Chapter 04 – Fundamentals of Cost Analysis for Decision Making
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Chapter 4
Fundamentals of Cost Analysis for Decision Making
Learning Objectives
1. Use differential analysis to analyze decisions.
2. Understand how to apply differential analysis to pricing decisions.
3. Understand several approaches for establishing prices based on costs for long-run pricing
decisions.
4. Understand how to apply differential analysis to production decisions.
5. Understand the theory of constraints.
Chapter Outline
I. DIFFERENTIAL ANALYSIS
A. Differential costs versus total costs
B. Differential analysis and pricing decisions
• The full-cost fallacy in setting prices
C. Short-run versus long-run pricing decisions
D. Short-run pricing decisions: Special orders
E. Long-run pricing decisions
F. Long-run versus short-run pricing: Is there a difference?
G. Cost analysis for pricing
1. Life-cycle product costing and pricing
2. Target costing from target pricing
H. Legal issues relating costs and sales prices
1. Predatory pricing
2. Dumping
3. Price discrimination
4. Peak-load pricing
5. Price fixing
II. USE OF DIFFERENTIAL ANALYSIS FOR PRODUCTION DECISIONS
A. Make-it or buy-it decisions
B. Make-or-buy decisions involving differential fixed costs
C. Opportunity costs of making
D. Decision to add or drop a product line or close a business unit
• Nonfinancial considerations of closing a business unit
E. Product choice decisions
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III. THE THEORY OF CONSTRAINTS
IV. SUMMARY
Key Concepts
LO 4-1 Use differential analysis to analyze decisions.
♦ Some common business decisions require an understanding of
(1) the effect of the decision on the organization’s revenues and costs, and
(2) the business and competitive environment.
• The decisions under consideration include:
How much business was required to be profitable?
How to price special orders?
Whether to do something in-house or outsource it to another firm?
Whether to drop one of the products?
What was the right product mix?
♦ Differential analysis refers to the process of estimating revenues and costs of alternative
actions available to decision makers and of comparing these estimates to the status quo.
• Every decision that a manager makes requires comparing one or more proposed
alternatives with the status quo.
• Differential analysis may be applicable for both short-run and long-run decisions.
• Short run is defined as the period of time over which capacity will be unchanged,
generally one year. Beyond that time frame, long-run considerations will apply.
• Both short-run and long-run decisions are concerned with the amount of cash flow.
Short-run decisions usually ignore the timing issues because the time value of money is
immaterial. For long-run decisions, the timing of cash flow is a significant factor. Time
value of money will be discussed in the Appendix to the book.
• The In Action box considers the impacts of cost analysis on the choice of office space
for a small business.
♦ Differential costs are costs that differ among alternatives. Differential costs change in
response to alternative courses of action.
Chapter 04 – Fundamentals of Cost Analysis for Decision Making
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• Both variable and fixed costs may be differential costs. All relevant facts for each
alternative should be examined to determine which costs will be affected, and therefore
differential.
• Variable costs are differential when a decision involves possible changes in volume.
• All of the affected costs are considered differential.
• Sunk costs are costs incurred in the past that cannot be changed by present or future
decisions. Sunk costs are not differential and, therefore, not relevant for decision making.
♦ For decision making purposes, the information for alternatives may be presented to managers
using either the total format, in which the detailed costs are included, or the differential format,
in which only the differences between alternatives are shown.
• There are two major advantages of using the total format:
(1) All the information is available so it is easy to derive the differential format if desired;
(2) When a particular alternative is chosen, the information about the resources required
for implementation is readily available.
• The advantage of the differential format is that it highlights the differences between
alternatives.
LO 4-2 Understand how to apply differential analysis to pricing decisions.
♦ Prices are determined by supply and demand. Pricing decisions, which impact profits, allow
managers to determine whether to sell goods and/or provide services in the market, thereby
contributing to the supply curve.
♦ Full (product) cost is defined as the sum of the fixed and variable costs of manufacturing and
selling a unit.
