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Managerial Accounting: An Introduction To Concepts, Methods, And Uses. Chapter 8 Differential Cost Analysis for Production Decisions. Maher, Stickney and Weil. Learning Objectives (Slide 1 of 2). Explain why businesses apply differential analysis to product choice decisions.

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Managerial Accounting: An Introduction To Concepts, Methods, And Uses

Chapter 8

Differential Cost Analysis

for Production Decisions

Maher, Stickney and Weil

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Learning Objectives (Slide 1 of 2)

  • Explain why businesses apply differential analysis to product choice decisions.

  • Explain the theory of constraints.

  • Identify the factors underlying make-or-buy decisions.

  • Explain how to identify the costs of producing joint products and the relevant costs for decisions to sell or process further.

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Learning Objectives (Slide 2 of 2)

  • Explain the use of differential analysis to determine when to add or drop parts of operations.

  • Identify the factors of inventory management decisions.

  • Explain how linear programming optimizes the use of scarce resources.

  • Identify the use of the economic order quantity model.

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Product Choice Decisions (Slide 1 of 2)

  • Due to capacity limitations, firms must often choose which goods to make and services to provide

    • When the firm has a scarce resource used in production (e.g., machine time, skilled labor)

      • Firm should produce product that gives the largest contribution margin per unit of constrained resource

    • If more than one scarce resource is involved, choice is more difficult

      • May use linear programming to determine best product mix

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Product Choice Decisions (Slide 2 of 2)

  • Incorrect use of accounting information

    • In making short-run product choice decisions, one should not rely on product cost information that includes cost allocations

    • Full-absorption product costing allocates fixed manufacturing costs to units produced

      • May result in incorrect decisions

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Theory of Constraints (Slide 1 of 3)

  • Focuses on increasing the excess of differential revenue over differential costs when firms face bottlenecks

    • Bottleneck-an operation in which the work performed equals or exceeds the available capacity

    • Results in inventory waiting until the bottleneck is free

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Theory of Constraints (Slide 2 of 3)

  • Encourages managers to find ways to increase profits by relaxing constraints and increasing throughput

  • Focuses on the following factors:

    • Throughput contribution - Sales dollars minus variable costs

    • Investments - Assets required for production and sales

    • Other operating costs - Other than short-run variable costs

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Theory of Constraints (Slide 3 of 3)

  • Objective is to maximize throughput contribution while minimizing investments and operating costs

  • Key steps involved:

    • Recognize that bottlenecks determine throughput contribution for the plant as a whole

    • Find the bottleneck resource

    • Subordinate all nonbottleneck resources to the bottleneck resource

    • Increase bottleneck efficiency and capacity

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Make-or-Buy Decisions

  • Involve the decision of whether to meet needs internally or to acquire goods and services from external sources (often called outsourcing)

    • Decision depends on cost factors as well as nonquantitative factors

  • Differential cost analysis is useful in making these decisions

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Example-Make or Buy Decision(Slide 1 of 2)

  • Ben & Jerry Cookie Co. can buy part of its product or produce it internally. Relevant info is as follows:

    Buy Make

    Unit Selling Price $ 30 $ 30

    Sales Volume 800/mth. 800/mth.

    Unit Variable Costs $ 11 $ 22

    Purchased Ingredients $ 12 $ 0

    Total Fixed Costs $3,840 $4,800

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Example-Make or Buy Decision(Slide 2 of 2)

__Buy Make Difference

Revenue $24,000 $24,000 -0-


Variable Costs

-Produce & Sell 8,800 17,600 $(8,800)

-Costs of Goods Bought 9,600 -0- 9,600

Contribution Margin $ 5,600 $ 6,400 $( 800)

Less Fixed Costs 3,8404,800 (960)

Operating Profit $ 1,760 $ 1,600 $ 160

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Joint Products: Sell or Process Further

  • As part of a single production process, multiple products are produced

    • The point in the production process at which identifiable products emerge is called the splitoff point

      • Costs incurred up to this point are called joint costs

      • Costs incurred after the splitoff point are called additional processing costs

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Joint Production Process


Processing Costs


Joint Costs:

Direct Materials

Direct Labor


Sale of

Product A

Sale of

Product B

Splitoff Point

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Adding or Dropping Parts of Operations

  • General Rule: If differential revenue from sale of a product > differential costs of providing the product, then the product generates profits and firm should continue production

    • Even though product may show a loss on financial statements due to overhead allocation to the product

  • This rule applies to short-run decisions

    • If more profitable uses of the facilities can be found, it may outweigh the contribution margin lost by dropping a product

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Inventory Management Decisions

  • Inventory management affects profitability

    • Having correct amount and type of inventory can:

      • Prevent production shutdowns

      • Avoid lost sales

    • Inventory is costly to maintain

      • Costs include storage, insurance, losses from damage and theft, property taxes, etc.

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Differential Costs for Inventory Management

  • Two opposing costs to consider

    • Setup or order costs - costs of setting up machinery for a production run or costs to process a purchase order

    • Carrying Costs - e.g., cost of maintaining warehouse facilities

  • Management would like to find the optimal trade-off point between these two costs

    • Called the economic order quantity (EOQ)

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Estimating Costs of Maintaining Inventory

  • Differential Costs to consider include:

    • Order costs - costs of salaries, lost time for production setups, receiving and inspecting orders, processing invoices, and freight costs

    • Carrying costs - insurance, inventory taxes, opportunity cost of funds invested in inventory, additional warehouse space

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Just-in-Time (Slide 1 of 2)

  • JIT is a method of managing purchasing, production, and sales where the firm attempts to:

    • Produce items only as needed for the next step in the production process, or

    • Time purchases so items arrive just in time for production or sale

  • Can substantially reduce inventory levels

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Just-in-Time (Slide 2 of 2)

  • Requires lay out of production process so there is a continuous flow once production starts

  • Requires reliable processing systems

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Linear Programming

  • Managers may face short-run constraints in production resources such as factory capacity, personnel time, floor space, etc

    • Linear programming is used to address production decisions involving limited resources

      • Referred to as a constrained optimization technique

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Economic Order Quantity

  • Can be determined through trial and error or use the following formula: N=D/Q

    Where: Q =

    N = optimal number of orders

    Q = economic order quantity

    D = period demand

    K0=order or setup cost

    Kc= cost of carrying one unit in inventory

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