Differential Analysis and Product Pricing

11e

Principles of Managerial Accounting

Chapter 9

Prepared by: C. Douglas Cloud

Professor Emeritus of Accounting
Pepperdine University

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Reeve Warren Duchac
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Learning Objectives
1. Prepare differential analysis reports for a variety
of managerial decisions.
2. Determine the selling price of a product, using the
product cost concept.
3. Compute the relative profitability of products in
bottleneck production processes.

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Learning Objective 1

Prepare differential
analysis reports for a
variety of managerial
decisions.

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 LO 1

Differential Analysis
 Managerial decision making involves choosing
between alternative courses of action.

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 LO 1

Differential Analysis
Managerial Decision Making
Step 2: Identify the
Step 1: Identify the
alternative
objective of
courses of
the decision
action

Step 3: Gather relevant

information and
Step 5: Review, analyze, and perform differential
assess the results of analysis.
the decision

Step 4: Make a
decision

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 LO 1

Differential Analysis
Bryant Restaurants, Inc.
Step 2: Use
Identify
floorthe
replace the
Step 1: Increase
Identify the
alternative
space
tables for
with a
objective
its income. of
courses
existing
salad [Link]
the decision
action or…
tables,

Tables
Step 3: Gather Salad
relevant
Bar information and
Step 5: Review, analyze, and Revenues perform
$100,000differential
$120,000
assess the results of Costs analysis.
60,000 65,000
the decision Income $ 40,000 $ 55,000

Step 4: Make a
decision

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 LO 1

Differential Analysis
 Differential analysis, sometimes called
incremental analysis, analyzes differential
revenues and costs to determine the differential
impact on income of two alternative courses of
action.

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 LO 1

Differential Analysis
 Differential revenue is the amount of increase or
decrease in revenue that is expected from a
course of action as compared to an alternative.

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 LO 1

Differential Analysis
 Differential cost is the amount of increase or
decrease in cost that is expected from a course of
action as compared to an alternative.

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 LO 1

Differential Analysis
 Differential income (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 that the decision is
expected to decrease income.

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 LO 1

Differential Analysis

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 LO 1

Differential Analysis
 In this chapter, differential analysis is illustrated for
the following common decisions:
1. Leasing or selling equipment
2. Discontinuing an unprofitable segment
3. Manufacturing or purchasing a needed part
4. Replacing fixed assets
5. Processing further or selling a product
6. Accepting additional business at a special price

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 LO 1

Lease or Sell
On June 22, 2012, Marcus Company is considering
leasing or disposing of the following equipment :
Cost of equipment $200,000
Less accumulated depreciation 120,000
Book value $ 80,000
Lease Option:
Total revenue for five-year lease 160,000
Total estimated repair, insurance, and
property tax expenses during life of lease 35,000
Residual value at end of 5th year of lease 0
Sell Option:
Sales price $100,000
Commission on sales 6%
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 LO 1

Lease or Sell

Marcus Company
uses differential
analysis to make the
decision. Exhibit 2
(next slide) provides
key information for
making this decision.

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 LO 1

Lease or Sell

Lease
Leasethe
the
equipment
equipment
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 LO 1

Lease or Sell
 The book value of equipment is a sunk cost and is
not considered in the differential analysis.
 Sunk costs are costs that have been incurred in
the past, cannot be recouped, and are not relevant
to future decisions.

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 EE 9-1

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 LO 1

Discontinue a Segment or Product B

C
attle

reek

Management may consider discontinuing a

product or segment of a business that is
generating losses. Based on the information in the
condensed income statement in Exhibit 3 (next
slide), management of Battle Creek Cereal Co. is
considering discontinuing Bran Flakes.

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 LO 1

Discontinue a Segment or Product B

C
attle

reek

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 LO 1

Discontinue a Segment or Product B

C
attle

reek

Don’t discontinue Bran Flakes!

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 LO 1

Discontinue a Segment or Product B

C
attle

reek

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 EE 9-2

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 LO 1

Make or Buy
 Companies often
manufacture products
made up of
components that are
assembled into a final
product. Should they
make or buy the
parts?

