ACG 2071 Module 11: Differential Analysis and Product Pricing

Differential Analysis 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. Differential revenue: Is the amount of increase or decrease in revenue expected from a course of action as compared with an alternative? 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: Is the difference between the differential revenue and the differential costs? Differential analysis: It focuses on the effect of alternative courses of action on the relevant revenues. Differential Revenue from alternatives Revenue from Alternative A Revenue from Alternative B Differential Revenue Differential cost of alternatives Cost of Alternative A Cost of B Differential cost
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ACG 2071 Module 11: Differential Analysis and Product Pricing

Net differential income or loss from alternatives Types of Decision-making:

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1. 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 differential costs associated with the lease or sell decision. 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? Differential Revenue from alternatives Revenue from selling Revenue from leasing Differential Revenue Differential cost of alternatives Cost of selling: Commissions 6% of sales price Cost of leasing: operating costs Differential cost Net differential loss from leasing $200,000 $200,000 $0 $12,000 $35,000 -$23,000 -$23,000

Therefore we should sell the asset and save $23,000 in additional costs. 2. 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 increased if the operating loss could be eliminated. Discontinuing the product or segment usually eliminates all of the product or segments variable costs. However, if the product or segment is a relatively small part of the business, discontinuing it may not decrease the fixed costs.
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ACG 2071 Module 11: Differential Analysis and Product Pricing

If contribution margin > 0 then continue production Example 3: Sales Cost of goods sold Variable Fixed Total CGS Gross profit Operating expenses Variable Fixed Total Income Shampoo $500,000 $220,000 $120,000 340,000 160,000 $95,000 $25,000 $120,000 $40,000 Conditioner $400,000 $200,000 $80,000 280,000 $120,000 $60,000 $20,000 $80,000 $40,000 Lotion $100,000 $60,000 $20,000 80,000 $20,000 $25,000 $6,000 $31,000 $(11,000) Total $1,000,000 $480,000 $220,000 700,000 $300,000 $180,000 $51,000 $231,000 $69,000

Should we discontinue the production of Lotion? Sales Variable cost of goods sold Manufacturing margin Variable operating expenses Contribution Margin $100,000 $60,000 $40,000 $25,000 $15,000

Since contribution margin is positive, we continue production of the product. 3. Make or Buy The assembly of many parts is often a major element in manufacturing some products, such as autos. The products manufacturer may make these parts or they may be purchased. Management uses differential costs to decide whether to make or buy a part. Only variable costs are considered.
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ACG 2071 Module 11: Differential Analysis and Product Pricing

Must have unused capacity in the factory. Example 5: A factory has unused capacity and is considering the production of a part for its product. The cost of making a part is direct materials $80, direct labor $75, variable factory overhead $52 and fixed factory overhead $68. The cost of purchasing the product is $240 a unit. Should we make or buy? Does it have unused capacity? Yes Total variable costs of production: Direct materials Direct labor Variable factory overhead Total variable costs Total cost of purchasing $80.00 $75.00 $52,00 $202.00 $240.00

Since it is cheaper to produce than buy, we will produce and save $38 per unit. 4. 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. Decisions to replace usable fixed assets should be based on relevant costs. The relevant costs are the future costs of continuing to use the equipment versus replacement The book values of the fixed assets being replaced are sunk costs and are irrelevant.
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ACG 2071 Module 11: Differential Analysis and Product Pricing

Example 7: 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? Sales price of old Cost savings: Old machine New machine Savings per year X five years Total savings Cost of new machine Differential income $25,000 $225,000 $150,000 $75,000 X 5 years

$375,000 $400,000 $250,000 $150,000

We should sell the old machine since the savings from the new machine does outweigh the costs. 5. Process or Sell When a product is manufactured, it progresses through various stages of production. Often a product can be sold at an intermediate stage of production, or it can be processed further and then sold. Only process further if the revenue is greater than the total costs of production. Example 9: Assume that 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. Kerosene can be sold without further processing for $0.80 per gallon. It can be processed further to yield gasoline, which can be sold for $1.25 per gallon. Gasoline requires
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ACG 2071 Module 11: Differential Analysis and Product Pricing

additional processing costs of $650 per batch, and 20% of the gallons of kerosene will evaporate during production. Should we sell or process further?

Kerosene Sales: 4,000g x $0.80 Costs of production: 4,000g x $0.60 Revenue from sales of kerosene Gasoline Sales: 3,200g* x $1.25 Cost of production: Kerosene Gasoline Total costs of production Revenue from sales of gasoline

$3,600 $2,400 $800 $4,000 $2,400 $ 650 $3,050 $950

Since the revenue from sales of kerosene are less than revenue from sale of gasoline, then gasoline will be produced. 6. Accept Businesses at a Special Price Differential analysis is also useful in deciding whether to accept additional business at a special price. 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. Only view variable costs Example 11: Assume that the monthly capacity is 12,500 units. Current sales and production are 10,000 units. The current manufacturing costs of
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ACG 2071 Module 11: Differential Analysis and Product Pricing

$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 special offer? Do we have unused capacity? Yes, capacity is 12,500 units and we are producing 10,000 units. So we can produce an additional 2,500 units per month. The order is 5,000 units over 3 months and that is feasible. Costs of production Less fixed costs Variable costs of production Special offer Revenue from special offer $20.00 $7.50 $12.50 $18.00 $5.50

Since revenue from special offer is positive, we should take the offer.

