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Differential Cost Analysis

Differential Cost Analysis. Chapter 25. Management decisions. Accepting/Rejecting certain orders Reducing the price of a single order Making a price cut in a competitive market Evaluating Make-or-buy alternatives Expanding or reducing plant capacity

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Differential Cost Analysis

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  1. Differential Cost Analysis Chapter 25

  2. Management decisions • Accepting/Rejecting certain orders • Reducing the price of a single order • Making a price cut in a competitive market • Evaluating Make-or-buy alternatives • Expanding or reducing plant capacity • Increasing, curtailing or stopping production • Replacing present equipment • Spending additional amounts for sales promotion

  3. Differential Cost • Difference between cost of alternative choices • Marginal/Incremental cost • Deals with determination of incremental revenue, costs and margins • Variable costs are significant • Fixed costs might be included

  4. Example • Total cost at 60,000 units = $324,250 • Total cost at 80,000 units = $423,400 • Calculate total differential cost • Calculate differential cost/unit

  5. Solution • Differential cost = 423,400 – 324,250 = $99,150 • Differential cost/unit = 99,150/20,000 = $4.96

  6. Accepting Additional Orders • Differential cost must be considered involving a change in output • Difference between the cost of producing present smaller output and that of the planned larger output • Possibility of selling additional output at a figure lower or greater than the existing average unit cost • New or additional business can be accepted as long as the variable cost is recovered

  7. Example • Maximum capacity=100,000 units • Normal capacity = 80,000 units • Variable cost per unit = $5 • Fixed cost= $100,000 • Sales price per unit= $9 • Profit at 80,000 and 81,000 units?

  8. Solution • Present business Additional business Total Sales $720,000 $9,000 $729,000 Variable cost 400,000 5,000 405,000 Contribution Margin 320,000 4,000 324,000 • Fixed cost 100,000 _-0-____ 100,000 • Profit320,0004,000 224,000

  9. Reducing the Price of a Special Order • At what minimum price the firm can afford to sell additional goods

  10. Example • Company manufactures 450,000 units using 90% of its capacity • Fixed factory overhead is $335,000 • Variable factory overhead = $0.50/unit • Direct materials = $1.80/unit • Direct labor = $1.40/unit • Each unit sells for $5

  11. Example • Sales $2,250,000 • Cost of goods sold: • Direct materials(450,000*1.80) 810,000 • Direct labor(450,000*1.40) 630,000 • Variable factory overheads(450,000*0.50) 225,000 • Fixed factory overheads(450,000*0.67) 301,5001,966,500 • Income from operations 283,500 • Unabsorbed fixed factory overheads(500,000-450,000)*0.67] 33,500 • Income from operations (adjusted) 250,000

  12. Special Order • Additional fixed cost if special order of 100,000 units is accepted = $10,000 • Sales price of a special order=$4.25

  13. Solution • Sales (100,000 units@4.25) $425,000 • Cost of goods sold: • Direct materials(100,000units @1.80) 180,000 • Direct labor (100,000units @ 1.40) 140,000 • Variable factory overheads • (100,000 units @0.50) 50,000 • Additional fixed cost 10,000380,000 • Gain on the order $45,000

  14. Exercise • The wood River plant of the Union Company has a normal capacity 0f 90,000 units per month. Monthly production costs are $12 variable cost per unit and $240,000 fixed. By increasing the fixed cost $10,000 a month, the plant can produce 95,000 units. • Differential cost of the production between 80% and 90% of normal capacity. • Differential cost of producing the 5,000 units above the normal capacity. • Per unit total production cost of the 95,000 units • Per unit differential production cost of the 5,000 units.

  15. Solution • Differential cost of the production between 80% and 90% of normal capacity. • 90,000 units *90% 81,000 units • 90,000 units *80% 72,000 units • 9,000 units • 9,000 units *$12 = $108,000

  16. Solution • Differential cost of producing the 5,000 units above the normal capacity. • 5,000 units *12 $60,000 • Differential Fixed cost 10,000 • 70,000

  17. Solution • Per unit total production cost of the 5,000 units • 95,000 units *12 $1,140,000 • Fixed costs(240,000+10,000) 250,000 • 1,390,000

  18. Solution • Per unit differential production cost of the 5,000 units. • =$70,000/5,000 units • = $14

  19. Make-Or-Buy Decisions • Compare the cost of making the parts with the cost of buying them • Costs for each of the alternatives must be based on the identical product specifications, quantities and quality standards

  20. Decisions to Shut Down Facilities • In the short run, a firm seems to be better off operating than not operating if revenue > variable costs • Shutting down of facilities • Does not eliminate all costs • Loss of investment spent on training employees • Recruiting and training costs after reopening • Loss of losing established markets & customers

  21. Decisions to Shut Down Facilities • If operations are continued • Certain expenses connected with the shutting down of the facilities can be saved • Costs that would have to be incurred when a closed facility is reopened will be saved

  22. Decisions to Discontinue Products • Requires careful analysis of relevant differential cost and revenue data • Following benefits can be achieved with the correct decision: • Expanded sales • Increased profits • Reduced inventory levels • Resources made available for more promising projects

  23. Decisions to Discontinue Products • Not only the profitability of the products being analyzed be considered but also the extent to which sales of other products will be affected when one product is removed should be evaluated

  24. Decisions to Discontinue Products • Management needs following signals to identify troubled products: • Declining sales volume • Decreasing market share • Malfunctioning of the product or introduction of a superior competitive product • Expected future sales and market potential not favorable • Return on investment below minimum acceptable level • Variable costs approaching or exceeding revenue • Price required to be constantly lowered to maintain sales

  25. Other Cost Concepts • Opportunity costs • Measurable value of an opportunity bypassed by rejecting an alternative use to resources • Measurement of sacrifices associated with alternatives • Imputed costs • Hypothetical costs representing the cost/value of a resource measured by its use value • Interest on invested capital, rental value of company-owned properties, salaries of owners of sole proprietors • Do not involve actual cash flows

  26. Other Cost Concepts • Out-Of-Pocket Costs • Involves cash outlays • Often identified as variable costs • Helpful in deciding whether a particular venture will at least return the cash expenditures • Sunk Costs • Irrecoverable costs • Not included in differential cost analysis

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