chapter 7 differential cost analysis (aka incremental analysis) for operating decisions

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Chapter 7 Differential Cost Analysis (aka Incremental Analysis) for Operating Decisions

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Page 1: Chapter 7 Differential Cost Analysis (aka Incremental Analysis) for Operating Decisions

Chapter 7Differential Cost Analysis (aka

Incremental Analysis)for Operating Decisions

Page 2: Chapter 7 Differential Cost Analysis (aka Incremental Analysis) for Operating Decisions

2

Describe & Define Differential Analysis

• Differential analysis focuses on differences among particular alternative actions

– Sometimes referred to as incremental cost analysis

• A differential cost or revenue is a cost or revenue that differs as a result of changing activities or levels of activities

Page 3: Chapter 7 Differential Cost Analysis (aka Incremental Analysis) for Operating Decisions

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Differential Analysis ModelAlternative - Status Quo = Difference

Revenue Revenue Revenue Change in Revenue

Less Variable Costs (VC) VC - VC =

Change in VC

Total Contribution Margin (CM) CM CM

Change in CM

Less Fixed Costs Fixed Costs - Fixed Costs =

Change in Fixed Costs

Operating ProfitProfit - Profit =

Change in Profit

Page 4: Chapter 7 Differential Cost Analysis (aka Incremental Analysis) for Operating Decisions

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Differential Analysis Cont.

• A cost (or revenue) is relevant only if it differs between alternatives under consideration

• Focus is typically on cash flows because:

– Cash is the medium of exchange

– Cash is a common, objective measure of benefits and costs of alternatives

Page 5: Chapter 7 Differential Cost Analysis (aka Incremental Analysis) for Operating Decisions

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Review Short-Run vs. Long-Run Pricing Decisions

• The time horizon of a decision is

important in determining the relevant

costs in a pricing decision

– Short-run decisions include pricing for a

one-time special order

– Long-run decisions include pricing a main

product in a major market

Page 6: Chapter 7 Differential Cost Analysis (aka Incremental Analysis) for Operating Decisions

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What is the differential approach to pricing?

This approach assumes that the price must be at

least equal or greater than the differential cost

of producing and selling the product

– In the short-run the price should provide a

positive contribution to covering fixed costs

and generating profit

– In the long-run the price must cover all

costs, because both fixed and variable costs

become differential in the long run

Page 7: Chapter 7 Differential Cost Analysis (aka Incremental Analysis) for Operating Decisions

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Long-Run Pricing Decisions (Slide 1 of 3)

• Define Full cost

This is the total cost of producing and

selling the product from R & D through

customer service

– Includes all costs incurred by activities

making up the value chain

Page 8: Chapter 7 Differential Cost Analysis (aka Incremental Analysis) for Operating Decisions

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Review the Value Chain

R & D DesignProduc-

tionMarket-

ingDistrib-

utionCustomer Service

Value Chain Activities

Costs

Premanufacturing(Upstream)

Manufacturing

Post-manufacturingDownstream

Page 9: Chapter 7 Differential Cost Analysis (aka Incremental Analysis) for Operating Decisions

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Long-Run Pricing Decisions (Slide 3 of 3)

• The full cost approach is justified in pricing decisions when:

– Entering into long-term contracts to supply a product

– Developing and producing a customized product

– Initially setting prices, then adjusting for market conditions

Page 10: Chapter 7 Differential Cost Analysis (aka Incremental Analysis) for Operating Decisions

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Review Life-Cycle Product Costing and Pricing

The product life cycle covers time period from initial R & D through the point at which support to customers is withdrawn

– This highlights the importance of setting prices that cover all costs in the value chain

– To be profitable, a firm must generate sufficient revenue to cover all costs

Page 11: Chapter 7 Differential Cost Analysis (aka Incremental Analysis) for Operating Decisions

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Explain Using Target Prices to Set Target Costs

• Target costing is the concept of price-based costing– Target price – is the estimated price a potential

customer is willing to pay

– Target Cost = target price – target profit

• The target cost is the estimated long-run cost of the product or service that enables company to realize targeted profit

Page 12: Chapter 7 Differential Cost Analysis (aka Incremental Analysis) for Operating Decisions

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Explain Legal Issues Relating Costs to Prices

• Pricing must not be predatory

– i.e., Cannot price products below cost in an effort to drive out competition

• Cost may be defined as full or variable costs depending on jurisdiction

• Dumping occurs when a foreign company sells products in U.S. at a price below market value in country of origin

Page 13: Chapter 7 Differential Cost Analysis (aka Incremental Analysis) for Operating Decisions

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Customer Profitability

• Differential analysis is useful in

determining which customers to keep or

drop

– Dropping a customer should result in cost

savings in excess of lost revenue

– The alternative uses of extra capacity

available after dropping a customer should

be included in the analysis

Page 14: Chapter 7 Differential Cost Analysis (aka Incremental Analysis) for Operating Decisions

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What are the four general categories of customer costs?