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 LO 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 of manufacturing a panel internally is
estimated as follows:
Direct materials $ 80
Direct labor 80
Variable factory overhead 52
Fixed factory overhead 68
Total estimated cost per unit $280

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 LO 1

Make or Buy

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 EE 9-3

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 LO 1

Replace Equipment

On November 28, 2012, a business is

considering replacing the following machine:
Old Machine:
Book value $100,000
Estimated annual variable
manufacturing costs 225,000
Estimated selling price 25,000
Estimated remaining useful life 5 years

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 LO 1

Replace Equipment

The business is considering replacing the old

machine with a new one, as shown below:
Old New
Book value $100,000
Cost of new machine $250,000
Estimated annual variable
manufacturing costs 225,000 150,000
Estimated selling price 25,000
Estimated residual value 0
Estimated remaining useful life 5 years 5 years

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 LO 1

Replace Equipment

replace old
machine
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 LO 1

Replace Equipment
 The revenue that is forgone from an alternative
use of an asset, such as cash, is called an
opportunity cost.
 Although the opportunity cost is not recorded in
the accounting records, it is useful in analyzing
alternative courses of action.

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 EE 9-4

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 LO 1

Process or Sell
 In some cases, a product can be sold at an
intermediate stage of production, or it can be
processed further and then sold.

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 LO 1

Process or Sell
A business produces kerosene as follows:
Batch size 4,000 gallons
Cost of producing kerosene $2,400 per batch
Selling price $2.50 per gallon

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 LO 1

Process or Sell

The kerosene can be processed further to yield

gasoline as follows:
Input batch size 4,000 gallons
Less evaporation (20%) 800 (4,000 x 20%)
Output batch size 3,200

Cost of producing
gasoline $3,050 per batch
Selling price $3.50 per gallon

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 LO 1

Process or Sell

process
further

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 EE 9-5

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 LO 1

Accept Business at a Special Price

 The differential costs of accepting additional
business depend on whether the company is
operating at full capacity.
 If the company is operating at full capacity, any
additional production increases fixed and variable
manufacturing costs.
 If the company is operating below full capacity, any
additional production does not increase fixed
manufacturing costs.

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 LO 1

Accept Business at a Special Price

B-Ball Inc. manufactures basketballs as follows:
Monthly productive capacity 12,500 basketballs
Current monthly sales 10,000 basketballs
Normal (domestic) selling price $30.00 per basketball
Manufacturing costs:
Variable costs $12.50 per basketball
Fixed costs 7.50
Total $20.00 per basketball

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 LO 1

Accept Business at a Special Price

On March 10, 2012, B-Ball Inc. 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. The domestic market will not be affected.

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 LO 1

Accept Business at a Special Price

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 EE 9-6

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 EE 9-6

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 Learning Objective 2

Determine the
selling price of a
product, using
the product cost
concept.

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 LO 2

Setting Normal Product Selling Prices

 The basic approaches to setting prices are:
 Market methods
Demand-based concept
Competition-based concept
 Cost-plus methods
Total cost concept
Product cost concept
Variable cost concept

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 LO 2

Setting Normal Product Selling Prices

 The demand-based concept sets the price
according to the demand for the product.
 The competition-based concept sets the price
according to the price offered by competitors.

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 LO 2

Product Cost Concept

 Under the product cost concept, only the costs of
manufacturing the product, termed the product
costs, are included in the cost amount per unit to
which the markup is added.

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 LO 2

Product Cost Concept

 Step 1: Estimate the total product costs as
follows:
Product costs:
Direct materials $XXX
Direct labor XXX
Factory overhead XXX
Total product cost $XXX

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 LO 2

Product Cost Concept

 Step 2: Estimate the total selling and
administrative expenses.

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 LO 2

Product Cost Concept

 Step 3: Divide the total product cost by the
number of units expected to be produced and
sold to determine the total product cost per
unit, as shown below.

Total Product Cost

Product Cost per unit =
Estimated Units Produced
and Sold

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 LO 2

Product Cost Concept

 Step 4. Compute the markup percentage as
follows:
Desired Profit + Total Selling
and Administrative Expenses
Markup Percentage =
Total Product Cost

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 LO 2

Product Cost Concept

 Step 5. Determine the markup per unit by
multiplying the markup percentage times the
product cost per unit as follows:

Markup per Unit = Markup Percentage x Product Cost per Unit

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 LO 2

Product Cost Concept

 Step 6. Determine the normal selling price by
adding the markup per unit to the product cost
per unit as follows:
Total product cost per unit $XXX
Markup per unit XXX
Normal selling price per unit $XXX

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 LO 2

Product Cost Concept

Assume the following data for 100,000 calculators
that Digital Solutions Inc. expects to produce and sell
during the current year:
Manufacturing costs:
Direct materials ($3.00 x 100,000) $ 300,000
Direct labor ($10.00 x 100,000) 1,000,000
Factory overhead 200,000
Total Manufacturing costs $1,500,000
Selling and administrative expenses 170,000
Total cost $1,670,000
Total assets $800,000
Desired rate of return 20%

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 LO 2

Product Cost Concept

 Step 1: Estimate the total product cost as
follows:
Product costs:
Direct materials $ XXXXX
Direct labor XXXXX
Factory overhead XXX
Total product cost $1,500,000

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 LO 2

Product Cost Concept

 Step 2: Estimate the total selling and
administrative expenses.

