Part 2 book “managerial accounting” has contents: differential analysis and product pricing, capital investment analysis, cost allocation and activity-based costing, cost management for just-in-time environments, statement of cash flows, financial statement analysis.
C H A P T E R © KEVIN P CASEY/ASSOCIATED PRESS Differential Analysis and Product Pricing R E A L N E T W O R K S , M any of the decisions that you make depend on comparing the estimated costs of alternatives The payoff from such comparisons is described in the following report from a University of Michigan study Richard Nisbett and two colleagues quizzed Michigan faculty members and university seniors on such questions as how often they walk out on a bad movie, refuse to finish a bad meal, start over on a weak term paper, or abandon a research project that no longer looks promising They believe that people who cut their losses this way are following sound economic rules: calculating the net benefits of alternative courses of action, writing off past costs that can’t be recovered, and weighing the opportunity to use future time and effort more profitably elsewhere Among students, those who have learned to use cost-benefit analysis frequently are apt to have far better grades than their Scholastic Aptitude Test scores would have predicted Again, the more economics courses the students have, the more likely they are to apply cost-benefit analysis outside the classroom Dr Nisbett concedes that for many Americans, cost-benefit rules often appear to conflict with such traditional principles as “never give up” and “waste not, want not.” I N C Managers must also apply cost-benefit rules in making decisions affecting their business RealNetworks, Inc., the Internet-based music and game company, like most companies must choose between alternatives Examples of decisions faced by RealNetworks include whether it should expand or discontinue services, such as its recent decision to Mac-enable its digital music service, Rhapsody,® and whether to accept business at special prices, such as special pricing on its Helix Media Delivery System® Other decisions include whether to replace network equipment, develop its own software, or buy software from others In this chapter, differential analysis, which reports the effects of decisions on total revenues and costs, is discussed Practical approaches to setting product prices are also described and illustrated Finally, how production bottlenecks influence product mix and pricing decisions is discussed Source: Alan L Otten, “Economic Perspective Produces Steady Yields,” from People Patterns, The Wall Street Journal, March 31, 1992, p B1 362 Chapter Differential Analysis and Product Pricing After studying this chapter, you should be able to: Prepare differential analysis reports for a variety of managerial decisions Determine the selling price of a product, using the total cost, product cost, and variable cost concepts Differential Analysis Setting Normal Product Selling Prices Lease or Sell EE 9-1 (page 365) Discontinue a Segment or Product EE 9-2 (page 367) Make or Buy EE (page 368) 9-3 Replace Equipment EE 9-4 (page 370) Process or Sell EE 9-5 (page 371) Accept Business at a Special Price Total Cost Concept EE (page 375) 9-7 Compute the relative profitability of products in bottleneck production processes Production Bottlenecks, Pricing, and Profits Production Bottlenecks and Profits Product Cost Concept EE 9-10 (page 382) EE 9-8 (page 377) Production Bottlenecks and Pricing Variable Cost Concept EE 9-9 (page 379) Choosing a Cost-Plus Approach Cost Concept Activity-Based Costing Target Costing EE 9-6 (page 372) At a Glance Prepare differential analysis reports for a variety of managerial decisions Menu Turn to pg 384 Differential Analysis Managerial decision making involves choosing between alternative courses of action Although the managerial decision-making process varies by the type of decision, it normally involves the steps shown at the top of page 363 The objective (Step 1) for most decisions is to maximize the company’s profits The alternative courses of action (Step 2) could include actions such as discontinuing an unprofitable segment, replacing equipment, or offering a product at a special price to an exporter The relevant information (Step 3) varies by decision, but oftentimes Chapter The management of Delta Air Lines decided to discontinue its low-fare Song Airline subsidiary after assessing its profitability Differential Analysis and Product Pricing Step Identify the objective of the decision Step Make a decision Step Identify the alternative courses of