Learning Objectives

1. Power Notes ChapterM8 Differential Analysis and Product Pricing 1. Differential Analysis 2. Setting Normal Product Selling Prices 3. Product Profitability and Pricing Under Production Bottlenecks Learning Objectives C8

2. Power Notes ChapterM8 Differential Analysis and Product Pricing Slide # Power Note Topics • 3 • 16 • 20 • 27 • Differential Analysis Decisions • Setting Normal Product Selling Prices • Cost-Plus Methods of Product Pricing • Production Bottlenecks Note: To select a topic, type the slide # and press Enter.

3. Differential Analysis Differential analysis is used for analyzing: 1. Leasing or selling equipment 2. Discontinuing an unprofitable segment 3. Manufacturing or purchasing a needed part 4. Replacing usable fixed assets 5. Processing further or selling an intermediate product 6. Accepting additional business at a special price

4. Proposal to Lease or Sell Equipment June 22, 2003 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 6,000 Differential cost of lease 29,000 Net differential income from leasing $31,000

5. Proposal to Lease or Sell Equipment June 22, 2003 Lease Sell Revenue from lease $160,000 Revenue from sales 100,000 Repairs, insurance, taxes (35,000) Commission expense on sale (6,000) Totals $125,000 $94,000 This alternative format separates the two options into columns. The net benefit is the same.

6. Proposal to Lease or Sell Equipment June 22, 2003 Lease Sell Revenue from lease $160,000 Revenue from sales 100,000 Repairs, insurance, taxes (35,000) Commission expense on sale (6,000) Totals $125,000 $94,000 Net benefit from leasing $31,000 This analysis indicates that it would be better to lease the equipment rather then sell it. What other factors should be considered?

7. Battle Creek Cereal Co. Condensed Income Statement For the Year Ended August 31, 2003 Bran Corn Toasted Total Flakes Flakes Oats Sales $100,000 $500,000 $400,000 $1,000,000 Cost of goods sold: Variable costs $ 60,000 $220,000 $200,000 $ 480,000 Fixed costs 20,000 120,000 80,000 220,000 Total cost of goods sold $ 80,000 $340,000 $280,000 $ 700,000 Gross profit $ 20,000 $160,000 $120,000 $ 300,000 Operating expenses: Variable expenses $ 25,000 $ 95,000 $ 60,000 $ 180,000 Fixed expenses 6,000 25,000 20,000 51,000 Total operating expenses $ 31,000 $120,000 $ 80,000 $ 231,000 Income (loss) from operations $ (11,000) $ 40,000 $ 40,000 $ 69,000 Should Bran Flakes be discontinued?

8. Battle Creek Cereal Co. Condensed Income Statement For the Year Ended August 31, 2003 Bran Corn Toasted Total Flakes Flakes Oats Differential items Sales $100,000 $500,000 $400,000 $1,000,000 Cost of goods sold: Variable costs $ 60,000 $220,000 $200,000 $ 480,000 Fixed costs 20,000 120,000 80,000 220,000 Total cost of goods sold $ 80,000 $340,000 $280,000 $ 700,000 Gross profit $ 20,000 $160,000 $120,000 $ 300,000 Operating expenses: Variable expenses $ 25,000 $ 95,000 $ 60,000 $ 180,000 Fixed expenses 6,000 25,000 20,000 51,000 Total operating expenses $ 31,000 $120,000 $ 80,000 $ 231,000 Income (loss) from operations $ (11,000) $ 40,000 $ 40,000 $ 69,000 Should Bran Flakes be discontinued?

9. Battle Creek Cereal Co. Condensed Income Statement For the Year Ended August 31, 2003 Bran Corn Toasted Total Flakes Flakes Oats Differential items Sales $100,000 $500,000 $400,000 $1,000,000 Cost of goods sold: Variable costs $ 60,000 $220,000 $200,000 $ 480,000 Fixed costs 20,000 120,000 80,000 220,000 Total cost of goods sold $ 80,000 $340,000 $280,000 $ 700,000 Gross profit $ 20,000 $160,000 $120,000 $ 300,000 Operating expenses: Variable expenses $ 25,000 $ 95,000 $ 60,000 $ 180,000 Fixed expenses 6,000 25,000 20,000 51,000 Total operating expenses $ 31,000 $120,000 $ 80,000 $ 231,000 Income (loss) from operations $ (11,000) $ 40,000 $ 40,000 $ 69,000 Should Bran Flakes be discontinued?

