Differential Analysis & Product Pricing

1. Differential Analysis &Product Pricing ACG 2071 Chapter 24 Module 11 Fall 2007

2. Terms • Costs • Relevant – estimated costs and revenues that are important in the decision making process • Sunk costs – that have been incurred in the past are not relevant to the decision

3. Differential Analysis • Focuses on the effect of alternative courses of action on the relevant revenues • Differential revenues • Is the amount of increases or decreases in revenue expected from a course of action as compared with an alternative

4. Differential Analysis • Differential cost • Is the amount of increase or decrease in cost that is expected from a course of action as compared with an alternative • Differential income or loss • Differential revenue – differential cost

5. Differential Analysis

6. Types of Decision Making • Lease or sell • Management may have a choice between leasing or selling a piece of equipment that is no longer needed in the business. • The relevant factors to be considered are the differential revenues and costs associated with the lease or sell decision

7. Example 1 • A corporation can sell an asset for $200,000 less a 6% selling commission. An alternative would be to lease the asset for five years at $40,000 per year less $35,000 in costs over the five years. Which decision would you make?

8. Example 1 • Lease: • Revenue: $40,000 X 5 = $200,000 • Cost 35,000 • Income 165,000 • Sell • Revenue $200,000 • Cost 6% X $200,000 12,000 • Income 188,000

9. Discontinue a segment or product • When a product or a department, branch, territory, or other segment of a business is generating losses, management may consider eliminating the product or segment. • It is often assumed, sometimes in error, that the total income from operations of a business would be increase if the operating loss could be eliminated • If contribution margin > 0 then continue with segment

10. Shampoo Conditioner Lotion Total Sales $500,000 $400,000 $100,000 $1,000,000 Cost of goods sold Variable $220,000 $200,000 $60,000 $480,000 Fixed $120,000 $80,000 $20,000 $220,000 Total CGS 340,000 280,000 80,000 700,000 Gross profit 160,000 $120,000 $20,000 $300,000 Operating expenses Variable $95,000 $60,000 $25,000 $180,000 Fixed $25,000 $20,000 $6,000 $51,000 Total $120,000 $80,000 $31,000 $231,000 Income $40,000 $40,000 $(11,000) $69,000 Example 2 • Should we discontinue the production of Lotion?

11. Example 2 • Lotion

12. Example 3 • A condensed income statement for Fresh Kola indicated the following Should we discontinue Kola?

13. Example 3 • Result

14. Make or Buy • The assembly of many parts is often a major element in manufacturing some products • The product’s manufacturer may make these parts or they may be purchased • Management uses differential cost to decide whether to make or buy • MUST HAVE UNUSED CAPACITY • Only look at variable costs

15. Example 4 • A factory has unused capacity and is considering the production of a part of its product. The cost of making a part in direct materials is $80, direct labor $70, variable factory overhead is $52 and fixed factory overhead is $68. The cost of purchasing the product is $240 per unit. Should we make or buy?

16. Make Unused capacity exists DM $80 DL $70 VFO 52 Total 202 Buy $240 Since we have unused capacity, we can make the product. Example 4

17. Replace Equipment • The usefulness of fixed assets may be reduced long before they are considered to be worn out • Equipment may no longer be efficient for the purposes for which it is used • On the other hand, the equipment may not have reached the point of complete inadequacy

18. Example 5 • The business is considering the disposal of a machine with book value of $100,000 and an estimated remaining live of five years. The old machine can be sold for $25,000. The new machine has a cost of $250,000. The new machine would have a life of five years and no residual value. Analysis indicates that the estimated annual reduction in variable manufacturing costs from $225,000 with the old machine to $150,000 per year with the new machine. Should we buy the new machine?

19. Example 5 • Reduction in cost • $225,000 - $150,000 = $75,000 • x 5 yrs • 375,000 • Selling price of old m/c 25,000 • 400,000 • Cost of new m/c 250,000 • Savings 150,000

20. Example 6 • Francis is considering purchasing a lathe. The old machine cost $250,000 and has book value of $50,000 with three years left. It has a disposal value of $10,000. The new machine has a cost of $350,000 for five years and no residual value. The new machine will decrease cost by $75,000 for the next three years. Should we buy the new machine?

21. Example 6 • Reduction in cost • $75,000 X 3 = $225,000 • Disposal value 10,000 • Total 235,000 • Cost of new machine 350,000 • Loss (115,000)

22. Process or Sell • When a product is manufactured, it progresses through carious stages of production • Often a product can be sold at an intermediate stage of production, or it can be processed further and then sold.

23. Oil Production • Process Crude oil Diesel Can sell diesel or process More to make gasoline Gasoline

24. Example 7 • A business produces product D in batches of 4,000 gallons. Standard quantities of 4,000 gallons of direct materials are processed which cost $0.60 per gallon. D can be sold without further processing for $0.80 per gallon. It can be processed further to yield G, which can be sold for $1.25 per gallon. G requires additional processing costs of $650 per batch and 20% of the gallons of D will evaporate during production. Should we sell or process further?