action Step Review, analyze, and assess the results of the decision 363 Step Gather relevant information Have you ever walked out on a bad movie? The cost of the ticket is a sunk cost and, thus, irrelevant to the decision to walk out early includes estimates and data that are not available in the accounting records Making decisions (Step 4) is the most important function of managers Once the decision is made, the results of the decision (Step 5) should be reviewed, analyzed, and assessed in terms of the initial objective of the decision Accounting facilitates the preceding process by: Gathering relevant information for managerial decisions Reporting this information to management Providing management feedback on the results of the decisions For managerial decisions, estimated future revenues and costs are relevant Costs that have been incurred in the past are not relevant to the decision These costs are called sunk costs Differential revenue is the amount of increase or decrease in revenue that is expected from a course of action as compared to an alternative To illustrate, assume that equipment can be used to manufacture digital clocks or calculators The estimated revenue from each product is as follows: Estimated Revenue Product Digital clocks Calculators Differential revenue $175,000 150,000 $ 25,000 The differential revenue from making and selling digital clocks is $25,000 Differential cost is the amount of increase or decrease in cost that is expected from a course of action as compared to an alternative For example, if increasing advertising expenses from $100,000 to $150,000 is being considered, the differential cost is $50,000 Differential income (or loss) is the difference between the differential revenue and the differential costs Differential income indicates that a decision is expected to be profitable, while a differential loss indicates the opposite Differential analysis, sometimes called incremental analysis, focuses on the effect of alternative courses of action on revenues and costs An example of a reporting format for differential analysis is shown in Exhibit Exhibit Differential Analysis Differential revenue from alternatives: Revenue from alternative A Revenue from alternative B Differential revenue Differential cost of alternatives: Cost of alternative A Cost of alternative B Differential cost Net differential income or loss from alternatives $XXX XXX $XXX XXX $XXX XXX $XXX 364 Chapter Differential Analysis and Product Pricing In this chapter, differential analysis is illustrated for the following decisions: Leasing or selling equipment Discontinuing an unprofitable segment Manufacturing or purchasing a needed part Replacing fixed assets Processing further or selling a product Accepting additional business at a special price Lease or Sell 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 To illustrate, assume that Marcus Company is considering leasing or disposing of the following equipment: Cost of equipment Less accumulated depreciation Book value $200,000 120,000 $ 80,000 Lease Option: Total revenue for five-year lease Total estimated repair, insurance, and property tax expenses during life of lease Residual value at end of fifth year of lease Sell Option: Sales price Commission on sales $160,000 35,000 $100,000 6% Exhibit shows the differential analysis of whether to lease or sell the equipment Exhibit Differential Analysis Report—Lease or Sell Many companies that manufacture expensive equipment give customers the choice of leasing the equipment For example, construction equipment from Caterpillar can either be purchased outright or leased through Caterpillar’s financial services subsidiary Proposal to Lease or Sell Equipment June 22, 2010 Differential revenue from alternatives: Revenue from lease Revenue from sale Differential revenue from lease Differential cost of alternatives: Repair, insurance, and property tax expenses from lease Commission expense on sale ($100,000 ϫ 6%) Differential cost of lease Net differential income from the lease alternative $160,000 100,000 $60,000 $ 35,000 6,000 29,000 _ $31,000 _ _ Exhibit includes only the differential revenues and differential costs associated with the lease or sell decision The $80,000 book value ($200,000 Ϫ $120,000) of the equipment is a sunk cost and is not considered in the differential analysis shown in Exhibit In other words, the $80,000 does not affect the decision to lease or sell the equipment This analysis is verified by the more traditional analysis shown in Exhibit To simplify, the following factors were not considered in Exhibits and 3: Differential revenue from investing