10. Battle Creek Cereal Co. Condensed Income Statement For the Year Ended August 31, 2003 Bran Corn Toasted Total Flakes Flakes Oats Differential items Sales $100,000 $500,000 $400,000 $1,000,000 Cost of goods sold: Variable costs $ 60,000 $220,000 $200,000 $ 480,000 Fixed costs 20,000 120,000 80,000 220,000 Total cost of goods sold $ 80,000 $340,000 $280,000 $ 700,000 Gross profit $ 20,000 $160,000 $120,000 $ 300,000 Operating expenses: Variable expenses $ 25,000 $ 95,000 $ 60,000 $ 180,000 Fixed expenses 6,000 25,000 20,000 51,000 Total operating expenses $ 31,000 $120,000 $ 80,000 $ 231,000 Income (loss) from operations $ (11,000) $ 40,000 $ 40,000 $ 69,000 If Bran Flakes are discontinued, how would net income be affected?

11. Battle Creek Cereal Co. Condensed Income Statement For the Year Ended August 31, 2003 Bran Corn Toasted Total Flakes Flakes Oats Differential items Sales $100,000 $500,000 $400,000 $1,000,000 Cost of goods sold: Variable costs $ 60,000 $220,000 $200,000 $ 480,000 Fixed costs 20,000 120,000 80,000 220,000 Total cost of goods sold $ 80,000 $340,000 $280,000 $ 700,000 Gross profit $ 20,000 $160,000 $120,000 $ 300,000 Operating expenses: Variable expenses $ 25,000 $ 95,000 $ 60,000 $ 180,000 Fixed expenses 6,000 25,000 20,000 51,000 Total operating expenses $ 31,000 $120,000 $ 80,000 $ 231,000 Income (loss) from operations $ (11,000) $ 40,000 $ 40,000 $ 69,000 If Bran Flakes are discontinued, $15,000 of net income will be lost and overall net income would be reduced to $54,000.

12. Proposal to Replace Equipment November 28, 2003 Annual variable costs—present $225,000 Annual variable costs—new equip. 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—new equipment $ 30,000

13. Proposal to Replace Equipment November 28, 2003 Present New Equipment Equipment Annual variable costs $ 225,000 $150,000 Number of years applicable x 5 x 5 Total variable costs $1,125,000 $750,000 Cost of new equipment 250,000 Less proceeds from sale (25,000) Total costs $1,125,000 $975,000 Net total benefit to replace $150,000 Net annual benefit to replace $ 30,000 This analysis indicates that it would be better to replace the existing equipment. What other factors should be considered?

14. Proposal to Process Kerosene Further October 1, 2003 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

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

16. Cost Structure Example (100,000 units) 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 admin. 1.50 150,000 Fixed Costs: Factory overhead .50 50,000 Selling and admin. .20 20,000 Total costs $16.70 $1,670,000 Product costs $15.00 $1,500,000 Variable costs $16.00 $1,600,000

17. Cost Structure Example (100,000 units) 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 admin. 1.50 150,000 Fixed Costs: Factory overhead .50 50,000 Selling and admin. .20 20,000 Total costs $16.70 $1,670,000 Product costs $15.00 $1,500,000 Variable costs $16.00 $1,600,000

18. Cost Structure Example (100,000 units) 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 admin. 1.50 150,000 Fixed Costs: Factory overhead .50 50,000 Selling and admin. .20 20,000 Total costs $16.70 $1,670,000 Product costs $15.00 $1,500,000 Variable costs $16.00 $1,600,000

19. Total Cost Concept Per Unit Total Selling Price: Desired profit $ 1.60 $ 160,000 Total to markup $ 1.60 $ 160,000 Total costs 16.70 1,670,000 Selling price $18.30 $1,830,000 Markup Percentage: Markup amount $1.60 Total costs $16.70 = = 9.6% Only the desired profit is covered in the markup.

