c8 - 1 learning objectives power notes 1.differential analysis 2.setting normal product selling...

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Learning Objectives

Power Notes

1. Differential Analysis2. Setting Normal Product Selling Prices3. Product Profitability and Pricing

Under Production Bottlenecks

Chapter M8

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Differential Analysis and Product PricingDifferential Analysis and Product Pricing

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• Differential Analysis Decisions• Setting Normal Product Selling Prices• Cost-Plus Methods of Product Pricing• Production Bottlenecks

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Chapter M8 Differential Analysis and Product PricingDifferential Analysis and Product Pricing

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Differential AnalysisDifferential Analysis

1. Leasing or selling equipment2. Discontinuing an unprofitable segment3. Manufacturing or purchasing a needed part4. Replacing usable fixed assets5. Processing further or selling an intermediate

product6. Accepting additional business at a special price

Differential analysis is used for analyzing:

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Proposal to Lease or Sell EquipmentJune 22, 2003

Differential revenue from alternatives:Revenue from lease $160,000Revenue from sales 100,000 Differential revenue from lease $60,000

Differential cost of alternatives:Repairs, insurance, taxes $ 35,000Commission expense on sale 6,000 Differential cost of lease 29,000

Net differential income from leasing $31,000

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Proposal to Lease or Sell EquipmentJune 22, 2003

Revenue from lease $160,000 Revenue from sales 100,000 Repairs, insurance, taxes (35,000)Commission expense on sale (6,000)

Totals $125,000 $94,000

Lease Sell

This alternative format separates the two options into columns. The net benefit is the same.

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Proposal to Lease or Sell EquipmentJune 22, 2003

Lease Sell

Revenue from lease $160,000 Revenue from sales 100,000 Repairs, insurance, taxes (35,000)Commission expense on sale (6,000)

Totals $125,000 $94,000 Net benefit from leasingNet benefit from leasing $31,000 $31,000

This analysis indicates that it would be better to lease the equipment rather then sell it. What other factors should be considered?

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Battle Creek Cereal Co.Condensed Income Statement

For the Year Ended August 31, 2003 Bran Corn Toasted Total Flakes Flakes

OatsSales $100,000 $500,000 $400,000 $1,000,000Cost of goods sold:

Variable costs $ 60,000 $220,000 $200,000 $ 480,000Fixed costs 20,000 120,000 80,000 220,000 Total cost of goods sold $ 80,000 $340,000 $280,000 $ 700,000

Gross profit $ 20,000 $160,000 $120,000 $ 300,000Operating expenses:

Variable expenses $ 25,000 $ 95,000 $ 60,000 $ 180,000Fixed expenses 6,000 25,000 20,000 51,000 Total operating expenses $ 31,000 $120,000 $ 80,000 $ 231,000

Income (loss) from operations$ (11,000) $ 40,000 $ 40,000 $ 69,000

Should Bran Flakes be discontinued?

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Battle Creek Cereal Co.Condensed Income Statement

For the Year Ended August 31, 2003Bran Corn Toasted Total Flakes Flakes

Oats

Differential itemsDifferential items

Should Bran Flakes be discontinued?

SalesSales $100,000$100,000 $500,000 $400,000 $1,000,000Cost of goods sold:

Variable costs $ 60,000 $220,000 $200,000 $ 480,000Fixed costs 20,000 120,000 80,000 220,000 Total cost of goods sold $ 80,000 $340,000 $280,000 $ 700,000

Gross profit $ 20,000 $160,000 $120,000 $ 300,000Operating expenses:

Variable expenses $ 25,000 $ 95,000 $ 60,000 $ 180,000Fixed expenses 6,000 25,000 20,000 51,000 Total operating expenses $ 31,000 $120,000 $ 80,000 $ 231,000

Income (loss) from operations$ (11,000) $ 40,000 $ 40,000 $ 69,000

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Battle Creek Cereal Co.Condensed Income Statement

For the Year Ended August 31, 2003

Should Bran Flakes be discontinued?

Bran Corn Toasted Total Flakes Flakes

OatsDifferential itemsDifferential items

SalesSales $100,000$100,000 $500,000 $400,000 $1,000,000Cost of goods sold:

Variable costsVariable costs $ 60,000$ 60,000 $220,000 $200,000 $ 480,000Fixed costs 20,000 120,000 80,000 220,000 Total cost of goods sold $ 80,000 $340,000 $280,000 $ 700,000

Gross profit $ 20,000 $160,000 $120,000 $ 300,000Operating expenses:

Variable expenses $ 25,000 $ 95,000 $ 60,000 $ 180,000Fixed expenses 6,000 25,000 20,000 51,000 Total operating expenses $ 31,000 $120,000 $ 80,000 $ 231,000

Income (loss) from operations$ (11,000) $ 40,000 $ 40,000 $ 69,000

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Battle Creek Cereal Co.Condensed Income Statement