funds Differential income tax Differential revenue (interest) could arise from investing the cash created by the two alternatives Differential income tax could arise from differences in the timing of the income from the two alternatives and differences in the amount that is taxed These factors are discussed in Chapter 10 Chapter Differential Analysis and Product Pricing 365 Exhibit Traditional Analysis Lease or Sell Lease alternative: Revenue from lease Depreciation expense for remaining five years Repair, insurance, and property tax expenses Net gain Sell alternative: Sales price Book value of equipment Commission expense Net gain Net differential income from the lease alternative Example Exercise 9-1 $160,000 $80,000 35,000 _ 115,000 $45,000 $100,000 $80,000 6,000 _ 86,000 14,000 _ $31,000 _ _ Lease or Sell Casper Company owns office space with a cost of $100,000 and accumulated depreciation of $30,000 that can be sold for $150,000, less a 6% broker commission Alternatively, the office space can be leased by Casper Company for 10 years for a total of $170,000, at the end of which there is no residual value In addition, repair, insurance, and property tax that would be incurred by Casper Company on the rented office space would total $24,000 over the 10 years Determine the differential income or loss from the lease alternative for Casper Company Follow My Example 9-1 Differential revenue from alternatives: Revenue from lease Revenue from sale Differential revenue from lease Differential cost of alternatives: Repair, insurance, and property tax expenses from lease Commission expense on sale Differential cost of lease Net differential income from the lease alternative $170,000 150,000 $20,000 $ 24,000 9,000 15,000 _ $ 5,000 _ _ For Practice: PE 9-1A, PE 9-1B Discontinue 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 In such cases, it may be erroneously assumed that the total company income will increase by eliminating the operating loss Discontinuing the product or segment usually eliminates all of the product’s or segment’s variable costs Such costs include 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 To illustrate, the income statement for Battle Creek Cereal Co is shown in Exhibit As shown in Exhibit 4, Bran Flakes incurred an operating loss of $11,000 Because Bran Flakes has incurred annual losses for several years, management is considering discontinuing it 366 Chapter Differential Analysis and Product Pricing Exhibit Income (Loss) by Product Battle Creek Cereal Co Condensed Income Statement For the Year Ended August 31, 2010 Sales Cost of goods sold: Variable costs Fixed costs Total cost of goods sold Gross profit Operating expenses: Variable expenses Fixed expenses Total operating expenses Income (loss) from operations Corn Flakes Toasted Oats Bran Flakes Total Company $500,000 $400,000 $100,000 $1,000,000 $220,000 120,000 $340,000 $160,000 $200,000 80,000 $280,000 $120,000 $ 60,000 20,000 $ 80,000 $ 20,000 $ 480,000 220,000 $ 700,000 $ 300,000 $ 95,000 25,000 $120,000 $ 40,000 $ 60,000 20,000 $ 80,000 $ 40,000 $ 25,000 6,000 $ 31,000 $ (11,000) $ 180,000 51,000 $ 231,000 $ 69,000 If Bran Flakes is discontinued, what would be the total annual operating income of Battle Creek Cereal? The first impression is that total annual operating income would be $80,000, as shown below Income from operations Corn Flakes Toasted Oats Total Company $40,000 $40,000 $80,000 However, the differential analysis report in Exhibit indicates that discontinuing Bran Flakes actually decreases operating income by $15,000 This is because discontinuing Bran Flakes has no effect on fixed costs and expenses This is supported by the traditional analysis in Exhibit 6, which indicates that income from operations would decrease from $69,000 to $54,000 Exhibits and consider only the short-term (one-year) effects of discontinuing Bran Flakes When discontinuing a product or segment, long-term effects should also be considered For example, discontinuing Bran Flakes could decrease sales of other products This might be the case if customers upset with the discontinuance of Bran Flakes quit buying other products from the company Finally, employee morale and productivity might suffer if employees have to be laid off or relocated Exhibit Differential Analysis Report— Discontinue an Unprofitable Segment Proposal to Discontinue Bran Flakes September 29, 2010 Differential revenue from annual sales of Bran Flakes: Revenue from sales Differential cost of annual sales of Bran Flakes: Variable cost of goods sold Variable operating expenses Annual differential income from sales of