• Full cost includes both
(1) the variable costs of producing and selling the product, and
(2) a share of the organization’s fixed costs.
• From the cost equation (TC = F + VX) in CVP analysis, full cost can be expressed as
Chapter 04 – Fundamentals of Cost Analysis for Decision Making
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F VX
X
=
F
X
+ V, where
V = Variable cost per unit,
X = Units of output, and
F = Fixed costs.
• In this setup, the fixed costs are unitized (i.e., divided by the units of output) and added
to the variable cost per unit to come up with the full cost. For short-run decisions (such as
whether to accept special orders), the fixed cost component generally is not differential
and should not be considered. The use of full cost for some short-run decisions will
erroneously render the alternative option less attractive, creating what is known as “the
full-cost fallacy.”
• In the long run, all costs must be covered or the company will fail.
Example 1: On a particular month, U-Develop receives a special order from an out-of-
town merchant who is willing to pay $4,000 for 10,000 photo prints developed, or
$0.40 per print. An analysis of U-Develop’s cost structure shows that it incurs variable
cost of $0.36 per print and $1,500 monthly fixed cost. U-Develop can handle the
special order without affecting its regular business.
The full cost of the special order is calculated by an employee as follows.
$1,500 $0.36 10,000
10,000

= $0.51 per print.
By unitizing the fixed cost, the full cost calculation gives the impression that the
special order is not a profitable one as the unit cost of $0.51 per print is higher than the
unit price offered of $0.40.
However, since the monthly fixed cost of $1,500 remains the same with or without the
special order, the differential cost relevant for this decision context is the variable cost
of $0.36 per print. Therefore, the special order should be accepted, netting an
additional profit of $400 (= ($0.40 – $0.36) × 10,000 prints) for the month. The “full–
cost fallacy” is avoided.
♦ Short-run pricing decisions include
(1) pricing for a one-time-only special order without long-term implications, and
(2) adjusting product mix and volume in a competitive market.
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• Long-run pricing decisions include pricing a main product in a large market in which
price setting has considerable leeway.
♦ Special order represents an order that will not affect other sales and is usually a short-run
occurrence. Exhibit 4.1 provides a framework for decision making in this context. Two options
are presented: status quo (reject special order) vs. alternative (accept special order). The option
that provides the highest economic value should be chosen.
• As seen in Exhibit 4.2, both the differential format and the total format work well to
resolve the special-order problem.
• For typical short-run decisions, fixed costs are not differential and therefore not relevant.
• The differential approach leads to correct short-run pricing decisions.
• The differential approach indicates only a minimum acceptable price for both the short
run and the long run. Given the market conditions, the firm may choose to charge a
higher price.
• A special order is usually acceptable when idle capacity is adequate for the job and
when the regular sales are not affected. If idle capacity is not available, then the costs of
additional personnel and machinery to tackle the job, both variable and fixed, must be
considered. If accepting the special order may adversely influence the regular sales, then
the lost sales due to the special order should also be considered.
• Financial analyses only look at factors that can be quantified. Nonfinancial issues must
be considered as well before a final decision is reached.
======================
Demonstration Problem 1
Nationwide Windows can produce 10,000 windows per year. Its normal year of operations
involves the following:
Sales (8,000 units @ $220)
$1,760,000
Manufacturing cost
Variable per unit
150
Fixed
260,000
Selling and administrative cost
Variable (commission) per unit on
sales
12
Fixed
60,000
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During the year, Nationwide is approached by a contractor to buy 1,500 windows for $165 each.
The variable sales commission is set to be a flat fee of $12,000 for the special order. The fixed
costs are not affected by the decision.
Required:
1. Should Nationwide Windows accept the special order? Explain.
2. If the contractor needs instead a total of 2,500 windows and still pays $165 each (all other
information remains the same), should Nationwide accept the special order? Explain.
Solution:
1. The special order should be accepted, because it generates the additional profit of
$10,500.