Customer costs generally consist of the

following 4 categories of activities:

1. Cost to acquire customers

2. Cost to provide goods and services

3. Cost to maintain customers

4. Cost to retain customers

ABC provides a better understanding of the cost

of these activities

Page 15: Chapter 7 Differential Cost Analysis (aka Incremental Analysis) for Operating Decisions

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Build a Chart of Activities to Compute Customer Costs

Customer Cost Activities

Acquire ◊Promote Product◊Win Back Lost Customers◊Run Advertising Campaigns

Provide Goods &

Services

◊Process Order◊Deliver Product◊Process Returns

Maintain ◊Bill Customers◊Process Payments◊Issue Refunds

Retain ◊Follow-up Calls

Page 16: Chapter 7 Differential Cost Analysis (aka Incremental Analysis) for Operating Decisions

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Comment on Decisions when Scarce Resources are Limited

• One of the most difficult decisions a

manager must make is how to allocate

scarce resources among multiple

products.

• The decisions is not based upon which

product has the largest selling price or

profit.

Page 17: Chapter 7 Differential Cost Analysis (aka Incremental Analysis) for Operating Decisions

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Decisions with Scarce Resources

• The manager must determine how much contribution

margin each product makes per unit of the scarce

resource.

• Once that is done the manager decides which product

makes the most contribution margin for equal amounts

of scarce resource.

• The product that makes the most contribution margin

per unit of the scarce resource is the product to make.

Page 18: Chapter 7 Differential Cost Analysis (aka Incremental Analysis) for Operating Decisions

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Define the Following

• Theory of Constraints

Focusing on increasing incremental revenue over incremental costs when bottlenecks exist

• Bottleneck

When work performed at an operation equals or exceeds its capacity

Page 19: Chapter 7 Differential Cost Analysis (aka Incremental Analysis) for Operating Decisions

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List the Five Steps to Managing Bottlenecks

1. Recognize bottlenecks determine throughput for the whole plant

2. Search for the bottlenecks by finding where inventory backs up

3. Subordinate non-bottleneck resources to bottleneck resources

4. Increase bottleneck capacity and efficiency

5. Repeat steps 1 through 4 for new bottlenecks

Page 20: Chapter 7 Differential Cost Analysis (aka Incremental Analysis) for Operating Decisions

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Explain Make or Buy Decisions

• Companies have the option of deciding to

meet needs internally or to acquire goods

or services externally (outsourcing)

• You should compare the relevant costs of

making to buying. The lower cost is the

better alternative, all other things being

equal. Only costs that differ between the

alternatives are relevant costs.

Page 21: Chapter 7 Differential Cost Analysis (aka Incremental Analysis) for Operating Decisions

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Define the Following

• Split-Off Point

Is the point at which multiple identifiable products emerge from a joint process

• Joint Costs

Are costs incurred up to the split-off point, they must be allocated to the multiple products

• Additional Processing Costs

Costs occurring after the split-off point

Page 22: Chapter 7 Differential Cost Analysis (aka Incremental Analysis) for Operating Decisions

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How do you decide whether to process further or not?

• List additional revenue of products if processed further

• List additional costs of products if processed further

• Subtract additional costs from additional revenue: if positive, then process further; if negative do not process further

Page 23: Chapter 7 Differential Cost Analysis (aka Incremental Analysis) for Operating Decisions

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Make or Buy

Outsourcing: The decision to buy parts or services rather than making them

Example:Baron Co. incurs the following costs to make 25,000 switches:

Switches can be purchased for $8 per switch ($200,000) Eliminates all variable costs and $10,000 of fixed

costs; however, $50,000 of fixed costs remain

Page 24: Chapter 7 Differential Cost Analysis (aka Incremental Analysis) for Operating Decisions

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Make or Buy Example (Continued)

Based on analysis of costs under both alternatives: Purchasing adds $25,000 to cost of switches

Net Income Make Buy Increase (Decrease)Direct materials $ 50,000 $ - 0 - $ 50,000 Direct labor 75,000 - 0 - 75,000 Variable manufacturing costs 40,000 - 0 - 40,000 Fixed manufacturing costs 60,000 50,000 10,000 Purchase price -0- 200,000 (200,000) Total annual cost $225,000 $250,000 $ (25,000)

Decision: Continue to make switches.