20. Total Cost Concept Per Unit Total Selling Price: Desired profit $ 1.60 $ 160,000 Total to markup $ 1.60 $ 160,000 Total costs 16.70 1,670,000 Selling price $18.30 $1,830,000 Markup Percentage: Markup amount $1.60 Total costs $16.70 Markup on total cost = = 9.6%

21. Product Cost Concept Per Unit Total Selling Price: Desired profit $ 1.60 $ 160,000 Selling and admin. 1.70 170,000 Total to markup $ 3.30 $ 330,000 Total product costs 15.00 1,500,000 Selling price $18.30 $1,830,000 Markup Percentage: Markup amount $3.30 Product costs $15.00 = = 22.0% The desired profit and selling and administrative costs are covered in the markup.

22. Product Cost Concept Per Unit Total Selling Price: Desired profit $ 1.60 $ 160,000 Selling and admin. 1.70 170,000 Total to markup $ 3.30 $ 330,000 Total product costs 15.00 1,500,000 Selling price $18.30 $1,830,000 Markup Percentage: Markup amount $3.30 Product costs $15.00 Markup on product cost = = 22.0%

23. Variable Cost Concept Per Unit Total Selling Price: Desired profit $ 1.60 $ 160,000 Fixed costs .70 70,000 Total to markup $ 2.30 $ 230,000 Total variable costs 16.00 1,600,000 Selling price $18.30 $1,830,000 Markup Percentage: Markup amount $2.30 Variable costs $16.00 = = 14.4% The desired profit and total fixed costs are covered in the markup.

24. Variable Cost Concept Per Unit Total Selling Price: Desired profit $ 1.60 $ 160,000 Fixed costs .70 70,000 Total to markup $ 2.30 $ 230,000 Total variable costs 16.00 1,600,000 Selling price $18.30 $1,830,000 Markup Percentage: Markup amount $2.30 Variable costs $16.00 Markup on variable cost = = 14.4%

25. Product Pricing Using a Cost-Plus Approach Total Product Variable Cost Cost Cost Cost amount per unit $16.70 $15.00 $16.00 Markup percentage x 9.6% x 22.0% x 14.4% Markup amount $ 1.60 $ 3.30 $ 2.30 Selling price $18.30 $18.30 $18.30 The most common method

26. Profitability Under Production Bottlenecks Products—Unit Analysis Small Medium Large Wrench Wrench Wrench Sales price $130 $140 $160 Variable cost 40 40 40 Contribution margin $ 90 $100 $120 The process is currently operating at full capacity and is a production bottleneck.

27. Profitability Under Production Bottlenecks Products—Unit Analysis Small Medium Large Wrench Wrench Wrench Sales price $130 $140 $160 Variable cost 40 40 40 Contribution margin $ 90 $100 $120 Bottleneck hours 1 4 8 The number of hours per unit for each product.

28. Profitability Under Production Bottlenecks Products—Unit Analysis Small Medium Large Wrench Wrench Wrench Sales price $130 $140 $160 Variable cost 40 40 40 Contribution margin $ 90 $100 $120 Bottleneck hours 1 4 8 Bottleneck contribution $ 90 $ 25 $ 15 Contribution after dividing by the bottleneck hours.

29. Profitability Under Production Bottlenecks Products—Unit Analysis Small Medium Large Wrench Wrench Wrench Sales price $130 $140 $160 Variable cost 40 40 40 Contribution margin $ 90 $100 $120 Bottleneck hours 1 4 8 Bottleneck contribution $ 90 $ 25 $ 15 What price for Product C would equate its profitability to Product A?

30. Profitability Under Production Bottlenecks Products—Unit Analysis Small Medium Large Wrench Wrench Wrench Sales price $130 $140 $160 $760 Variable cost 40 40 40 40 Contribution margin $ 90 $100 $120 $720 Bottleneck hours 1 4 8 8 Bottleneck contribution $ 90 $ 25 $ 15 $ 90 A price of $760 will provide the same contribution as Product A.

31. Note: To see the topic slide, type 2 and press Enter. Power Notes ChapterM8 Differential Analysis and Product Pricing This is the last slide in Chapter M8.