Status Quo
(Do not accept)
Alternative
(Accept)
Difference
$1,760,000
$2,007,500
$247,500
(1,296,000)
(1,521,000)
(225,000)
$464,000
$486,500
$22,500
(320,000)
(332,000)
(12,000)
$144,000
$154,500
$10,500
2. The special order should be rejected because of the net loss of $3,500 relative to the
status quo. By accepting the special order, Nationwide can only sell 7,500 windows at the
regular price of $220 each. The rest (up to its capacity limit of 10,000 windows per year)
will be delivered to the contractor for $165 each.
Status Quo
(Do not accept)
Alternative
(Accept)
Difference
$1,760,000
$2,062,500a
$302,500
(1,296,000)
(1,590,000)b
(294,000)
$464,000
$472,500
$8,500
(320,000)
(332,000)c
(12,000)
$144,000
$140,500
$(3,500)
a $220 × 7,500 + $165 × 2,500 = $2,062,500
b $162 × 7,500 + $150 × 2,500 = $1,590,000
c $260,000 + $60,000 + $12,000 = $332,000
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Chapter 04 – Fundamentals of Cost Analysis for Decision Making
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LO 4-3 Understand several approaches for establishing prices based on costs
for long-run pricing decisions.
♦ Full cost includes all costs incurred by the activities that make up the value chain to produce
and sell a unit. The marketing department receives cost reports from the accounting department,
and then adds markups to determine benchmark or target prices for all products the firm
normally sells. This approach is known as the cost-plus pricing.
• Pricing decisions based on full cost may be appropriate when
(1) a long-term contractual relationship is established to supply a product and both the
variable and the fixed costs are specified in the contract,
(2) dealing with government procurements, customized products or regulated industries
in which full cost plus a markup determines product prices, or
(3) full-cost-based prices are adjusted upward or downward to reflect short-term market
conditions.
• For unique products in construction, defense, custom orders, and many new products,
full costs plus a markup become the basis for pricing as well as bidding on a job.
♦ Based on the differential analysis, short-run prices may be low enough just to cover the
variable costs of providing one additional unit of goods or services, much like the concept of
marginal cost in economics. On the other hand, long-run prices have to be much higher so that
both the variable and fixed costs can be recovered and still make a profit. This will ensure a
firm’s long-term survival.
• A common saying in business: “I can drop my price to just cover variable costs in the
short run, but in the long run, my prices have to cover full product costs.”
♦ In addition to the full cost or cost-plus approach, other cost-based pricing approaches include
(1) life-cycle product costing and pricing, and
(2) target costing for target pricing.
• These approaches are especially useful in making long-run pricing decisions.
♦ Product life cycle covers the time from initial research and development to the time at which
support to the customer ends.
• Life-cycle costing (or cradle-to-grave costing), the important basis for pricing, tracks
costs from start to finish for each product.
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• A product life-cycle budget highlights for managers the importance of setting prices that
will cover costs in all value-chain categories to be profitable.
• Manufacturers of environmentally sensitive products have to meet the recent “take–
back” requirement by paying for the recycling and disposal costs at the end of the
products’ useful life. The additional costs must be considered in making pricing decisions.
This in turn influences how products are designed to tradeoff the cost of manufacture and
disposal.
♦ Most of the firms in a competitive market are price takers. A target price is the price based on
customers’ perceived value for the product and the price that competitors charge. A target cost
equals the target price minus desire profit margin. That is,
Target cost = Target price – Desired profit margin.
• A firm constrained by the price it can charge, with a desire to make a healthy profit,
must limit the costs it incurs to manufacture the product in the long run in the spirit of
“price–based costing.”
♦ Legal issues regarding costing and pricing get a lot of attention as competition heats up and as
companies move more goods and provide services around the globe.
• Predatory pricing is the practice of setting a selling price below cost with the intent to
harm competition by driving competitors out of the market or by creating a barrier to
entry for new competitors.
• Predatory pricing is considered anti-competitive and illegal under antitrust laws.
