# ACT-500: Managerial Accounting Disccsion3

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Differential Analysis and Product Pricing

Chapter 11

Differential Analysis
(slide 1 of 6)

Managerial decision making involves choosing between alternative courses of action.

Differential analysis, sometimes called incremental analysis, analyzes differential revenues and costs in order to determine the differential impact on profit of two alternative courses of action.

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

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

© 2020 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

2

Differential Analysis
(slide 2 of 6)

Differential profit (loss) is the difference between the differential revenue and differential costs.

Differential profit indicates that a decision is expected to increase income.

Differential loss indicates that a decision is expected to decrease income.

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3

Differential Analysis
(slide 3 of 6)

The differential analysis is prepared in three columns, where positive amounts indicate the differential effect is to increase profit and income and negative amounts indicate the effect is to decrease profit and income.

The first column is the revenues, costs, and profit (loss) for maintaining floor space for tables (Alternative 1).

The second column is the revenues, costs, and profit (loss) for using that floor space for a salad bar (Alternative 2).

The third column is the difference between the revenues, costs, and profit (loss) of two alternatives.

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Differential Analysis
(slide 4 of 6)

The salad bar (Alternative 2) is being considered over keeping the existing tables (Alternative 1).

The differential revenue of a salad bar over tables is \$20,000 (\$120,000 − \$100,000). Because the salad bar would increase revenue and profit, it is entered as a positive \$20,000 in the Differential Effects column.

The differential cost of a salad bar over tables is \$5,000 (\$65,000 − \$60,000). Because the salad bar would increase costs and decrease profit, the \$5,000 is entered as a negative \$(5,000) in the Differential Effects column.

The differential effect of a salad bar over tables is determined by subtracting the differential costs from the differential revenues in the Differential Effects column.

© 2020 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Differential Analysis
(slide 5 of 6)

The differential profit of a salad bar is \$15,000 (\$20,000 − \$5,000).

Based upon the differential analysis, Bryant Restaurants should decide to replace some of its tables with a salad bar.

Doing so will increase its profit and income by \$15,000.

Over time, Bryant Restaurants should review its decision based upon actual revenues and costs.

If the actual revenues and costs differ significantly from those shown in Slide 5, another differential analysis should be performed.

© 2020 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Differential Analysis
(slide 6 of 6)

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Lease or Sell
(slide 1 of 2)

Management may lease or sell a piece of equipment that is no longer needed.

This may occur when a company changes its manufacturing process and can no longer use the equipment in the manufacturing process.

In making a decision, differential analysis can be used.

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Lease or Sell
(slide 2 of 2)

Only the differential revenues and differential costs associated with the lease-or-sell decision are included 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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Discontinuing a Segment or Product

A product, department, branch, territory, or other segment of a business may be generating losses. As a result, management may consider discontinuing (eliminating) the product or segment.

Discontinuing the product or segment usually eliminates all of the product’s or segment’s variable costs such as direct materials, direct labor, variable factory overhead, and sales commissions.

However, fixed costs such as depreciation, insurance, and property taxes may not be eliminated.

Thus, it is possible for total company income to decrease rather than increase if the unprofitable product or segment is discontinued.

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Companies that manufacture products made up of components that are assembled into a final product, such as automobile manufacturers, must decide whether to make a part or purchase it from a supplier.

Differential analysis can be used to decide whether to make or buy a part.

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Replace Equipment
(slide 1 of 2)

The usefulness of a fixed asset may decrease before it is worn out.

For example, old equipment may no longer be as efficient as new equipment.

Differential analysis can be used for decisions to replace fixed assets such as equipment and machinery.

The analysis normally focuses on the costs of continuing to use the old equipment versus replacing the equipment.

The book value of the old equipment is a sunk cost and, thus, is irrelevant.

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Replace Equipment
(slide 2 of 2)

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Process or Sell

During manufacturing, a product normally progresses through various stages or processes. In some cases, a product can be sold at an intermediate stage of production, or it can be processed further and then sold.

Differential analysis can be used to decide whether to sell a product at an intermediate stage or to process it further.

In doing so, the differential revenues and costs from further processing are compared.

The costs of producing the intermediate product do not change, regardless of whether the intermediate product is sold or processed further.

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Accept Business at a Special Price

A company may be offered the opportunity to sell its products at prices other than normal prices.

For example, an exporter may offer to sell a company’s products overseas at special discount prices.

Differential analysis can be used to decide whether to accept additional business at a special price.

The differential revenue from accepting the additional business is compared to the differential costs of producing and delivering the product to the customer.

The differential costs of accepting additional business depend on whether the company is operating at less than capacity.

If the company is operating at less than full capacity, then the additional production does not increase fixed manufacturing costs.

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Setting Normal Product Selling Prices
(slide 1 of 3)

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Setting Normal Product Selling Prices
(slide 2 of 3)

Managers can use one of two market methods to determine selling price.

Demand-based method

The demand-based method sets the price according to the demand for the product.

If there is high demand for the product, then the price is set high.

Likewise, if there is low demand for the product, then the price is set low.

Competition-based method

The competition-based method sets the price according to the price offered by competitors.

For example, if a competitor reduces the price, then management adjusts the price to meet the competition.

© 2020 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Setting Normal Product Selling Prices
(slide 3 of 3)

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Cost-Plus Methods

Cost-plus methods determine the normal selling price by estimating a cost amount per unit and adding a markup, computed as follows:

Management determines the markup based on the desired profit for the product.