Page 25: Chapter 7 Differential Cost Analysis (aka Incremental Analysis) for Operating Decisions

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Opportunity CostsExample – Baron Company Continued

Assume that buying the switches allows Baron to use the released capacity to generate $28,000 additional income.

Thus, the $28,000 lost income is an additional cost of making the switches

Net Income Make Buy Increase (Decrease)Total annual cost $225,000 $250,000 $(25,000) Opportunity cost 28,000 - 0 - 28,000 Total cost $253,000 $250,000 $ 3,000

Decision: Based on the analysis, Baron should buy the switches

as the company will be $3,000 better off.

Page 26: Chapter 7 Differential Cost Analysis (aka Incremental Analysis) for Operating Decisions

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Sell or Process Further

Manufacturers may have to decide, at a given point in production, whether to sell now or to process further and sell at a higher price later.

Decision Rule:Process further as long as the incremental revenue from such processing exceeds the incremental processing costs

Page 27: Chapter 7 Differential Cost Analysis (aka Incremental Analysis) for Operating Decisions

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Sell or Process FurtherSingle-Product Case

Cost to manufacture one unfinished table:Direct materials $15Direct labor 10Variable manufacturing overhead 6Fixed manufacturing overhead 4Manufacturing cost per unit $35

Selling price of unfinished unit is $50 Unused capacity will be used to finish the tables

and sell them for $60 per table. Relevant unit costs of finishing tables:

Direct materials increase $2 Direct labor increase $4 Variable manufacturing overhead costs increase

by $2.40 (60 percent of direct labor increase) Fixed manufacturing costs will not increase

Page 28: Chapter 7 Differential Cost Analysis (aka Incremental Analysis) for Operating Decisions

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Sell or Process FurtherSingle-Product Case (Continued)

Process Net Income Sell Further Increase (Decrease)Sales per unit $50.00 $60.00 $10.00 Cost per unit Direct materials 15.00 17.00 (2.00) Direct labor 10.00 14.00 (4.00) Variable manufacturing overhead 6.00 8.40 (2.40) Fixed manufacturing overhead 4.00 4.00 - 0 - Total $35.00 $43.40 $(8.40) Net income per unit $15.00 $16.60 $1.60

Decision: Process further.

Incremental revenue ($10) exceeds incremental processing costs ($8.40); income increases $1.60 per unit

Page 29: Chapter 7 Differential Cost Analysis (aka Incremental Analysis) for Operating Decisions

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Sell or Process FurtherMultiple-Product Case

Incremental analysis is especially appropriate when multiple products are produced simultaneously

Many end-products are produced from a single raw material and a common production process

Joint products – are when you have multiple end products

Petroleum – gasoline, lubricating oil, kerosene Joint costs

Are all costs incurred prior to split-off point

And are allocated to individual products based on relative sales value

Joint costs are sunk costs for sell or process further decisions.

Page 30: Chapter 7 Differential Cost Analysis (aka Incremental Analysis) for Operating Decisions

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Sell or Process FurtherMultiple-Product Case

Example - Marais Creamery decision:

Sell cream and skim milk

or

Process them further before selling

Page 31: Chapter 7 Differential Cost Analysis (aka Incremental Analysis) for Operating Decisions

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Sell or Process FurtherMultiple-Product Case – Example

(Continued)

Process Net Income Sell Further Increase (Decrease)Sales per day $19,000 $27,000 $ 8,000 Cost per day Processing cream into cottage cheese - 0 - 10,000 (10,000) $19,000 $17,000 $ (2,000)

Sell cream or process further into cottage cheese? Joint cost allocated to cream $ 9,000 Processing cream into cottage cheese $10,000 Expected revenue per day:

Cream $19,000 Cottage cheese $27,000

Decision: Do not process the cream further.Incremental revenue ($8,000) is less than incremental costs

($10,000); income decreases $2,000.