For the Year Ended August 31, 2003Bran Corn Toasted Total Flakes Flakes

Oats

Differential itemsDifferential items

SalesSales $100,000$100,000 $500,000 $400,000 $1,000,000Cost of goods sold: Variable costsVariable costs $ 60,000$ 60,000 $220,000 $200,000 $ 480,000

Fixed costs 20,000 120,000 80,000 220,000 Total cost of goods sold $ 80,000 $340,000 $280,000 $ 700,000

Gross profit $ 20,000 $160,000 $120,000 $ 300,000Operating expenses:

Variable expensesVariable expenses $ 25,000 $ 25,000 $ 95,000 $ 60,000 $ 180,000Fixed expenses 6,000 25,000 20,000 51,000 Total operating expenses $ 31,000 $120,000 $ 80,000 $ 231,000

Income (loss) from operations$ (11,000) $ 40,000 $ 40,000 $ 69,000If Bran Flakes are discontinued, how would net income be affected?

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Battle Creek Cereal Co.Condensed Income Statement

For the Year Ended August 31, 2003

Differential itemsDifferential items Bran Corn Toasted Total Flakes Flakes

OatsSalesSales $100,000$100,000 $500,000 $400,000 $1,000,000Cost of goods sold: Variable costsVariable costs $ 60,000$ 60,000 $220,000 $200,000 $ 480,000

Fixed costs 20,000 120,000 80,000 220,000 Total cost of goods sold $ 80,000 $340,000 $280,000 $ 700,000

Gross profit $ 20,000 $160,000 $120,000 $ 300,000Operating expenses:

Variable expensesVariable expenses $ 25,000 $ 25,000 $ 95,000 $ 60,000 $ 180,000Fixed expenses 6,000 25,000 20,000 51,000 Total operating expenses $ 31,000 $120,000 $ 80,000 $ 231,000

Income (loss) from operations$ (11,000) $ 40,000 $ 40,000 $ 69,000If Bran Flakes are discontinued, $15,000 of net income will be lost and overall net income would be reduced to $54,000.

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Annual variable costs—present $225,000Annual variable costs—new equip. 150,000Annual differential decrease in cost $ 75,000Number of years applicable x 5Total differential decrease in cost $375,000Proceeds from sale of present equipment 25,000 $400,000Cost of new equipment 250,000Net differential decrease in cost, 5-years $150,000Annual net differential—new equipment $ 30,000

Proposal to Replace EquipmentNovember 28, 2003

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Proposal to Replace EquipmentNovember 28, 2003

Present NewEquipment Equipment

This analysis indicates that it would be better to replace the existing equipment. What other factors should be considered?

Annual variable costs $ 225,000 $150,000 Number of years applicable x 5 x 5 Total variable costs $1,125,000 $750,000 Cost of new equipment 250,000 Less proceeds from sale (25,000) Total costs $1,125,000 $975,000 Net total benefit to replace $150,000 Net annual benefit to replaceNet annual benefit to replace $ 30,000 $ 30,000

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Differential revenue from further processing per batch:Revenue from sale of gasoline [(4,000 gallons - 800 gallons evaporation) x $1.25] $4,000Revenue from sale of kerosene (4,000 gallons x $0.80) 3,200

Differential revenue $800Differential cost per batch:

Additional cost of producing gasoline 650Differential income from further processing gasoline per batch $150

Proposal to Process Kerosene FurtherOctober 1, 2003

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Setting Normal Product Selling PricesSetting Normal Product Selling Prices

1. Demand-based methods2. Competition-based methods

1. Total cost concept2. Product cost concept3. Variable cost concept

Cost-Plus MethodsCost-Plus Methods

Market MethodsMarket Methods

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Per Unit TotalCost Cost

Cost Structure Example (100,000 units)Cost Structure Example (100,000 units)

Variable Costs:Direct materials $ 3.00 $ 300,000Direct labor 10.00 1,000,000Factory overhead 1.50 150,000Selling and admin. 1.50 150,000

Fixed Costs:Factory overhead .50 50,000Selling and admin. .20 20,000

Total costs $16.70 $1,670,000Product costs $15.00 $1,500,000Variable costs $16.00 $1,600,000

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Per Unit TotalCost Cost

Cost Structure Example (100,000 units)Cost Structure Example (100,000 units)

Variable Costs:Direct materials $ 3.00 $ 300,000Direct labor 10.00 1,000,000Factory overhead 1.50 150,000Selling and admin. 1.50 150,000

Fixed Costs:Factory overhead .50 50,000Selling and admin. .20 20,000

Total costs $16.70 $1,670,000Product costs $15.00 $1,500,000Variable costs $16.00 $1,600,000

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Per Unit TotalCost Cost

Cost Structure Example (100,000 units)Cost Structure Example (100,000 units)

Variable Costs:Direct materials $ 3.00 $ 300,000Direct labor 10.00 1,000,000Factory overhead 1.50 150,000Selling and admin. 1.50 150,000

Fixed Costs:Factory overhead .50 50,000Selling and admin. .20 20,000

Total costs $16.70 $1,670,000Product costs $15.00 $1,500,000Variable costs $16.00 $1,600,000

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Selling Price:Desired profit $ 1.60 $ 160,000Total to markup $ 1.60 $ 160,000Total costs 16.70 1,670,000 Selling price $18.30 $1,830,000

Markup Percentage:Markup amount $1.60 Total costs $16.70

Per Unit Total

Total Cost ConceptTotal Cost Concept

= 9.6%

Only the desired profit is covered in the markup.