Setting Normal Product Selling Prices Differential analysis may be useful in deciding to lower selling prices for special short run decisions, such as whether to accept business at a price lower than the normal price. The normal selling price must be set high enough to cover all costs and expenses and provide a reasonable profit. The normal selling price can be viewed as the targeted selling price to be achieved in the long run. The basic approaches to setting this price as follows: Market Methods Demand based Competition based Cost plus Methods Total cost concept Product cost concept Variable cost concept

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ACG 2071 Module 11: Differential Analysis and Product Pricing

Managers using the market methods refer to the external market to determine the price. Demand based methods set the price according to the demand for the product. If there is high demand for the product, then the price may be set high, while the lower demand may require the price to be set low. Managers using the cost plus methods price the product in order to achieve a target profit. Managers add to the cost an amount called MARKUP. Total Cost Concept All the costs of manufacturing a product plus the selling and administrative expenses are included in the cost amount to which the markup is added.

Steps: 1. Determine the total cost of manufacturing the product. a. Includes the direct materials, direct labor, and factory overhead b. Includes the selling and administrative expenses 2. Cost per unit is then computed by dividing the total costs by the total units expected to be produced and sold. 3. Markup percentage = Desired profit Total cost 4. Selling price = Cost per unit + ( markup percentage X cost per unit)

Example 13: The desired profit is $160,000. Variable costs 100,000 units Direct materials Direct labor Factory overhead Selling and administrative expenses
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Total Cost $300,000 $1,000,000 $150,000 $150,000

Unit Cost $3.00 $10.00 $1.50 $1.50

ACG 2071 Module 11: Differential Analysis and Product Pricing

Total variable costs Fixed costs Factory overhead Selling and administrative Total Fixed costs

$1,600,000

$16.00 $50,000 $20,000 $70,000

Steps: 1. Determine the total cost of manufacturing the product. a. Includes the direct materials, direct labor, and factory overhead b. Includes the selling and administrative expenses Cost of manufacturing the product = Fixed costs + Variable Costs Variable costs = $16.00 x 1,000,000 units = $1,600,000 Fixed costs = $20,000 + $50,000 = $70,000 Total cost = $1,600,000 + $70,000 = $1,670,000 2. Cost per unit is then computed by dividing the total costs by the total units expected to be produced and sold. Cost per unit = Total Cost Total units = $1,670,000 100,000 = $16.70 per unit 3. Markup percentage = Desired profit Total cost Markup Percentage = $160,000 $1,670,000 = 9.6% 4. Selling price = Cost per unit + ( markup percentage X cost per unit)
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ACG 2071 Module 11: Differential Analysis and Product Pricing

= $16.70 + ($16.70 X 9.6%) = $18.30 Product Cost Concept Only the cost of manufacturing the product termed the product cost, are included in the cost amount to which the markup is added. Estimated selling expenses, administrative expenses, and profits are included in the markup. 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 %)

Example 15 The desired profit is $160,000 with production of 100,000 units. Variable costs 100,000 units Direct materials Direct labor Factory overhead Selling and administrative expenses Total variable costs
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Total Cost $300,000 $1,000,000 $150,000 $150,000 $1,600,000

Unit Cost $3.00 $10.00 $1.50 $1.50 $16.00

ACG 2071 Module 11: Differential Analysis and Product Pricing

Fixed costs Factory overhead Selling and administrative Total Fixed costs

$50,000 $20,000 $70,000

Steps: 4. Determine the total cost of manufacturing the product. a. Includes the direct materials, direct labor, and factory overhead Cost of manufacturing the product = Fixed costs + Variable Costs Variable costs = $14.50 x 1,000,000 units = $1,450,000 Fixed costs = $50,000 Total cost = $1,450,000 + $50,000 = $1,500,000 5. Cost per unit is then computed by dividing the total costs by the total units expected to be produced and sold. Cost per unit = Total Cost Total units = $1,500,000 100,000 = $15.00 per unit 6. Markup percentage = Desired profit + Total selling & administrative expenses Total cost Markup Percentage = $160,000 + $150,000 + $20,000 $1,500,000 = 22% 4. Selling price = Cost per unit + ( markup percentage X cost per unit)
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ACG 2071 Module 11: Differential Analysis and Product Pricing

= $15.00 + ($15.00 X 22%) = $15.00 + $3.30 = $18.30 Variable Cost Concept Emphasizes the distinction between variable and fixed costs in product pricing. Only variable costs are included in the cost amount to which the markup is added 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 %)

Example 15 The desired profit is $160,000 with production of 100,000 units. Variable costs 100,000 units Direct materials Direct labor Factory overhead Selling and administrative expenses Total variable costs Fixed costs
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Total Cost $300,000 $1,000,000 $150,000 $150,000 $1,600,000

Unit Cost $3.00 $10.00 $1.50 $1.50 $16.00

ACG 2071 Module 11: Differential Analysis and Product Pricing

Factory overhead Selling and administrative Total Fixed costs

$50,000 $20,000 $70,000

Steps: 7. Determine the total cost of manufacturing the product. a. Includes the direct materials, direct labor, and factory overhead Cost of manufacturing the product = Fixed costs Variable costs = $13.00 x 1,000,000 units = $1,300,000 Variable factory overhead = $1,50 x 100,000 = $150,000 Variable selling and administrative = $1,50 x 100,000 = $150,000 Total cost = $1,300,000 + $150,000 + $150,000 = $1,600,000 8. Cost per unit is then computed by dividing the total costs by the total units expected to be produced and sold. Cost per unit = Total Cost Total units = $1,600,000 100,000 = $16.00 per unit 9. Markup percentage = Desired profit + Total fixed costs Total variable cost Markup Percentage = $160,000 + $50,000 + $20,000 $1,600,000 = 14.4% 4. Selling price = Cost per unit + ( markup percentage X cost per unit) = $16.00 + ($16.00 X 14.4%)
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ACG 2071 Module 11: Differential Analysis and Product Pricing

= $16.00 + $2.30 = $18.30

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