Bran Flakes $100,000 $60,000 25,000 85,000 $ 15,000 Chapter 367 Differential Analysis and Product Pricing Exhibit Traditional Analysis Proposal to Discontinue Bran Flakes September 29, 2010 Sales Cost of goods sold: Variable costs Fixed costs Total cost of goods sold Gross profit Operating expenses: Variable expenses Fixed expenses Total operating expenses Income (loss) from operations Bran Flakes, Toasted Oats, and Corn Flakes Discontinue Bran Flakes* Toasted Oats and Corn Flakes $1,000,000 $100,000 _ $900,000 _ $ 480,000 220,000 $ 700,000 $ 300,000 $ 60,000 — _ $ _ 60,000 $ _ 40,000 $420,000 220,000 _ $640,000 _ $260,000 _ $ 180,000 51,000 $ 231,000 $ 69,000 $ 25,000 — $ 25,000 _ _ $ 15,000 _ _ $155,000 51,000 $206,000 $ 54,000 *Fixed costs are assumed to remain unchanged with the discontinuance of Bran Flakes Example Exercise 9-2 Discontinue a Segment Product A has revenue of $65,000, variable cost of goods sold of $50,000, variable selling expenses of $12,000, and fixed costs of $25,000, creating a loss from operations of $22,000 a b Determine the differential income or loss from sales of Product A Should Product A be discontinued? Follow My Example 9-2 a b Differential revenue from annual sales of Product A: Revenue from sales Differential cost of annual sales of Product A: Variable cost of goods sold Variable selling expenses Annual differential income from sales of Product A $65,000 $50,000 12,000 _ 62,000 _ $ 3,000 _ Product A should not be discontinued For Practice: PE 9-2A, PE 9-2B Make or Buy Ford Motor Co purchases spark plugs, GPS units, nuts, and bolts from suppliers Companies often manufacture products made up of components that are assembled into a final product For example, an automobile manufacturer assembles tires, radios, motors, interior seats, transmissions, and other parts into a finished automobile In such cases, the manufacturer 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 The analysis is similar whether management is considering making a part that is currently being purchased or purchasing a part that is currently being made 368 Chapter Differential Analysis and Product Pricing To illustrate, assume that an automobile manufacturer has been purchasing instrument panels for $240 a unit The factory is currently operating at 80% of capacity, and no major increase in production is expected in the near future The cost per unit of manufacturing an instrument panel internally is estimated as follows: Direct materials Direct labor Variable factory overhead Fixed factory overhead Total cost per unit $ 80 80 52 68 _ $280 _ _ If the make price of $280 is simply compared with the buy price of $240, the decision is to buy the instrument panel However, if unused capacity could be used in manufacturing the part, there would be no increase in the total fixed factory overhead costs Thus, only the variable factory overhead costs would be incurred The differential report for this make or buy decision is shown in Exhibit As shown in Exhibit 7, there is a cost savings from manufacturing the instrument panel of $28 per panel However, other factors should also be considered For example, productive capacity used to make the instrument panel would not be available for other production The decision may also affect the future business relationship with the instrument panel supplier For example, if the supplier provides other parts, the company’s decision to make instrument panels might jeopardize the timely delivery of other parts Exhibit Differential Analysis Report—Make or Buy Proposal to Manufacture Instrument Panels February 15, 2010 Purchase price of an instrument panel Differential cost to manufacture: Direct materials Direct labor Variable factory overhead Cost savings from manufacturing an instrument panel Example Exercise 9-3 $240 $80 80 52_ _ 212_ $ 28 Make or Buy A company manufactures a subcomponent of an assembly for $80 per unit, including fixed costs of $25 per unit A proposal is offered to purchase the subcomponent from an outside source for $60 per unit, plus $5 per unit freight Provide a differential analysis of the outside purchase proposal Follow My Example 9-3 Differential cost to purchase: Purchase price of the subcomponent Freight for subcomponent Differential cost to manufacture: Variable manufacturing costs ($80 Ϫ $25 fixed costs) Cost savings from manufacturing subcomponent $60 $65 55 _ $10 _ _ For Practice: PE 9-3A, PE 9-3B Chapter Differential Analysis and Product Pricing 369 Replace Equipment 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 To illustrate, assume that a business is considering replacing the following