Differential Analysis And Product Pricing

Chapter 24 Differential Analysis and Product Pricing Accounting, 21st Edition Warren Reeve Fess

PowerPoint Presentation by Douglas Cloud Professor Emeritus of Accounting Pepperdine University

© Copyright 2004 South-Western, a division of Thomson Learning. All rights reserved. Task Force Image Gallery clip art included in this electronic presentation is used with the permission of NVTech Inc.

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Objectives Objectives 1. Prepare a differential analysis report for After studying this After studying this decisions involving leasing or selling chapter, you should chapter, you should equipment, discontinuing an unprofitable be able to: be able to:or purchasing a segment, manufacturing needed part, replacing usable fixed assets, processing further or selling an intermediate product, or accepting additional business at a special price.

Objectives Objectives 2. Determine the selling price of a product, using the total cost, product cost, and variable cost concepts. 3. Calculate the relative profitability of products in bottleneck production environments.

Differential Differential Analysis Analysis Differential analysis is used for analyzing:      

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.

Differential Differential Analysis Analysis

Decisions Alternative A or Alternative B

Differential Analysis Differential revenue – Differential costs Differential income or loss

Lease or Sell Equipment Marcus Company

Marcus Company is considering disposing of equipment that cost $200,000 and that has $120,000 of accumulated depreciation.

Lease or Sell Equipment Marcus Company

Sell Sellequipment equipment to to

Broker

The equipment can be sold through a broker for $100,000, less a 6% commission.

Lease or Sell Equipment Marcus Company

Potamkin Company, OR the lessee, has offered to lease the equipment for five years for a total consideration of $160,000.

Lease Lease equipment equipmentto to Potamkin Company

Lease or Sell Equipment Marcus Company

At the end of the fifth year, 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.

Proposal to Lease or Sell Equipment June 22, 2006 Differential revenue from alternatives: Revenue from lease Revenue from sales Differential revenue from lease Differential cost of alternatives: Repairs, insurance, taxes Commission expense on sale Differential cost of lease Net differential income from the lease alternative

$160,000 100,000 $60,000 $ 35,000 6,000

Lease the equipment!

29,000 $31,000

OR

Proposal to Lease or Sell Equipment June 22, 2006 Lease alternative: Revenue from lease $160,000 Depreciation expense for remaining 5 years $80,000 Repairs, insurance, and property tax expense 35,000 115,000 Net gain $45,000 Sell alternative: Sales price $100,000 Book value of equipment $80,000 Commission expense 6,000 86,000 Net gain 14,000 Net differential income from the lease alternative $31,000

This This isis the the traditional traditional analysis. analysis. The The differential differential income income isis the the same. same.

Discontinue a Segment or Product

Battle Creek Cereal Co. Condensed Income Statement For the Year Ended August 31, 2006

Differential items Sales Sales Cost of goods sold: Variable costs Variable cost Fixed costs Total cost of goods sold Gross profit Operating expenses: Variable expenses Variable expenses Fixed expenses Total operating expenses Income (loss) from operations

Bran Flakes

Other Cereals

Total

$100,000 $100,000 $900,000 $1,000,000 $ 60,000 60,000 $420,000 $ 480,000 20,000 200,000 220,000 $ 80,000 $620,000 $ 700,000 $ 20,000 $280,000 $ 300,000 $ 25,000 25,000 $155,000 $ 180,000 6,000 45,000 51,000 $ 31,000 $200,000 $ 231,000 $ (11,000) $ 80,000 $ 69,000

Should ShouldBran BranFlakes Flakesbe bediscontinued? discontinued?

Battle Creek Cereal Co. Condensed Income Statement For the Year Ended August 31, 2006

Differential items Sales Sales Cost of goods sold: Variablecost costs Variable Fixed costs Total cost of goods sold Gross profit Operating expenses: Variableexpenses expenses Variable Fixed expenses Total operating expenses Income (loss) from operations

Bran Flakes

Other Cereals

Total

$100,000 $100,000

$900,000 $1,000,000

60,000 $$ 60,000 20,000 $ 80,000 $ 20,000

$420,000 200,000 $620,000 $280,000

$ 480,000 220,000 $ 700,000 $ 300,000

25,000 $155,000 $$ 25,000 6,000 45,000 $ 31,000 $200,000 $ (11,000) $ 80,000

$ 180,000 51,000 $ 231,000 $ 69,000

IfIfBran BranFlakes Flakesisisdiscontinued, discontinued,net net income incomewill willdecrease decreaseby by$15,000. $15,000.