=

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Per Unit TotalSelling Price:Desired profit $ 1.60 $ 160,000Total to markup $ 1.60 $ 160,000Total costs 16.70 1,670,000 Selling price $18.30 $1,830,000

Markup Percentage:Markup amount $1.60 Total costs $16.70

Total Cost ConceptTotal Cost Concept

= 9.6%

Markup on total cost

=

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Selling Price:Desired profit $ 1.60$ 160,000Selling and admin. 1.70170,000Total to markup $ 3.30$ 330,000Total product costs 15.001,500,000

Selling price $18.30$1,830,000

Markup Percentage:Markup amount $3.30 Product costs $15.00

Per Unit Total

Product Cost ConceptProduct Cost Concept

= 22.0%

The desired profit and selling and administrative costs are covered in the markup.

=

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Per Unit TotalSelling Price:Desired profit $ 1.60$ 160,000Selling and admin. 1.70170,000Total to markup $ 3.30$ 330,000Total product costs 15.001,500,000

Selling price $18.30$1,830,000

Markup Percentage:Markup amount $3.30 Product costs $15.00

Product Cost ConceptProduct Cost Concept

= 22.0%

Markup on product cost

=

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Selling Price:Desired profit $ 1.60$ 160,000Fixed costs .7070,000Total to markup $ 2.30$ 230,000Total variable costs 16.001,600,000

Selling price $18.30$1,830,000

Markup Percentage:Markup amount $2.30 Variable costs $16.00

Per Unit Total

Variable Cost ConceptVariable Cost Concept

= 14.4%

The desired profit and total fixed costs are covered in the markup.

=

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Per Unit TotalSelling Price:Desired profit $ 1.60$ 160,000Fixed costs .7070,000Total to markup $ 2.30$ 230,000Total variable costs 16.001,600,000

Selling price $18.30$1,830,000

Markup Percentage:Markup amount $2.30Variable costs $16.00

Variable Cost ConceptVariable Cost Concept

= 14.4%

Markup on variable cost

=

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Total Product Variable Cost Cost Cost

Cost amount per unit $16.70 $15.00 $16.00Markup percentage x 9.6% x 22.0% x 14.4%Markup amount $ 1.60 $ 3.30 $ 2.30Selling price $18.30 $18.30 $18.30

Product Pricing Using a Cost-Plus ApproachProduct Pricing Using a Cost-Plus Approach

The most common method

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Products—Unit Analysis Small Medium Large

Wrench Wrench WrenchSales price $130 $140 $160Variable cost 40 40 40Contribution margin $ 90 $100 $120

Profitability Under Production BottlenecksProfitability Under Production Bottlenecks

The process is currently operating at full capacity and is a production bottleneck.

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Sales price $130 $140 $160Variable cost 40 40 40Contribution margin $ 90 $100 $120Bottleneck hours 1 4 8

Products—Unit Analysis Small Medium Large

Wrench Wrench Wrench

Profitability Under Production BottlenecksProfitability Under Production Bottlenecks

The number of hours per unit for each product.

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Products—Unit Analysis Small Medium Large

Wrench Wrench Wrench

Profitability Under Production BottlenecksProfitability Under Production Bottlenecks

Contribution after dividing by the bottleneck hours.

Sales price $130 $140 $160 Variable cost 40 40 40 Contribution margin $ 90 $100 $120 Bottleneck hours 1 4 8 Bottleneck contribution $ 90 $ 25 $ 15

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Products—Unit Analysis Small Medium Large

Wrench Wrench WrenchSales price $130 $140 $160Variable cost 40 40 40 Contribution margin $ 90 $100 $120 Bottleneck hours 1 4 8 Bottleneck contribution $ 90 $ 25 $ 15

Profitability Under Production BottlenecksProfitability Under Production Bottlenecks

What price for Product C would equate its profitability to Product A?

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Products—Unit Analysis Small Medium Large

Wrench Wrench WrenchSales price $130 $140 $160 $760Variable cost 40 40 40 40Contribution margin $ 90 $100 $120 $720Bottleneck hours 1 4 8 8Bottleneck contribution $ 90 $ 25 $ 15 $ 90

Profitability Under Production BottlenecksProfitability Under Production Bottlenecks

A price of $760 will provide the same contribution as Product A.

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Power NotesChapter M8 Differential Analysis and Product PricingDifferential Analysis and Product Pricing