Manufacturing costs: Direct materials ($3.00 × 100,000) $ 300,000 Direct labor ($10.00 × 100,000) 1,000,000 Factory overhead: Variable costs ($1.50 × 100,000) $150,000 Fixed costs 50,000 200,000 Total manufacturing costs $1,500,000 Selling and administrative expenses: Variable expenses ($1.50 × 100,000) $150,000 Fixed costs 20,000 Total selling and administrative expenses 170,000 Total cost $1,670,000

25. Total cost per calculator $16.70 Markup ($16.70 ×9.6%) 1.60 Selling price $18.30 2 Markup Percentage Desired profit Total costs $160,000 $1,670,000 = = 9.6% Only the desired profit is covered in the markup.

26. 2 Product Cost Concept Using the product cost concept, only the costs of manufacturing the product are included in the cost amount to which the markup is added. The markup percentage is computed as follows: Desired Profit + Total Selling and Administrative Expenses Total Product Cost Markup Percentage =

27. 2 Manufacturing costs: Direct materials ($3.00 × 100,000) $ 300,000 Direct labor ($10.00 × 100,000) 1,000,000 Factory overhead: Variable costs ($1.50 × 100,000) $150,000 Fixed costs 50,000 200,000 Total manufacturing costs $1,500,000 Selling and administrative expenses: Variable expenses ($1.50 × 100,000) $150,000 Fixed costs 20,000 Total selling and administrative expenses 170,000 Total cost $1,670,000

28. Desired Selling Price Administrative Expense + Selling Expense + Desired Profit 2 Desired Selling Price Markup Manufacturing Cost Product Cost

29. $160,000 + $170,000 Markup Percentage = $1,500,000 Markup Percentage 22% = 2 Calculating the Markup Percentage Total Selling and Administrative Expenses Markup Percentage Desired Profit + = Total Manufacturing Costs

30. 2 Digital Solutions Inc. would price each calculator at $18.30 per unit, as shown below: Manufacturing cost per calculator $15.00 Markup ($15.00 ×22%) 3.30 Selling price $18.30

31. 2 Variable Cost Concept The variable cost concept emphasizes the distinction between variable and fixed costs in product pricing. Only variable costs are include in the cost amount to which the markup is added.

32. Total Fixed Costs + Desired Profit Desired Selling Price 2 Markup Variable Manufacturing Cost + Variable Administrative and Selling Expenses Product Cost

33. Total Fixed Costs Desired Profit + Markup Percentage = $160,000 + $50,000 + $20,000 Markup Percentage = $1,600,000 Direct materials ($3 × 100,000) $ 300,000 Direct labor ($10 × 100,000) 1,000,000 Variable factory overhead ($1.50 × 100,000) 150,000 Variable selling and administrative expenses ($1.50 × 100,000) 150,000 Total variable costs $1,600,000 2 Markup Percentage Total Variable Costs

34. Total Fixed Costs Desired Profit + Markup Percentage = $160,000 + $50,000 + $20,000 Markup Percentage = $1,600,000 $230,000 Markup Percentage = = 14.4% $1,600,000 2 Markup Percentage Total Variable Costs

35. Variable cost per calculator $16.00 Markup ($16.00 ×14.4%) 2.30 Selling price $18.30 2 Digital Solutions Inc. would price each calculator at $18.30 per unit, as shown below:

36. 2 Target Costing Target costing is a method of setting prices that combines market-based pricing with a cost reductive emphasis. A future price is anticipated, using the demand-based methods or the competition-based methods. Target Cost = Expected Selling Price – Desired Profit

37. 1 3 Compute the relative profitability of products in bottleneck production processes. 24-37

38. 3 Production Bottlenecks and Profits A productionbottleneck (or constraint) occurs at the point in the process where the demand for the company’s product exceeds the ability to produce the product.

39. 3 The product unit contribution margin and the number of hours of heat treatment used by each wrench are as follows: Small Medium Large Wrench Wrench Wrench Sales price per unit $130 $140 $160 Variable cost per unit 40 40 40 Contribution margin per unit $ 90 $100 $120 Heat treatment hours per unit 1 hr. 4 hrs. 8 hrs. (continued)

40. Small Wrenches $90 1 hr. Unit Contribution Margin per Bottleneck Hour = $90 per hour = Medium Wrenches $100 4 hrs. Unit Contribution Margin per Bottleneck Hour = $25 per hour = Large Wrenches $120 8 hrs. Unit Contribution Margin per Bottleneck Hour = $15 per hour = 3 Unit Contribution Margin Heat Treatment Hours per Unit Unit Contribution Margin per Bottleneck Hour =

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

42. Revised Price of Large Wrench – $40 = $90 8 3 Contribution Margin (per unit) per Bottleneck Hour for Small Wrench Variable Cost per Unit for Large Wrench Revised Price of Large Wrench – = Bottleneck Hours per Unit for Large Wrench $720= Revised Price of Large Wrench – $40 $760 = Revised Price of Large Wrench