ch 25 differential cost analysis

7/27/2019 Ch 25 Differential Cost Analysis

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Differential Cost Analysis

Chapter 25


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Management decisions

Accepting/Rejecting certain orders

Reducing the price of a single order

Making a price cut in a competitive market

Evaluating Make-or-buy alternatives

Expanding or reducing plant capacity

Increasing, curtailing or stopping production

Replacing present equipment

Spending additional amounts for sales promotion


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Differential Cost

Difference between cost of alternativechoices

Marginal/Incremental cost

Deals with determination of incrementalrevenue, costs and margins

Variable costs are significant

Fixed costs might be included


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Example

Total cost at 60,000 units = $324,250

Total cost at 80,000 units = $423,400

Calculate total differential cost

Calculate differential cost/unit


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Solution

Differential cost = 423,400

324,250

= $99,150

Differential cost/unit = 99,150/20,000

= $4.96


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Accepting Additional Orders

Differential cost must be considered involving achange in output

Difference between the cost of producing

present smaller output and that of the plannedlarger output

Possibility of selling additional output at a figure

lower or greater than the existing average unitcost

New or additional business can be accepted as

long as the variable cost is recovered


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Example

Maximum capacity=100,000 units

Normal capacity = 80,000 units

Variable cost per unit = $5

Fixed cost= $100,000

Sales price per unit= $9

Profit at 80,000 and 81,000 units?


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Solution

Present business Additional business Total

Sales $720,000 $9,000 $729,000

Variable cost 400,000 5,000 405,000

ContributionMargin 320,000 4,000 324,000

Fixed cost 100,000 _-0-____ 100,000

Profit 320,000 4,000 224,000


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Reducing the Price of a SpecialOrder

At what minimum price the firm canafford to sell additional goods


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Example

Company manufactures 450,000 units using90% of its capacity

Fixed factory overhead is $335,000

Variable factory overhead = $0.50/unit

Direct materials = $1.80/unit Direct labor = $1.40/unit

Each unit sells for $5


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Example

Sales

$2,250,000

Cost of goods sold:

Direct materials(450,000*1.80) 810,000

Direct labor(450,000*1.40) 630,000

Variable factory overheads(450,000*0.50) 225,000

Fixed factory overheads(450,000*0.67) 301,500 1,966,500

Income from operations

283,500

Unabsorbed fixed factory overheads(500,000-450,000)*0.67]33,500

Income from operations (adjusted)

250,000


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Special Order

Additional fixed cost if special order of100,000 units is accepted = $10,000

Sales price of a special order=$4.25


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Solution

Sales (100,000 [email protected]) $425,000

Cost of goods sold:

Direct materials(100,000units @1.80) 180,000

Direct labor (100,000units @ 1.40) 140,000 Variable factory overheads

(100,000 units @0.50) 50,000

Additional fixed cost 10,000 380,000

Gain on the order $45,000
mailto:[email protected]:[email protected]:[email protected]:[email protected]


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Exercise

The wood River plant of the Union Company has anormal capacity 0f 90,000 units per month. Monthlyproduction costs are $12 variable cost per unit and$240,000 fixed. By increasing the fixed cost $10,000 a

month, the plant can produce 95,000 units.

Differential cost of the production between 80% and90% of normal capacity.

Differential cost of producing the 5,000 units above thenormal capacity.

Per unit total production cost of the 95,000 units

Per unit differential production cost of the 5,000 units.


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Solution

Differential cost of the production between80% and 90% of normal capacity.

90,000 units *90% 81,000 units

90,000 units *80% 72,000 units

9,000 units

9,000 units *$12 = $108,000


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Solution

Differential cost of producing the 5,000units above the normal capacity.

5,000 units *12 $60,000

Differential Fixed cost 10,000

70,000


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Solution

Per unit total production cost of the5,000 units

95,000 units *12 $1,140,000

Fixed costs(240,000+10,000) 250,000

1,390,000


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Solution

Per unit differential production cost ofthe 5,000 units.

=$70,000/5,000 units

= $14


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Make-Or-Buy Decisions

Compare the cost of making the parts withthe cost of buying them

Costs for each of the alternatives must bebased on the identical productspecifications, quantities and qualitystandards


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Decisions to Shut Down Facilities

In the short run, a firm seems to be better offoperating than not operating if revenue >variable costs

Shutting down of facilities Does not eliminate all costs Loss of investment spent on training employees Recruiting and training costs after reopening Loss of losing established markets & customers


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Decisions to Shut DownFacilities If operations are continued

Certain expenses connected with the shuttingdown of the facilities can be saved

Costs that would have to be incurred when a

closed facility is reopened will be saved


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Decisions to Discontinue Products

Requires careful analysis of relevant differentialcost and revenue data

Following benefits can be achieved with the

correct decision: Expanded sales

Increased profits

Reduced inventory levels

Resources made available for more promisingprojects


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Decisions to DiscontinueProducts

Not only the profitability of the products beinganalyzed be considered but also the extent towhich sales of other products will be affectedwhen one product is removed should be

evaluated


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Decisions to DiscontinueProducts Management needs following signals to identifytroubled products:

Declining sales volume

Decreasing market share

Malfunctioning of the product or introduction of a

superior competitive product Expected future sales and market potential not favorable

Return on investment below minimum acceptable level

Variable costs approaching or exceeding revenue

Price required to be constantly lowered to maintain sales


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Other Cost Concepts

Opportunity costs Measurable value of an opportunity bypassed by rejecting

an alternative use to resources

Measurement of sacrifices associated with alternatives

Imputed costs Hypothetical costs representing the cost/value of a

resource measured by its use value

Interest on invested capital, rental value of company-owned properties, salaries of owners of sole proprietors

Do not involve actual cash flows


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Other Cost Concepts

Out-Of-Pocket Costs Involves cash outlays

Often identified as variable costs

Helpful in deciding whether a particular venturewill at least return the cash expenditures

Sunk Costs

Irrecoverable costs Not included in differential cost analysis

ch 25 differential cost analysis

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