Management
Management expects
expects total
total
selling
selling and
and administrative
administrative
expenses
expenses toto be
be $170,000.
$170,000.

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 LO 2

Product Cost Concept

 Step 3: Divide the total product cost by the
number of units expected to be produced and
sold to determine the total product cost per
unit, as shown below.

Total Product Cost

Product Cost per Unit =
Estimated Units Produced
and Sold
$1,500,000
= = $15.00 per unit
100,000 units

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 LO 2

Product Cost Concept

 Step 4. Compute the markup percentage as
follows:
Desired Profit + Total Selling and
Administrative Expenses
Markup Percentage =
Total Product Cost

Desired
DesiredRate
Rateof
of
$160,000 + $170,000
Return x Total
Markup Percentage = Return x Total
Assets
$1,500,000
Assets

$330,000
Markup Percentage = 0.20 $800,000= 22%
0.20xx$800,000
$1,500,000

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 LO 2

Product Cost Concept

 Step 5. Determine the markup per unit by
multiplying the markup percentage times the
product cost per unit as follows:

Markup per Unit = Markup Percentage x Product Cost per Unit

Markup per Unit = 22% x $15.00 = $3.30 per unit

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 LO 2

Product Cost Concept

 Step 6. Determine the normal selling price by
adding the markup per unit to the product cost
per unit as follows:
Total product cost per unit $15.00
Markup per unit 3.30
Normal selling price per unit $18.30

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 LO 2

Product Cost Concept

De
Se sir Administrative
e
Pr llin d Expense Markup
ice g
+
Selling Expense
+
Desired Profit
Product Cost
Manufacturing
Cost

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 EE 9-7

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 LO 2

Target Costing
 Target costing is a method of setting prices that
combines market-based pricing with a cost-
reduction emphasis. A future selling price is
anticipated, using the demand-based or the
competition-based methods.

Target
Target Cost
Cost == Expected
Expected Selling
Selling Price
Price ––
Desired
Desired Profit
Profit

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 LO 2

Target Costing
 The planned cost reduction is sometimes referred
to as the cost “drift.” Costs can be reduced in a
variety of ways such as:
 Simplifying the design
 Reducing the cost of direct materials
 Reducing the direct labor costs
 Eliminating waste

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 LO 2

Target Costing

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 Learning Objective 3

Compute the relative

profitability of
products in
bottleneck
production
processes.

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 LO 3

Production Bottlenecks, Pricing, and Profits

 A production bottleneck (or constraint) is a point

in the manufacturing process where the demand
for the company’s product exceeds the ability to
produce the product.

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 LO 3

Production Bottlenecks, Pricing, and Profits

 The theory of constraints (TOC) is a

manufacturing strategy that focuses on reducing
the influence of bottlenecks on production
processes.

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 LO 3

Production Bottlenecks and Profits

PrideCraft Tool Company makes
three types of wrenches: small,
medium, and large. All three
products are processed through a
heat treatment operation, which
hardens the steel tools. PrideCraft
Tool’s heat treatment process is
operating at full capacity and is a
production bottleneck.

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 LO 3

Production Bottlenecks and Profits

The product unit contribution margin and the
number of hours of heat treatment used by each
type of wrench are as follows:
Small Medium Large
Wrench Wrench Wrench

Sales price per unit $130 $140 $160

Variable cost per unit 40 40 40
Contribution margin per unit $ 90 $100 $120
Heat treatment hours per unit 1 hr. 4 hrs. 8 hrs.

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 LO 3

Production Bottlenecks and Profits

Unit Contribution Margin per = Unit Contribution Margin
Production Bottleneck Hour Heat Treatment Hours per Unit
Small Wrenches
Unit Contribution Margin per $90 = $90
= $90per
perhour
hour
Production Bottleneck Hour 1 hr.
Medium Wrenches
Unit Contribution Margin per $100 The small wrench is the
= = $25 per hour
Production Bottleneck Hour 4 hrs. most profitable product
per bottleneck hour.
Large Wrenches
Unit Contribution Margin per $120
= = $15 per hour
Production Bottleneck Hour 8 hrs.

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 LO 3

Production Bottlenecks and Pricing

PrideCraft Tool Company can improve the
profitability of producing the large wrenches by
any combination of the following:
 Increase the selling price of the large wrenches.
 Decrease the variable cost per unit of the large
wrenches.
 Decrease the heat treatment hours required for the
large wrenches.