machine: Old Machine Book value Estimated annual variable manufacturing costs Estimated selling price Estimated remaining useful life $100,000 225,000 25,000 years New Machine Cost of new machine Estimated annual variable manufacturing costs Estimated residual value Estimated useful life $250,000 150,000 years The differential report for the decision to replace the old machine is shown in Exhibit Exhibit Differential Analysis Report— Replace Machine Proposal to Replace Machine November 28, 2010 Annual variable costs—present machine Annual variable costs—new machine Annual differential decrease in cost Number of years applicable Total differential decrease in cost Proceeds from sale of present machine Cost of new machine Net differential decrease in cost, five-year total Annual net differential decrease in cost—new machine $225,000 150,000 _ $ 75,000 ϫ _ $375,000 25,000 _ $400,000 250,000 $150,000 $ 30,000 As shown in Exhibit 8, there is an annual decrease in cost of $30,000 ($150,000 Ϭ years) from replacing the old machine Thus, the decision should be to purchase the new machine and sell the old machine Other factors are often important in equipment replacement decisions For example, differences between the remaining useful life of the old equipment and the estimated life of the new equipment could exist In addition, the new equipment might improve the overall quality of the product and, thus, increase sales The time value of money and other uses for the cash needed to purchase the new equipment could also affect the decision to replace equipment.1 The revenue that is forgone from an alternative use of an asset, such as cash, is called an opportunity cost Although the opportunity cost is not recorded in the accounting records, it is useful in analyzing alternative courses of action To illustrate, assume that in the preceding illustration the cash outlay of $250,000 for the new machine, less the $25,000 proceeds from the sale of the old machine, could be invested to yield a 15% return Thus, the annual opportunity cost related to the purchase of the new machine is $33,750 (15% ϫ $225,000) Since the opportunity cost of $33,750 exceeds the annual cost savings of $30,000, the old machine should not be replaced The time value of money in purchasing equipment (capital assets) is discussed in Chapter 10 370 Chapter Differential Analysis and Product Pricing RELATED-PARTY DEALS The make-or-buy decision can be complicated if the purchase (buy) is being made by a related party A related party is one in which there is direct or indirect control of one party over another or the presence of a family member in a transaction Such dependence or familiarity may interfere with the appropriateness of the business transaction One investor has said, “Related parties are akin to steroids used by athletes If you’re an athlete and you can cut the mustard, you Example Exercise 9-4 don’t need steroids to make yourself stronger or faster By the same token, if you’re a good company, you don’t need related parties or deals that don’t make sense.” While related-party transactions are legal, GAAP (FASB Statement No 56) and the SarbanesOxley Act require that they must be disclosed under the presumption that such transactions are less than arm’s length Source: Herb Greenberg, “Poor Relations: The Problem with Related-Party Transactions,” Fortune Advisor (February 5, 2001), p 198 Replace Equipment A machine with a book value of $32,000 has an estimated four-year life A proposal is offered to sell the old machine for $10,000 and replace it with a new machine at a cost of $45,000 The new machine has a four-year life with no residual value The new machine would reduce annual direct labor costs by $11,000 Provide a differential analysis on the proposal to replace the machine Follow My Example 9-4 Annual direct labor cost reduction Number of years applicable Total differential decrease in cost Proceeds from sale of old equipment Cost of new equipment Net differential decrease in cost from replacing equipment, four-year total $11,000 ϫ $44,000 10,000 Annual net differential decrease in cost—new equipment $54,000 45,000 _ $ _ 9,000 _ $ 2,250 For Practice: PE 9-4A, PE 9-4B 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 not change, regardless of whether the intermediate product is sold or processed further These costs are sunk costs and are irrelevant to the decision To illustrate, assume that a business produces kerosene as follows: Kerosene: Batch size Cost of producing kerosene Selling price 4,000 gallons $2,400 per batch $2.50 per gallon B-18 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