Differential Analysis & Product PricingTermsDifferential AnalysisSlide 4Slide 5Types of Decision MakingExample 1Slide 8Discontinue a segment or productExample 2Slide 11Example 3Slide 13Make or BuyExample 4Slide 16Replace EquipmentExample 5Slide 19Example 6Slide 21Process or SellOil ProductionExample 7Slide 25Example 8Accept Business at Special PriceBusiness at Special PriceExampleSetting Normal Product Selling PriceTotal Cost ConceptSteps to ComputeSlide 33Example (cont’d)Slide 35Slide 36Slide 37Product Cost ConceptExample (data from before)Slide 40ExampleSlide 42Slide 43Variable Cost ConceptSlide 45Slide 46Slide 47Differential Analysis &Product PricingACG 2071Chapter 24Module 11Fall 2007Terms•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 decisionDifferential Analysis•Focuses on the effect of alternative courses of action on the relevant revenues•Differential revenues–Is the amount of increases or decreases in revenue expected from a course of action as compared with an alternativeDifferential Analysis•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–Differential revenue – differential costDifferential AnalysisDifferential Revenue from alternativesRevenue from Alternative A $$$Revenue from Alternative B $$$ Differential Revenue $$$Differential cost of alternativesCost of Alternative A $$$Cost of B $$$ Differential cost $$$Net differential income or loss from alternatives$$$Types of Decision Making•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 costs associated with the lease or sell decisionExample 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?Example 1•Lease: – Revenue: $40,000 X 5 = $200,000–Cost 35,000–Income 165,000•Sell–Revenue $200,000–Cost 6% X $200,000 12,000–Income 188,000Discontinue 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 increase if the operating loss could be eliminated•If contribution margin > 0 then continue with segmentExample 2•Should we discontinue the production of Lotion? Shampoo Conditioner Lotion TotalSales $500,000 $400,000 $100,000 $1,000,000Cost of goods sold Variable $220,000 $200,000 $60,000 $480,000 Fixed $120,000 $80,000 $20,000 $220,000Total CGS 340,000 280,000 80,000 700,000Gross profit 160,000 $120,000 $20,000 $300,000Operating expenses Variable $95,000 $60,000 $25,000 $180,000 Fixed $25,000 $20,000 $6,000 $51,000Total $120,000 $80,000 $31,000 $231,000Income $40,000 $40,000 $(11,000) $69,000Example 2•LotionSales 100,000.00$ Var COGS 60,000.00$ Manufacturing margin 40,000.00$ Var selling exp 25,000.00$ Contribution margin 15,000.00$Example 3•A condensed income statement for Fresh Kola indicated the followingSales 250,000.00$ Cost of goods sold 175,000.00$ Gross profit 50,000.00$ Operating expenses 60,000.00$ Operating income (10,000.00)$ Variable costs of goods sold is $120,000Variable operating was $15,000Should we discontinue Kola?Example 3•ResultSales 250,000.00$ Var COGS 120,000.00$ Manufacturing margin 130,000.00$ Var operating 15,000.00$ Contribution margin 115,000.00$Make or Buy•The assembly of many parts is often a major element in manufacturing some products•The product’s manufacturer may make these parts or they may be purchased•Management uses differential cost to decide whether to make or buy•MUST HAVE UNUSED CAPACITY•Only look at variable costsExample 4•A factory has unused capacity and is considering the production of a part of its product. The cost of making a part in direct materials is $80, direct labor $70, variable factory overhead is $52 and fixed factory overhead is $68. The cost of purchasing the product is $240 per unit. Should we make or buy?Example 4•Make–Unused capacity exists–DM $80–DL $70–VFO 52–Total 202•Buy $240•Since we have unused capacity, we can make the product.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 inadequacyExample 5•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?Example 5•Reduction in cost • $225,000 - $150,000 = $75,000• x 5 yrs• 375,000• Selling price of old m/c 25,000• 400,000•Cost of new m/c 250,000•Savings 150,000Example 6•Francis is considering purchasing a lathe. The old machine cost $250,000 and has book value of $50,000 with three years left. It has a disposal value of $10,000. The new machine has a cost of $350,000 for five years and no residual value. The new machine will decrease cost by $75,000 for the next three years. Should we buy the new machine?Example 6•Reduction in cost• $75,000 X 3 = $225,000•Disposal value 10,000•Total 235,000•Cost of new machine 350,000•Loss (115,000)Process or Sell•When a product is manufactured, it progresses through