Chapter 23

1. © 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. Chapter 23 Differential Analysis and Product Pricing Financial and Managerial Accounting 8th Edition Warren Reeve Fess PowerPoint Presentation by Douglas CloudProfessor Emeritus of AccountingPepperdine University

2. Some of the action has been automated, so click the mouse when you see this lightning bolt in the lower right-hand corner of the screen. You can point and click anywhere on the screen.

3. Objectives 1.Prepare a differential analysis report for decisions involving 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, or accepting additional business at a special price. After studying this chapter, you should be able to:

4. 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.

5. Differential 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.

6. Differential Analysis Differential Analysis Decisions Alternative A Differential revenue – Differential costs or Differential income or loss Alternative B

7. Marcus Company Lease or Sell Equipment Marcus Company is considering disposing of equipment that cost $200,000 and that has $120,000 of accumulated depreciation.

8. Marcus Company Broker Lease or Sell Equipment The equipment can be sold through a broker for $100,000, less a 6% commission. Sell equipment to

9. Marcus Company Potamkin Company Lease or Sell Equipment Potamkin Company, the lessee, has offered to lease the equipment for five years for a total consideration of $160,000. Lease equipment to OR

10. Marcus Company Lease or Sell Equipment 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.

11. Proposal to Lease or Sell Equipment June 22, 2006 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 the lease alternative $31,000 Lease the equipment!

12. OR

13. 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 is the traditional analysis. The differential income is the same.

14. Discontinue a Segment or Product

15. Differential items Variable cost $ 60,000 Variable expenses $ 25,000 Battle Creek Cereal Co. Condensed Income Statement For the Year Ended August 31, 2006 Bran Flakes Other Cereals Total Sales$100,000$900,000$1,000,000 Cost of goods sold: Variable costs $ 60,000 $420,000 $ 480,000 Fixed costs 20,000 200,000 220,000 Total cost of goods sold $ 80,000$620,000$ 700,000 Gross profit $ 20,000$280,000$ 300,000 Operating expenses: Variable expenses $ 25,000 $155,000 $ 180,000 Fixed expenses 6,000 45,000 51,000 Total operating expenses $ 31,000$200,000$ 231,000 Income (loss) from operations $ (11,000) $ 80,000 $ 69,000 Sales $100,000 Should Bran Flakes be discontinued?

16. Differential items Variable cost $ 60,000 Variable expenses $ 25,000 Battle Creek Cereal Co. Condensed Income Statement For the Year Ended August 31, 2006 Bran Flakes Other Cereals Total Sales$100,000$900,000$1,000,000 Cost of goods sold: Variable costs $ 60,000 $420,000 $ 480,000 Fixed costs 20,000 200,000 220,000 Total cost of goods sold $ 80,000$620,000$ 700,000 Gross profit $ 20,000$280,000$ 300,000 Operating expenses: Variable expenses $ 25,000 $155,000 $ 180,000 Fixed expenses 6,000 45,000 51,000 Total operating expenses $ 31,000$200,000$ 231,000 Income (loss) from operations $ (11,000) $ 80,000 $ 69,000 Sales $100,000 If Bran Flakes is discontinued, net income will decrease by $15,000.

17. 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 Proposal to Discontinue Bran Flakes September 29, 2006 Don’t discontinue!

18. MAKE or BUY

19. 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 $ 80 Direct labor 80 Variable factory overhead 52 Fixed factory overhead 68 Total cost per unit $280 INITIAL REACTION—DON’T MAKE INTERNALLY

20. Proposal to Manufacture Automobile Part February 15, 2006 Purchase price of part $240.00 Differential cost to manufacture: Direct materials $80.00 Direct labor 80.00 Variable factory overhead 52.00 212.00 Cost savings from manufacturing part $ 28.00 The fixed factory overhead is excluded because it is not relevant—so continue making the part.

21. Replace Equipment

22. 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?

23. 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 x 5 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 $ 30,000 Buy the new equipment!

24. Process or Sell

25. 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.

26. 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 further!

27. Accept Business at a Special Price

28. 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.

29. 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 the offer be accepted or rejected?

30. Accept the offer! Proposal to Sell Basketballs to Exporter March 10, 2006 Differential revenue from accepting offer: Revenue from sale of 5,000 additional units at $18 $90,000 Differential cost of accepting offer: Variable cost of 5,000 additional units at $12.50 62,500 Differential income from accepting offer $27,500

31. Setting Normal Product Selling Prices

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

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

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

35. Total Cost Concept Using the Total cost concept, all cost of manufacturing a product... Manufacturing Cost

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

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

38. Desired selling price Administrative Expenses Selling Expenses Manufacturing Cost Total Cost Concept The company’s desired profit is $160,000. Desired Profit

39. Total Cost Concept Cost Structure Example (100,000 units) Per Unit Total Cost Cost Variable Costs (per unit): Direct materials $ 3.00 $ 300,000 Direct labor 10.00 1,000,000 Factory overhead 1.50 150,000 Selling and administrative 1.50 150,000 Total variable costs $16.00$1,600,000 Fixed Costs: Factory overhead .50 50,000 Selling and administrative .20 20,000 Total fixed costs . 70 70,000 Total costs $16.70 $1,670,000

40. Total cost per calculator $16.70 Markup ($16.70 x 9.6%) 1.60 Selling price $18.30 Total Cost Concept Markup Percentage: Desired profit $160,000 Total costs $1,670,000 = = 9.6% Only the desired profit is covered in the markup.

41. Digital Solutions Inc. Income Statement For the Year Ended December 31, 2006 Sales (100,000 units x $18.30) $1,830,000 Expenses: Variable (100,000 units x $16.00) $1,600,000 Fixed ($50,000 + $20,000) 70,000 1,670,000 Income from operations $ 160,000 Total Cost Concept Proof that a sale of 100,000 computers at $18.30 each will generate a desired profit of $160,000.

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

43. Product Cost Concept 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 administrative 1.50 150,000 Total variable costs $16.00$1,600,000 Fixed Costs: Factory overhead .50 50,000 Selling and administrative .20 20,000 Total fixed costs .70 70,000 Total costs $16.70 $1,670,000 Product Cost = $15 per unit

44. Administrative Expense + Selling Expense + Desired Profit Desired Selling Price Product Cost Concept Markup Manufacturing Cost Product Cost

45. Total selling and administrative expenses Desired profit + Total manufacturing costs Markup percentage = Product Cost Concept

46. DM ($3 x 100,000) $ 300,000 DL ($10 x 100,000) 1,000,000 Factory overhead: Variable ($1.50 x 100,000) 150,000 Fixed 50,000 Total manufacturing costs $1,500,000 Markup percentage = 22% Product Cost Concept $160,000 + $170,000 Markup percentage = $1,500,000

47. Product Cost Concept Manufacturing cost per calculator $15.00 Markup ($15 x 22%) 3.30 Selling price $18.30

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

49. Desired Selling Price Variable Cost Concept Markup Total Fixed Costs + Desired Profit Variable Manufacturing Cost + Variable Administrative and Selling Expenses Product Cost

50. Total fixed costs Desired profit + Total variable costs Markup percentage = Variable Cost Concept