The markup should be sufficient to earn the desired profit plus cover any costs and expenses that are not included in the cost amount.

© 2020 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Product Cost Method
(slide 1 of 5)

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Product Cost Method
(slide 2 of 5)

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Product Cost Method
(slide 3 of 5)

The product cost method is applied using the following steps:

Step 1: Estimate the total product cost as follows:

Step 2: Estimate the total selling and administrative expenses.

 Product costs: Direct materials \$XXX Direct labor XXX Factory overhead XXX Total product cost \$XXX

© 2020 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Product Cost Method
(slide 4 of 5)

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, computed as follows:

Step 4: Compute the markup percentage as follows:

The desired profit is normally computed based on a rate of return on assets as follows:

© 2020 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Product Cost Method
(slide 5 of 5)

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

Step 6: Determine the normal selling price by adding the markup per unit to the product cost per unit as follows:

 Product cost per unit \$XXX Markup per unit XXX Normal selling price per unit \$XXX

© 2020 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Target Costing Method
(slide 1 of 2)

Target costing is a method of setting prices that combines market-based pricing with a cost-reduction emphasis.

Under target costing, a future selling price is anticipated, using the demand-based or the competition-based methods.

The target cost is then determined by subtracting a desired profit from the expected selling price, computed as follows:

Target costing tries to reduce costs.

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Target Cost Method

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26

Target Costing Method
(slide 2 of 2)

The target cost is normally less than the current cost.

Managers must try to reduce costs from the design and manufacture of the product.

The planned cost reduction is sometimes referred to as the cost drift.

Costs can be reduced in a variety of ways such as the following:

Simplifying the design

Reducing the cost of direct materials

Reducing the direct labor costs

Eliminating waste

© 2020 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Production Bottlenecks
(slide 1 of 2)

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Production Bottlenecks
(slide 2 of 2)

When a company has a production bottleneck in its production process, it should attempt to maximize its profits, subject to the production bottleneck.

In doing so, the unit contribution margin of each product per production bottleneck constraint is used.

In a production bottleneck operation, the best measure of profitability is the unit contribution margin per production bottleneck constraint.

© 2020 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Appendix: Total Cost Method
(slide 1 of 4)

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Total Cost Method

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31

Appendix: Total Cost Method
(slide 2 of 4)

The total cost method is applied using the following steps:

Step 1: Estimate the total manufacturing cost as follows:

Step 2: Estimate the total selling and administrative expenses.

 Manufacturing costs: \$XXX Direct materials XXX Direct labor XXX Factory overhead XXX Total manufacturing cost \$XXX

© 2020 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Appendix: Total Cost Method
(slide 3 of 4)

Step 3: Estimate the total cost as follows:

Step 4: Divide the total cost by the number of units expected to be produced and sold to determine the total cost per unit, as follows:

 Total manufacturing costs \$XXX Selling and administrative expenses XXX Total cost \$XXX

© 2020 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Appendix: Total Cost Method
(slide 4 of 4)

Step 5: Compute the markup percentage as follows:

The desired profit is normally computed based on a rate of return on assets as follows:

Step 6: Determine the markup per unit by multiplying the markup percentage times the total cost per unit as follows:

Step 7: Determine the normal selling price by adding the markup per unit to the total cost per unit as follows:

 Total cost per unit \$XXX Markup per unit XXX Normal selling price per unit \$XXX

© 2020 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Appendix: Variable Cost Method
(slide 1 of 4)

© 2020 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Variable Cost Method

© 2020 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

36

Appendix: Variable Cost Method
(slide 2 of 4)

The variable cost method is applied using the following steps:

Step 1: Estimate the total variable product cost as follows:

 Variable product costs: \$XXX Direct materials XXX Direct labor XXX Variable factory overhead XXX Total variable product cost \$XXX

© 2020 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Appendix: Variable Cost Method
(slide 3 of 4)

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

Step 3: Determine the total variable cost as follows:

Step 4: Compute the variable cost per unit as follows:

 Total variable product cost \$XXX Total variable selling and administrative expenses XXX Total variable cost \$XXX

© 2020 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Appendix: Variable Cost Method
(slide 4 of 4)

Step 5: Compute the markup percentage as follows:

The desired profit is normally computed based on a rate of return on assets as follows:

Step 6: Determine the markup per unit by multiplying the markup percentage times the variable cost per unit as follows:

Step 7: Determine the normal selling price by adding the markup per unit to the variable cost per unit as follows:

 Variable cost per unit \$XXX Markup per unit XXX Normal selling price per unit \$XXX

© 2020 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Yield pricing is a type of “accepting business at a special price” differential analysis.

© 2020 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Normal selling price = Cost amount per

unit + Markup

Total product cost

Product cost per unit =

Estimated units produced and sold

Desired profit + Total selling and admin

istrative expenses

Markup percentage =

Total product cost

Desired profit = Desired return × Tota

l assets

´

Markup per unit = Markup percentage P

roduct cost per unit

Target cost = Expected selling price

Desired profit

Total cost

Total cost per unit =

Estimated units produced and sold

Desired profit

Markup percentage =

Total cost

´

al assets

´

Markup per unit = Markup percentage T

otal cost per unit

Total variable cost

Variable cost per unit =

Estimated units produced and sold

Desired profit + Total fixed costs and

expenses

Markup percentage =

Total variable cost

Desired profit = Desired return × Tota

l assets

Markup per unit = Markup percentage ×

Variable cost per unit

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