Differential Analysis and Product Pricing

1. 0 24 Differential Analysis and Product Pricing

2. 0 24-1 Objective 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, process further or selling an intermediate product, or accepting additional business at a special price.

3. 0 24-1 Differential Analysis Relevant revenues and costs focus on the differences between each alternative. Costs that have been incurred in the past are not relevant to the decision. These costs are called sunk costs.

4. 0 24-1 Differential revenue is the amount of increase or decrease in revenue that is expected from a course of action as compared with an alternative.

5. 0 24-1 Differential cost is the amount of increase or decrease in cost that is expected from a course of action as compared with an alternative.

6. 0 24-1 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. 0 24-1 Differential analysis focuses on the effect of alternative courses of action on the relevant revenues and costs.

8. 0 24-1 Summary Differential Analysis Decisions Alternative A Differential revenue – Differential cost or Differential income or loss Alternative B 8

9. 0 24-1 Differential Analysis 9

10. 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. 0 24-1 Uses of Differential Analysis Differential analysis is used for analyzing: 10

11. 0 24-1 Lease or Sell Marcus Company is considering disposing of equipment that cost $200,000 and that has $120,000 of accumulated depreciation. The equipment can be sold through a broker for $100,000, less a 6% commission.

12. 0 24-1 Potamkin Company, the lessee, has offered to lease the equipment for five years for a total consideration of $160,000.

13. 0 24-1 At the end of the fifth year of the lease, 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.

14. 0 24-1 Differential Analysis Report—Lease or Sell 14

15. 0 24-1 Traditional Analysis 15

16. 4 0 24-1 Income (Loss) by Product 16

17. 0 24-1 Discontinue a Segment or Product Based on the information contained in the condensed income statement (Slide 16), management of Battle Creek Cereal Co. is considering discontinuing Bran Flakes.

18. 0 24-1 Differential Analysis Report—Discontinue an Unprofitable Segment Proposal to Discontinue Bran Flakes September 29, 2008 Differential revenue from annual sales of Bran Flakes: Revenue from sales $100,000 Differential cost of annual sales of Bran Flakes: Variable cost goods sold $60,000 Variable operating expenses 25,000 85,000 Annual differential income from sales of Bran Flakes $15,000 18 Don’t discontinue Bran Flakes!

19. 0 24-1 Traditional Analysis 19

20. Direct materials $ 80 Direct labor 80 Variable factory overhead 52 Fixed factory overhead 68 Total estimated cost per unit $280 0 24-1 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: 20

21. 0 24-1 Differential Analysis Report—Make or Buy Proposal to Manufacture Instrument Panels February 15, 2008 Purchase price of instrument panel $240.00 Differential cost to manufacture: Direct materials $80.00 Direct labor 80.00 Variable factory overhead 52.00 212.00 Cost savings from manufacturing instrument panel $ 28.00 21

22. 0 24-1 Replace Equipment 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.

23. 0 24-1 The old machines can be sold for $25,000. They can be replaced by a single high-speed machine at a cost of $250,000. The new machine has an estimated useful life of five years and no residual value. Using the new machine will reduce variable manufacturing costs from $225,000 to $150,000.

24. 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 25,000 $400,000 Cost of new equipment 250,000 Net differential decrease in cost, 5-years $150,000 Annual net differential decrease in cost—new equipment $ 30,000 0 24-1 Differential Analysis Report—Replace Equipment Proposal to Replace Equipment November 28, 2008 24

25. 0 24-1 Process or Sell A business produces kerosene in batches of 4,000 gallons. Standard quantities of 4,000 gallons of direct materials are processed, which cost $0.60 per gallon.

26. 0 24-1 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 costs $650 per batch, and 20% of the gallons of kerosene will evaporate during production.

27. Differential revenue from further processing per batch: Revenue from sale of gasoline [(4,000 gallons – 800 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 650 Differential income from further processing gasoline per batch $150 0 24-1 Differential Analysis Report—Process or Sell Proposal to Process Kerosene Further October 1, 2008 27

28. 0 24-1 Accept Business at a Special Price 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 per unit (variable, $12.50; fixed, $7.50). The domestic unit selling price is $30.

29. 0 24-1 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.

