Differential Analysis and Product Pricing

1. Differential Analysis and Product Pricing Chapter 12

2. Learning Objectives After studying this chapter, you should be able to: • Prepare differential analysis reports for a variety of managerial decisions. • Determine the selling price of a product, using the total cost, product cost, and variable cost concepts. • Compute the relative profitability of products in bottleneck production processes.

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

4. Differential Analysis

5. Differential Analysis • Differential analysis looks at the effects of different alternatives. • Uses estimated revenues and costs. • Focuses on relevant revenues and costs. • Ignores sunk costs – those costs that have occurred in the past and are irrelevant for future decision making.

6. Differential Analysis in Six Situations • Leasing or selling equipment • Discontinuing an unprofitable segment • Manufacturing or purchasing a needed part • Replacing fixed assets • Processing further or selling an intermediate product • Accepting additional business at a special price

7. Lease or Sell • Karnes Company has equipment to dispose. The equipment originally cost $200,000, and accumulated depreciation is $120,000. • Two alternatives: • Lease the equipment for $160,000 less $35,000 in repairs, taxes, etc. • Sell the equipment for $100,000 less 6% commission.

8. Lease or Sell Exhibit 2: Differential Analysis Report-Lease or Sell Decision: Leasing the equipment would increase overall income by $31,000. Exhibit 3: Traditional Analysis NOTE: The $80,000 book value is a sunk cost and is ignored in differential analysis.

9. Discontinue a Segment or Product Exhibit 4: Income (Loss) by Product Montana Wheat Cereal Co. produces and sells three kinds of cereal. Bran Flakes exhibits an operating loss so the company is considering discontinuing production and sale of the product. If fixed costs remain the same, is this the right decision?

10. Discontinue a Segment or Product Exhibit 5: Differential Analysis Report- Discontinue an Unprofitable Segment Decision: Discontinuing Bran Flakes would reduce overall profit by $15,000 because that is the amount that Bran Flakes contributes to covering fixed costs. Exhibit 6: Traditional Analysis

11. Make or Buy • An automobile company has been buying a part for $240 per unit. It is considering making the part at the following cost: • $80 in direct materials • $80 in direct labor • $52 in variable overhead • $68 in fixed overhead • 80% capacity • Should the company make or buy the part?

12. Make or Buy Decision: Making the instrumental panels will provide a cost saving of $28 per unit because fixed costs will not change. Exhibit 7: Differential Analysis Report- Make or Buy Focus the analysis on differential costs. Since the automobile company has excess factory capacity, fixed costs will not change and hence they are irrelevant to the decision.

13. Replace Equipment • A manufacturer is considering replacing several old machines with a new one. • Total book value of the old machines: $100,000. • Total remaining useful life of the old machines is 5 years. • New machine cost $250,000; 5-year useful life. • The old equipment can be sold for $25,000. • The new machine will reduce annual variable costs from $225,000 to $150,000. • Should the company buy the new machine?

14. Replace Equipment Exhibit 8: Differential Analysis Report - Replace Machine Decision: Replacing the old equipment with the new equipment will provide an annual decrease in cost of $30,000. Focus the analysis on relevant costs. The book value of the equipment ($100,000) is a sunk cost and is not considered. Relevant costs include the cost savings of more efficient equipment, product quality, etc.

15. Opportunity Cost • Measures the amount of revenue that is foregone from an alternative use of an asset. • Assume that the $250,000 for the new equipment less the $25,000 sale proceeds could be invested to yield a 15% return. • The annual opportunity cost of the new equipment is $33,750 ($225,000 × 15%). • It is not beneficial to replace the equipment for an annual cost savings of $30,000.

16. Process or Sell • A 4,000 gallon batch of kerosene sells at $0.80 per gallon; produced from 4,000 gallons of raw material costing $0.60 per gallon. • Alternatively, could continue processing these raw material into gasoline selling at $1.25 per gallon for an additional cost of $650 per batch; 20% of the gallons of kerosene will evaporate during production. • Should the company sell or process further?

17. Process or Sell Exhibit 9: Differential Analysis Report – Process or Sell Initial raw material cost will be incurred in both alternatives and is not considered. The differential revenue and the cost to process the batch further will be the focus.

18. Accept Business at a Special Price • A company currently produces an average of 10,000 basketballs per month; factory has a monthly capacity of 12,500 basketballs. • Variable costs are $12.50 per ball. • Fixed costs are $7.50 per ball. • The domestic selling price is $30 per ball. • The company received an offer for 5,000 additional basketballs at $18 each from a foreign buyer. The balls can be produced over 3 months. • Should the company accept the offer?