Proposal to Discontinue Bran Flakes September 29, 2006 Differential revenue from annual sales of Bran Flakes: Revenue from sales $100,000 Differential cost of annual sales of Brian Flakes: Variable cost goods sold $60,000 Variable operating expenses 25,000 85,000 Annual differential income from sales of Bran Flakes $15,000

Don’t discontinue!

or

Currently, a firm manufactures the dashboards that it uses in making automobiles. The cost of manufacturing this part is summarized below. An outside supplier has offered to provide the part for $240. Should the car manufacturer accept the offer? Direct materials Direct labor Variable factory overhead Fixed factory overhead Total cost per unit

$ 80 80 52 68 $280

INITIAL REACTION—DON’T MAKE INTERNALLY

Proposal to Manufacture Automobile Part February 15, 2006 Purchase price of part Differential cost to manufacture: Direct materials Direct labor Variable factory overhead Cost savings from manufacturing part

$240.00 $80.00 80.00 52.00 212.00 $ 28.00

The The fixed fixed factory factory overhead overhead isis excluded excluded because because itit isis not not relevant—so relevant—so continue continue making making the the part. part.

Replace Equipment

Assume that 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. The old machines can be sold for $25,000. They can be replaced by a single high-speed machine at a cost $250,000. The new machine has a n estimated useful life of five years and no residual value. Analyses indicate an estimated annual reduction in variable manufacturing costs from $225,000 with the old machine to $150,000 with the new machine. No other changes in the manufacturing costs or the operating expenses are expected. Should the new machine be purchased?

Proposal to Replace Equipment November 28, 2006 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 x5 Total differential decrease in cost $375,000 Proceeds from sale of present equipment 5,000 $400,000 Cost of new equipment 250,000 Net differential decrease in cost, 5-years $150,000 Annual net differential—new equipment

Buy Buy the the new new equipment! equipment!

$ 30,000

Process Process or or Sell Sell

A refinery produces kerosene in batches of 4,000 gallons at a processing cost of $0.60 per gallon. 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 cost $650 per batch, and 20% of the gallons of kerosene will evaporate during production.

Proposal to Process Kerosene Further October 1, 2006 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

Process Process further! further!

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 (variable, $12.50; fixed, $7.50). The domestic selling price is $30.

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. Should Should the the offer offer be be accepted accepted or or rejected? rejected?

Proposal to Sell Basketballs to Exporter March 10, 2006 Differential revenue from accepting offer: Revenue from sale of 5,000 additional units at $18 Differential cost of accepting offer: Variable cost of 5,000 additional units at $12.50 Differential income from accepting offer

Accept Accept the the offer! offer!

$90,000 62,500 $27,500

Setting Normal Product Selling Prices

Setting Setting Normal Normal Product Product Selling Selling Prices Prices 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

Market Market Methods Methods Demand-based Demand-based methods methods set set the the price price according according to to the the demand demand for for the the product. product.

Market Market Methods Methods Competition-based Competition-based methods methods set set the the price price according according to to the the price price offered offered by by the the competitors. competitors.

Total Cost Concept Using Using the the Total Total cost cost concept, concept, all all cost cost of of manufacturing manufacturing aa product... product...

Manufacturing Cost

Total Cost Concept …plus …plus the the selling selling and and administrative administrative expenses... expenses... Administrative Expenses Selling Expenses Manufacturing Cost

Total Cost Concept …are …are included included in in the the cost cost to to which which the the markup markup isis added. added. Desired Profit Administrative Expenses Selling Expenses Manufacturing Cost

Total cost

Total Cost Concept

Desired Profit Administrative Expenses Selling Expenses Manufacturing Cost

Desired selling price

The The company’s company’s desired desired profit profit isis $160,000. $160,000.

Total Cost Concept Cost Structure Example (100,000 units) Per Unit Variable Costs (per unit): Cost

Direct materials $ 3.00 Direct labor 10.00 Factory overhead 1.50 Selling and administrative 1.50 Total variable costs $16.00 Fixed Costs: Factory overhead .50 Selling and administrative .20 Total fixed costs . 70 Total costs $16.70

Total Cost

$ 300,000 1,000,000 150,000 150,000 $1,600,000 50,000 20,000 70,000 $1,670,000

Total Cost Concept Markup Percentage: Desired profit Total costs

$160,000 $1,670,000 =

Total cost per calculator Markup ($16.70 x 9.6%) Selling price

= 9.6% $16.70 1.60 $18.30

Only Only the the desired desired profit profit isis covered covered in in the the markup. markup.

Total Cost Concept Proof Proof that that aa sale sale of of 100,000 100,000 computers computers at at $18.30 $18.30 each each will will generate generate aa desired desired profit profit of of $160,000. $160,000. Digital Solutions Inc. Income Statement For the Year Ended December 31, 2006 Sales (100,000 units x $18.30) Expenses: units x $16.00) Fixed ($50,000 + $20,000) Income from operations

$1,830,000 Variable (100,000 $1,600,000 70,000 1,670,000 $ 160,000

Product Product Cost Cost Concept Concept Using Using the the product product cost cost concept concept only only the the manufacturing manufacturing costs costs are are included included in in the the amount amount to to which which the the markup markup isis applied. applied.