25. Example 7 • D • SP: 4,000g x $0.80 = $3,200 • Cost 4,000g X $0.60 = 2,400 • Profit 800 • G • SP (4,000g X .8) X $1.25 = $4,000 • Cost $2,400 + $650 3,050 • Profit 950 • Produce gasoline

26. Example 8 • Environ produces Gecko. Production starts with 10,000 gallons of direct materials processed for $2 per gallon. It can be sold at $3 per gallon. Gecko can be further processed into Frye for additional costs of $1.50 per gallon with a cost of 10% of the product. The selling price of Frye is $4.50 per gallon. Should we process further?

27. Accept Business at Special Price • Differential analysis is also useful in deciding whether to accept additional business at a special rate • The differential revenue that would be provided from the additional business is compared to the differential costs of producing and delivering the product to the customer. • If the company is operating at full capacity, any additional production will increase both fixed costs and variable • However, the normal production of the company is below full capacity, additional business may be undertaken without increasing fixed production costs.

28. Business at Special Price • Assume that monthly capacity is 12,500 units. Current sales and production are 10,000 units. The current manufacturing costs of $20 per unit with fixed costs of $7.50. The normal selling price of the product is $30. The manufacturer receives from an exporter an offer for 5,000 units at $18 per unit. The production can be spread over three months. Should we accept the offer?

29. Example • SP 5,000 units X $18 = $90,000 • Cost • $20 - $7.50 = $12.50 • 5,000 units X $12.50 = 62,500 • Profit 27,500

30. Setting Normal Product Selling Price • Can be viewed as the target selling price to be achieved in the long run • Approaches

31. Total Cost Concept • Selling price = Cost + Markup • Total cost concept • All costs of manufacturing a product plus the selling and administrative expenses are included in the cost amount to which the markup is added. • $ amount of markup = profit on the product

32. Steps to Compute • Steps: • Determine the total cost of manufacturing the product. • Includes the direct materials, direct labor, and factory overhead • Includes the selling and administrative expenses • Cost per unit is then computed by dividing the total costs by the total units expected to be produced and sold. • Markup percentage = Desired profit • Total cost • Selling price = Cost per unit + ( markup percentage X cost per unit)

33. Example

34. Example (cont’d) • Desires a profit equal to a 20% rate of return on assets. • $800,000 of assets • Desired profit = 20% X $800,000 Desired profit =$160,000 • 100,000 units are expected to be produced and sold

35. Example (cont’d) • Total Cost =

36. Example • Total Cost Concept Markup percentage = Desired profit Total Cost = $160,000 = 9.6% $1,670,000

37. Example • Selling price Total cost per unit $16.70 Markup ($16.70 X 9.6%) 1.60 Selling price $18.30

38. Product Cost Concept • Steps: • Determine the total cost of manufacturing the product include direct materials, direct labor, and factory overhead. • Cost per unit is total cost manufacturing divided by the total units. • Markup % = • Desired profit + Total selling & Administrative Expenses • Total Manufacturing Costs • Selling price = Cost per unit + (Cost per unit X Markup %)

39. Example (data from before) • Manufacturing costs = Direct materials $ 3.00 Direct labor $10.00 Variable Factory overhead $1.50 Total $14.50

40. Example (data from before) • Total manufacturing costs Total variable costs ($14.50 x 100,000) $1,450,000 Fixed manufacturing 50,000 Total manufacturing 1,500,000 Manufacturing costs per unit = $15.00

41. Example • Total selling & administrative Variable ($1.50 x 100,000) $150,000 Fixed 20,000 Total $ 170,000

42. Example (data from before) • Product Cost Concept • Markup Percentage = Desired Profit + Total selling & adm exp Total manufacturing costs = $160,000 + $170,000 $1,500,000 = $330,000 $1,500,000 = 22%

43. Example • Selling Price Total manufacturing costs $15.00 Markup (22% x $15) 3.30 Selling price $18.30

44. Variable Cost Concept • Steps: • Determine the total cost of manufacturing the product include direct materials, direct labor, variable selling and administrative expenses, and variable factory overhead. • Cost per unit is total cost manufacturing divided by the total units. • Markup % = Desired profit + Total Fixed Costs • Total Variable Costs • Selling price = Cost per unit + (Cost per unit X Markup %)

45. Example (data from before) • Variable cost

46. Example • Markup percentage = Desired profit + Total fixed costs Total variable costs = $160,000 + $50,000 + $20,000 $1,600,000 = $230,000 = 14.4% $1,600,000

47. Example Total selling price Variable cost $16.00 Markup ($16 X 14.4%) 2.30 Total selling price $18.30