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 EE 9-8

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 LO 3

Production Bottlenecks and Pricing

How much should PrideCraft Tool Co. charge for

the large wrench in order to deliver the same
contribution margin of $90 that is being provided
by the small wrench?

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 LO 3

Production Bottlenecks and Pricing

Contribution Variable Cost per Unit

Revised Price of
Margin (per unit)
Large Wrench – for Large Wrench
per Bottleneck =
Hour for Small Bottleneck Hours per Unit for
Wrench Large Wrench

Revised Price of
Large Wrench – $40
$90 =
8

$720 = Revised Price of Large Wrench – $40

$760 = Revised Price of Large Wrench

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 LO 3

Production Bottlenecks and Pricing

Proof
Unit Contribution Margin Unit Contribution Margin
per Bottleneck Hour =
Heat Treatment Hours per Unit

Unit Contribution Margin $760 - $40

=
per Bottleneck Hour 8 hrs.
Unit Contribution Margin
= $90 per hr.
per Bottleneck Hour

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Appendix

Total and Variable

Cost Concepts
Cost Concepts to
to
Setting Normal Price

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Appendix

Total Cost Concept

 Under the total cost
concept, all costs of
manufacturing a
product plus the
selling and
administrative
Administrative
expenses are included
Expenses
Total cost in the total cost to
Selling
Expenses which the markup is
added.
Manufacturing
Cost

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Appendix

Total Cost Concept

 The markup percentage is

determined by applying the
Desired Profit
following formula:
Administrative
Expenses Markup Desired profit
Selling
Expenses
percentage = Total cost
Manufacturing
Cost

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Appendix

Total Cost Concept

To illustrate the seven steps used when the total

cost concept is applied, examine the data in the
next slide. Digital Solutions Inc. expects to
produce and sell 100,000 calculators during the
current year. The company desires a 20% rate of
return on its total assets of $800,000.

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Appendix

Total Cost Concept

Manufacturing costs:
Direct materials ($3.00 x 100,000) $ 300,000
Direct labor ($10.00 x 100,000) 1,000,000
Factory overhead:
Variable costs ($1.50 x 100,000) $150,000
Fixed costs 50,000 200,000
Total Manufacturing costs $1,500,000
Selling and administrative expenses:
Variable expenses ($1.50 x 100,000) $150,000
Fixed costs 20,000
Total selling and administrative expenses 170,000
Total cost $1,670,000

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Appendix

Total Cost Concept

Desired profit $160,000

Total cost
= = 9.6%
$1,670,000
Total cost per calculator $16.70
Markup ($16.70 x 9.6%) 1.60
Selling price $18.30

Only
Only the
the desired
desired profit
profit is
is
covered
covered inin the
the markup.
markup.

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Appendix

Total Cost Concept

The ability of the selling price of $18.30 to generate
the desired profit of $160,000 is illustrated by the
income statement shown below.

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Appendix

Variable Cost Concept

 Under the variable cost concept, only variable
costs are included in the cost amount per unit to
which the markup is added.

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Appendix

Variable Cost Concept

De Total Fixed Markup

Se sir Costs +
Pr llin ed Desired
ic g
e Profit

Variable
Manufacturing
Cost Product Cost
+
Variable
Administrative
and Selling
Expenses

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Appendix

Variable Cost Concept

Markup Desired Profit + Total Fixed Costs and Expenses
=
Percentage Total Variable Cost

Markup $160,000 + $50,000 + $20,000

=
Percentage $1,600,000

Direct materials ($3 x 100,000) $ 300,000

Direct labor ($10 x 100,000) 1,000,000
Variable factory overhead
($1.50 x 100,000) 150,000
Variable selling and
administrative expenses
($1.50 x 100,000) 150,000
Total variable costs $1,600,000

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Appendix

Variable Cost Concept

Markup Desired Profit + Total Fixed Costs and Expenses
=
Percentage Total Variable Cost

Markup $160,000 + $50,000 + $20,000

=
Percentage $1,600,000

Markup $230,000
= = 14.4%
Percentage $1,600,000

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Appendix

Variable Cost Concept

Digital Solutions Inc. would price each calculator at
$18.30 per unit, as shown below:
Variable cost per calculator $16.00
Markup ($16.00 x 14.4%) 2.30
Selling price $18.30

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Differential Analysis and Product Pricing

The
The End
End
Prepared by: C. Douglas Cloud
Professor Emeritus of Accounting
Pepperdine University

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.