30. Proposal to Sell Basketballs to Exporter March 10, 2008 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 $12.50 62,500 Differential income from accepting offer $27,500 0 24-1 Differential Analysis Report—Sell at Special Price 30

31. 0 24-2 Objective 2 Determine the selling price of a product using the total cost, product cost, variable cost, and target cost concepts.

32. 0 24-2 Setting Normal Product Selling Prices The basic approaches to setting prices are: 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. 0 24-2 Market Methods • Demand-based methods set the price according to the demand for the product. • Competition-based methods set the price according to the price offered by competitors.

34. 0 24-2 Markup Using the cost-plus methods, managers add to the cost an amount called a markup, so that all costs plus a profit are included in the selling price.

35. 0 24-2 Total Cost Concept Using the total costconcept, all costs of manufacturing a product... Manufacturing Cost 35

36. 0 24-2 …plus the selling and administrative expenses... Administrative Expenses Selling Expenses Manufacturing Cost 36

37. Total cost 0 24-2 …are included in the cost to which the markup is added. Administrative Expenses Selling Expenses Manufacturing Cost 37

38. Desired selling price Administrative Expenses Selling Expenses Markup percentage Desired profit Total costs = Manufacturing Cost 0 24-2 The markup is determined by applying the following formula: Desired Profit 38

39. Variable Costs: Direct materials $ 3.00 $ 300,000 Direct labor 10.00 1,000,000 Factory overhead 1.50 150,000 Selling and admin. exp. 1.50 150,000 Total variable costs $16.00$1,600,000 Fixed Costs: Factory overhead .50 50,000 Selling and admin. exp. .20 20,000 Total fixed costs . 70 70,000 Total costs $16.70 $1,670,000 0 24-2 Digital Solutions Inc.—100,000 calculators Per Unit Total Cost Cost 39

40. Total cost per calculator $16.70 Markup ($16.70 x 9.6%) 1.60 Selling price $18.30 0 24-2 Markup Percentage Desired profit Total costs $160,000 $1,670,000 = = 9.6% Only the desired profit is covered in the markup. 40

41. 0 24-2 Proof That Selling the Calculators at $18.30 Will Generate the Desired Profit Digital Solutions Inc. Income Statement For the Year Ended December 31, 2008 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) 70,000 1,670,000 Income from operations $ 160,000 41

42. 0 24-2 Product Cost Concept Using the product cost concept, only the costs of manufacturing the product, termed the product cost, are included in the cost amount to which the markup is added.

43. Product cost $1.5 million 0 24-2 Digital Solutions Inc.—100,000 calculators Per Unit Total Cost Cost Variable Costs: Direct materials $ 3.00 $ 300,000 Direct labor 10.00 1,000,000 Factory overhead 1.50 150,000 Selling and administrative 1.50 150,000 Total variable costs $16.00$1,600,000 Fixed Costs: Factory overhead .50 50,000 Selling and administrative .20 20,000 Total fixed costs .70 70,000 Total costs $16.70 $1,670,000 43

44. Administrative Expense + Selling Expense + Desired Profit Desired Selling Price 0 24-2 Desired Selling Price Markup Manufacturing Cost Product Cost 44

45. Total Selling and Administrative Expenses Desired Profit + Markup Percentage = Total Manufacturing Costs 0 24-2 Markup Percentage Formula The markup percentage for the product cost concept is determined by applying the following formula: 45

46. Total Selling and Administrative Expenses Desired Profit + Markup Percentage = Total Manufacturing Costs 0 24-2 Markup Percentage 46

47. Total Selling and Administrative Expenses Desired Profit + Markup Percentage = Total Manufacturing Costs $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 50,000 Total manufacturing costs $1,500,000 0 24-2 Markup Percentage 47

48. Total Selling and Administrative Expenses Desired Profit + Markup Percentage = Total Manufacturing Costs $160,000 + $170,000 Markup Percentage = $1,500,000 0 24-2 Markup Percentage Markup Percentage $330,000 = = 22% $1,500,000 48

49. Manufacturing cost per calculator $15.00 Markup ($15.00 x 22%) 3.30 Selling price $18.30 0 24-2 Digital Solutions Inc. would price each calculator at $18.30 per unit, as shown below: 49

50. 0 24-2 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.