19. Accept Business at a Special Price Exhibit 9: Differential Analysis Report – Sell at Special Price The company has excess capacity and can produce additional product without incurring additional fixed costs. Whether differential revenue covers relevant costs and produces income is the issue.

20. Learning Objective 2 Determine the selling price of a product, using the total cost, product cost, and variable cost concepts

21. Setting Normal Product Selling Prices • In the long run, the normal selling price must be enough to cover all expenses and provide a reasonable profit. • Approaches for setting prices: • Market methods • Cost-plus methods

22. Market Methods • Demand-based concept– set the selling price according to demand for the product. • Competition-based concept – set the price according to the price offered by competitors.

23. Cost-Plus Methods Managers price the product in order to achieve a target profit. The price covers all costs plus a profit. • Total Cost Concept • Markup added to all costs (including selling & administrative). • Product Cost Concept • Markup added to product costs. • Variable Cost Concept • Markup added to variable costs.

24. Cost-Plus Examples We’ll use these facts to illustrate the three cost-plus methods.

25. Total Cost Concept Desired Profit Total Cost Markup % = • Nebular Inc. desires a profit equal to 20% of total assets. If total assets are $800,000, the desired profit is $160,000, or $1.60 per unit, assuming 100,000 units. • Assuming 100,000 units, the total cost per unit is as follows: • After adding the markup to the total cost the selling price per unit is:

26. Total Cost Concept Desired Profit Total Cost $160,000 $1,670,000 Markup % = = 9.6% = $16.70 total cost/unit × 1.096 = $18.30

27. Product Cost Concept Desired Profit + Selling/Admin Exp. Total Product Cost Markup % = • The product cost concept applies the markup to the manufacturing cost per unit. • Assuming 100,000 units, the manufacturing cost per unit is as follows:

28. Product Cost Concept Desired Profit + Total Selling and Administrative Expenses $160,000+ $170,000 $1,500,000 Markup % = Total Product Cost = 22.0% $15.00 Manufacturing Cost/Unit × 22% = $3.30 Markup

29. Variable Cost Concept Desired Profit + Total Fixed Costs and Expenses Total Variable Costs Markup % = • The variable cost concept applies the markup to the variable cost per unit. • Assuming 100,000 units, the variable cost per unit is as follows:

30. Variable Cost Concept $160,000+ $50,000 + $20,000 $1,600,000 Markup % = Desired Profit + Total Fixed Costs and Expenses Total Variable Costs = 14.4% $16.00 Variable Cost/Unit × 14.4% = $2.30 Markup

31. Choosing a Cost-Plus Approach Cost Concept • Each method requires different estimates of costs and expenses. • Things to consider when choosing a method: • Difficulty in gathering data. • Complexity of manufacturing operations. • Decision-making needs of management. Exhibit 11: Cost-Plus Approach to Setting Normal Selling Prices

32. Other Cost Concepts • Activity-Based Costing • Identifies and traces costs to specific activities. • Target Costing • Combines market-based pricing with cost reduction. Exhibit 12: Target Cost Concept

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

34. Production Bottleneck • Occurs at the point in the process where the demand for the product exceeds the ability to produce the product. • The theory of constraints focuses on reducing the influence of bottlenecks on a process.

35. Analyzing a Bottleneck • The contribution margin per unit suggests that the large wrench is the most profitable. However…

36. Small Wrench Unit Contribution Margin Bottleneck Hours = $90 per hr. Medium Wrench Unit Contribution Margin Bottleneck Hours = $25 per hr. Large Wrench Unit Contribution Margin Bottleneck Hours = $15 per hr. Analyzing a Bottleneck • …the contribution margin per unit of constrained resource suggests the small wrench is the most profitable. $100 4 hour $120 8 hour $90 1 hour

37. Product Pricing in Bottleneck Situations • The contribution margin per unit of scarce resource can be used to set product prices. • Products that use a large amount of the constrained resource require a higher contribution margin.

38. Product Pricing in Bottleneck Situations • Mathematical equations can help determine the needed contribution margin and product selling price in a bottleneck situation. • Assume that the variable cost per unit and the heat treatment hours for the large wrench cannot be decreased. • The price of the large wrench that would make it as profitable as the small wrench is determined as follows:

39. End of Chapter 12