Product Product Cost Cost Concept Concept Cost Structure Example (100,000 units) Per Unit Cost

Variable Costs: Direct materials $ 3.00 Direct labor 10.00 Factory overhead 1.50 Selling and administrative 1.50 Total variable costs $16.00 Fixed Costs: Factory overhead .50 Selling and administrative .20 Total fixed costs .70 Total costs $16.70

Total Cost

$ 300,000 1,000,000 150,000 150,000 $1,600,000 50,000 20,000 70,000 $1,670,000

Product Cost = $15 per unit

Product Product Cost Cost Concept Concept De Se sir ed l l i Pr ng ice

Administrative Expense +

Markup

Selling Expense + Desired Profit Manufacturing Cost

Product Cost

Product Product Cost Cost Concept Concept

Markup = percentage

Total selling and Desired profit + administrative expenses Total manufacturing costs

Product Product Cost Cost Concept Concept Markup = percentage

$160,000 + $170,000 $1,500,000

Markup = 22% percentage DM DM($3 ($3xx100,000) 100,000)

DL DL($10 ($10xx100,000) 100,000) Factory Factoryoverhead: overhead: Variable Variable($1.50 ($1.50xx100,000) 100,000) Fixed Fixed Total Totalmanufacturing manufacturingcosts costs

$$ 300,000 300,000 1,000,000 1,000,000 150,000 150,000 50,000 50,000 $1,500,000 $1,500,000

Product Product Cost Cost Concept Concept

Manufacturing Manufacturing cost cost per per calculator calculator Markup Markup ($15 ($15 xx 22%) 22%) Selling Selling price price

$15.00 $15.00 3.30 3.30 $18.30 $18.30

Variable Variable Cost Cost Concept Concept The The variable variable cost cost concept concept uses uses total total of of the the variable variable manufacturing manufacturing costs costs and and the the variable variable selling selling and and administrative administrative expenses expenses as as the the amount amount to to apply apply aa markup. markup.

Variable Variable Cost Cost Concept Concept De Se sir ed l l i Pr ng ice

Total Fixed Costs + Desired Profit Variable Manufacturing Cost

+ Variable Administrative and Selling Expenses

Markup

Product Cost

Variable Variable Cost Cost Concept Concept

Desired profit + Total fixed costs Markup = percentage Total variable costs

Variable Variable Cost Cost Concept Concept Markup = percentage Markup = percentage

$160,000 + $50,000 + $20,000 $1,600,000 14.4%

Direct $$ 300,000 Directmaterials materials($3 ($3xx100,000) 100,000) 300,000 Direct 1,000,000 Directlabor labor($10 ($10xx100,000) 100,000) 1,000,000 Variable Variablefactory factoryoverhead overhead ($1.50 150,000 ($1.50xx100,000) 100,000) 150,000 Variable Variableselling sellingand andadministrative administrative expenses 150,000 expenses($1.50 ($1.50xx100,000) 100,000) 150,000 Total $1,600,000 Totalvariable variablecosts costs $1,600,000

Variable Variable Cost Cost Concept Concept Variable Variable cost cost per per calculator calculator Markup Markup ($16 ($16 xx 14.4%) 14.4%) Selling Selling price price

$16.00 $16.00 2.30 2.30 $18.30 $18.30

Target Target Costing Costing Using Using target target costing costing the the cost cost isis determined determined by by subtracting subtracting aa desired desired profit profit from fromthe theselling sellingprice. price. Present Market Price

Profit

Actual Cost

Present

Drif t

Required cost reduction

Profit Target Cost

Future

Expected Market Price

Bottlenecks

Product Product Profitability Profitability Under Under Production Production Bottlenecks Bottlenecks

Sales price Variable cost Contribution margin Bottleneck hours

Small Wrench

Medium Large Wrench Wrench

$130 40 $ 90 1

$140 40 $100 4

The The number number of of heat heat treatment treatment hours hours per per unit unit for for each each product. product.

$160 40 $120 8

Product Product Profitability Profitability Under Under Production Production Bottlenecks Bottlenecks Small Wrench

Sales price Variable cost Contribution margin Bottleneck hours Bottleneck contribution

Medium Large Wrench Wrench

$130$140$160 40 40 40 $ 90$100$120 ÷1 ÷4 ÷8 $ 90$ 25$ 15

Largest Largest contribution contribution margin margin per per bottleneck bottleneck hour hour

Product Product Profitability Profitability Under Under Production Production Bottlenecks Bottlenecks

How much should the firm charge for the large wrench in order to deliver the same contribution as the small wrench?

Product Product Profitability Profitability Under Under Production Production Bottlenecks Bottlenecks Contribution margin per bottleneck hour = per small wrench

$90 =

Revised price of large wrench

Variable cost – per large wrench

Bottleneck hours per large wrench Revised price of large wrench

–

$40

8

$720 = Revised price of large wrench – $40 $760 = Revised price of large wrench

Product Product Profitability Profitability Under Under Production Production Bottlenecks Bottlenecks Revised price of large wrench per formula on the previous slide $760 Less: Variable cost per unit of large wrench 40 Contribution margin per unit of large wrench $720 Bottleneck hours per unit of large wrench ÷8 Revised contribution margin per bottleneck hour $ 90

Chapter 24 The The End End