• Marginal cost (in theory) or average variable cost (in practice) is used as the floor below
which predatory pricing practice is established in courts.
Example 2: Two companies, P(redator) and C(ompetitor), produce similar products
while employing similar technologies. The variable cost per unit is $5.10 for both.
Company C adopts an industry practice of adding 10% markup to the variable cost to
come up with a selling price of $5.61 per unit.
In order to dominate the market, Company P decides to charge a price of $5 per unit for
the same product, resulting a loss of $0.10. Over a short period time, the strategy of
predatory pricing attracts customers old and new, eventually driving Company C out of
the market. Company P then raises its price to $6.63, enjoying a markup of 30% and
recouping its losses many times over.
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• Dumping occurs when a company exports its product to consumers in another country
at an export price below its domestic price.
• Dumping benefits consumers in the short run at the expense of the producers in the
importing country, who usually seek protection in the form of tariffs on the dumped
products to bring up the prices and to level the playing field.
• Policy makers disagree on the merits of prohibiting dumping: protection of domestic
industries for national security reasons vs. practice of free trade and free markets.
• Price discrimination is the practice of selling identical goods or services to different
customers at different prices.
• Price discrimination requires market segmentation based on price sensitivity.
• Price discrimination on the basis of race, religion, disability, or gender is illegal.
• Peak-load pricing is the practice of setting prices highest when the quantity demanded
for the product approaches the physical capacity to produce it (and lower at other times).
• Price fixing represents the agreement among business competitors to set prices at a
particular level.
• The prices being “fixed” are at a level higher than the equilibrium prices in competitive
markets.
• Pricing fixing is not universally illegal. However, when it is considered illegal, mere
informal or unspoken agreements may result in jail time and/or huge fines.
LO 4-4 Understand how to apply differential analysis to production decisions.
♦ Differential analysis helps managers address ongoing production and operating issues,
including
(1) make-or-buy decisions,
(2) whether to add or drop a product line or close a business unit,
(3) production choices, and
(4) product mix decisions.
• The keys are to identify relevant costs and revenues under different alternatives and
to choose the course of action that provides the best economic value for the firm.
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♦ Make-or-buy decision involves any decision concerning whether to make the needed goods
internally or purchase them from outside sources.
• A sourcing decision is often strategic and long-run, as the firm chooses to either
integrate vertically upstream and/or downstream to exercise more control, or develop
long-term relationships with suppliers and only specialize in certain areas of the total
manufacturing process.
• A make-or-buy decision is ultimately a question of which firm in the value chain can
produce the product or service at the lowest cost.
• In addition to quantitative considerations (i.e., differential costs and revenues), other
factors (such as market structure, suppliers’ dependability and quality control) may also
play a role.
• In make–or-buy decisions, the relevant costs include the variable manufacturing costs
(direct materials, direct labor, variable overhead) that can be saved, the fixed overhead
that may be eliminated, and the purchase price of the parts under consideration. Exhibit
4.3 illustrates an example.
• Make-or-buy decisions are sensitive to volume. When the cost information can be
separated into variable and fixed components in the accounting system, a unique volume
may exist that makes the firm indifferent as to whether to outsource or not. Above or
below that volume, the decision will be reversed. That is, setting VX + F = PX will lead
to
X =
F
PV
, where
X = The indifferent volume between make or buy,
V = Variable cost per unit,
F = Fixed costs, and
P = Purchase price per unit.
(VX + F) represents the costs of “Make,” while PX represents the costs of “Buy.” See
Exhibit 4.4 for an illustration.
• The Goal Seek formula in Microsoft Excel can also be used to find the volume where
the cost to make is the same as the cost to buy. Exhibit 4.5 shows how the spreadsheet is
set up.
• Opportunity costs are the forgone returns from not employing a resource in its best
alternative use and are not routinely reported with other accounting cost data. The fact
that they are difficult to estimate or subject to considerable uncertainty does not mean