Page 32: Chapter 7 Differential Cost Analysis (aka Incremental Analysis) for Operating Decisions

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Sell or Process FurtherMultiple-Product Case – Example

(Continued)

Process Net Income Sell Further Increase (Decrease)Sales per day $11,000 $26,000 $ 15,000 Cost per day Processing skim milk into condensed milk - 0 - 8,000 ( 8,000) $11,000 $18,000 $ 7,000

Sell skim milk or process further into condensed milk? Joint cost allocated to skim milk $ 5,000 Processing skim milk into condensed milk $ 8,000 Expected revenue per day:

Skim milk $11,000 Condensed milk $26,000

Decision: Process the skim milk further.Incremental revenue ($15,000) exceeds incremental costs

($8,000); income increases $7,000.

Page 33: Chapter 7 Differential Cost Analysis (aka Incremental Analysis) for Operating Decisions

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Eliminate an Unprofitable Segment

Key: Focus on relevant costs

Consider effect on related product lines

Determine if fixed costs allocated to the unprofitable segment must be absorbed by the other segments

Net income may decrease when an unprofitable segment is eliminated

Decision Rule:

Retain the segment unless fixed costs eliminated exceed the contribution margin lost

Page 34: Chapter 7 Differential Cost Analysis (aka Incremental Analysis) for Operating Decisions

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Eliminate an Unprofitable Segment

Example – Martina Company Manufactures three models of tennis racquets:

Profitable lines: Pro and Master Unprofitable line: Champ Champs fixed costs are not eliminated

Condensed Income Statement data:

Should Champ be eliminated?

Pro Master Champ Total Sales $800,000 $300,000 $100,000 $1,200,000Variable expenses 520,000 210,000 90,000 820,000Contribution margin 280,000 90,000 10,000 380,000Fixed expenses 80,000 50,000 30,000 160,000Net income $200,000 $ 40,000 $(20,000) $ 220,000

Page 35: Chapter 7 Differential Cost Analysis (aka Incremental Analysis) for Operating Decisions

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Eliminate an Unprofitable Segment

Example (Continued)

If Champ is eliminated, allocate its $30,000 fixed costs:

2/3 to Pro and 1/3 to Master Revised Income Statement data:

Total income has decreased by $10,000 ($220,000 - $210,000)

Pro Master Total Sales $800,000 $300,000$1,100,000Variable expenses 520,000 210,000 730,000Contribution margin 280,000 90,000 370,000Fixed expenses 100,000 60,000 160,000Net income $180,000 $ 30,000 $ 210,000

ELIMINATE CHAMP?

Page 36: Chapter 7 Differential Cost Analysis (aka Incremental Analysis) for Operating Decisions

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Eliminate an Unprofitable Segment

Example (Continued) Incremental analysis of Champ provides the same

results

The decrease in net income is due to Champ’s contribution margin ($10,000) that will not be realized if the segment is discontinued

ELIMINATE CHAMP? Net Income Continue Eliminate Increase (Decrease)Sales $100,000 $ - 0 - $(100,000) Variable expenses 90,000 - 0 - 90,000 Contribution margin 10,000 - 0 - (10,000) Fixed expenses 30,000 30,000 - 0 - Net income $(20,000) $ (30,000) $ (10,000)

Decision: Do not eliminate Champ. Decision: Do not eliminate Champ.

Page 37: Chapter 7 Differential Cost Analysis (aka Incremental Analysis) for Operating Decisions

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Allocate Limited Resources

Resources are always limited. For example: floor space for a retail firm raw material, direct labor hours, or

machine capacity for a manufacturing firm

Management must decide which products to make and sell to maximize net income

Page 38: Chapter 7 Differential Cost Analysis (aka Incremental Analysis) for Operating Decisions

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Allocate Limited Resources

Example – Collins Company Produces standard and deluxe pen and pencil sets Limiting resource – 3,600 machine hours per month

The deluxe set has the higher contribution margin: $8 The standard set takes fewer machine hours per unit

Deluxe set Standard setContribution margin per unit $8 $6Machine hours required 0.4 per unit 0.2 per unit

Page 39: Chapter 7 Differential Cost Analysis (aka Incremental Analysis) for Operating Decisions

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Allocate Limited ResourcesExample (Continued)

Must compute contribution margin per unit of limited

resource

The standard sets have higher contribution margin per unit of limited resources

Decision:Shift sales mix to standard sets or increase

machine capacity