433
chapter
24(10)
Differential Analysis and
Product Pricing
______________________________________________
OPENING COMMENTS
of production bottlenecks on pricing and other decisions. Finally, the chapter appendix covers additional
ways (i.e., total cost and variable cost methods) to determine the markup when setting prices. All topics in
After studying the chapter, your students should be able to:
1. Prepare differential analysis reports for a variety of managerial decisions.
2. Determine the selling price of a product, using the product cost concept.
3. Describe and illustrate the managing of manufacturing bottlenecks.
ADM: Describe and illustrate the sue of yield pricing for a service business.
KEY TERMS
competition-based method
cost-plus methods
demand-based methods
differential analysis
differential cost
differential income (loss)
Chapter 24(10) Differential Analysis and Product Pricing 434
differential revenue
opportunity cost
product cost concept
production bottleneck
sunk cost
target costing
theory of constraints (TOC)
total cost concept
variable cost concept
STUDENT FAQS
What are some guidelines I can use to decide which method to use to set a normal price for a
product?
How do you determine what your profit is in real life?
Why are proper cost driver uses so important in determining correct cost per item?
Why is sunk cost never an item to consider in differential analysis?
OBJECTIVE 1
Prepare differential analysis reports for a variety of managerial decisions.
SYNOPSIS
Managerial decision making involves choosing between alternative courses of action. This decision
making involves five steps: (1) identify the objective of the decision, (2) identify alternative courses of
action, (3) gather information and perform differential analysis, (4) make a decision and (5) review,
analyze, and assess the results of the decision. Differential revenue is the amount of increase or decrease
in revenue that is expected from a course of action compared to an alternative. Differential cost is the
increase or decrease in cost that is expected from a course of action as compared to an alternative.
Differential income indicates that a decision is expected to increase income, while a differential loss
indicates the decision is expected to decrease income. A simple differential analysis is presented in
Exhibit 1. Observe in the exhibit the differential formulas: differential revenue = revenue (alt. 2) –
revenue (alt. 1), differential costs = costs (alt. 2) – costs (alt. 1) and differential income (loss) = income
(alt. 2) – income (alt. 1). Differential analysis is used to make many common business decisions. As
summarized in Exhibit 2, management may lease or sell a piece of equipment that is no longer needed.
The analysis in the book uses only the differential revenues and differential costs associated with the
lease-or-sell decision. Sunk costs are not considered because they were incurred in the past and cannot be
recouped. If a part of the business is generating a loss, the manager may consider discontinuing the
product or segment. Discontinuing the product or segment may not eliminate all associated costs and this
must be analyzed. Exhibits 3 and 4 show this analysis. Differential analysis can aid a manufacturing
company in deciding whether to make or buy a part. Exhibit 5 shows how costs may react to the two
alternatives, make or buy. The usefulness of a fixed asset may decrease before it is worn out. Old
equipment may not be as efficient as new equipment. The analysis focuses on the costs of continuing to
use the old equipment verses replacing the equipment. Other important factors, such as the remaining
Chapter 24(10) Differential Analysis and Product Pricing 435
useful life of the old equipment, the estimated life of the new equipment, and potential quality
improvements, may all be considered. The revenue that is foregone from an alternative use of an asset is
called an opportunity cost. Exhibit 6 summarizes this keep or replace decision. Differential analysis can
also be used to decide whether to sell a product at an intermediate stage or to process it further. This
decision is summarized in Exhibit 7. Revenue and costs from further processing are compared as the cost
of the intermediate product will not change. Finally, a company may be offered the opportunity to sell its
products at prices other than normal prices. Exhibit 8 summarizes this decision. Differential analysis may
be used to decide whether to accept additional business at a special price. If a company is operating at less
than full capacity, then additional production does not increase fixed manufacturing costs. Proposals to
sell products at special prices often require additional considerations. Special (discount) prices in one
geographical area may result in price reductions in other areas. This may result in an overall sales revenue
decrease.
Key Terms and Definitions
Differential Analysis—The area of accounting concerned with the effect of alternative courses
of action on revenues and costs.
Differential Cost—The amount of increase or decrease in cost expected from a particular course
of action compared with an alternative.
Differential Income (Loss)—The difference between the differential revenue and the
differential costs.
Differential Revenue—The amount of increase or decrease in revenue expected from a
particular course of action as compared with an alternative.
Opportunity Cost—The amount of income forgone from an alternative to a proposed use of cash
or its equivalent.
Sunk Cost—A cost that is not affected by subsequent decisions.
Relevant Check Up Corner and Exhibits
Exhibit 1—Differential Analysis—Bryant Restaurants
Exhibit 2—Differential Analysis—Lease or Sell Equipment
Exhibit 3—Income (Loss) by Product
Exhibit 4—Differential Analysis—Continue or Discontinue Bran Flakes
Exhibit 5—Differential Analysis—Make or Buy Instrument Panels
Exhibit 6—Differential Analysis—Continue with or Replace Old Equipment
Exhibit 7—Differential Analysis—Sell Kerosene or Process into Gasoline
Exhibit 8—Differential Analysis—Accept Business at a Special Price
Check Up Corner 24(10)-1 – Differential Analysis
SUGGESTED APPROACH
Differential analysis is a method used to evaluate quantitatively alternative courses of action. Under
differential analysis, the difference between the revenues and costs of alternatives is compared. The goal
is to choose the alternative that produces the greatest amount of profit or the lowest cost.
Begin your discussion of differential analysis by using the Group Learning Activity that follows. This
activity will ask your students to compare the differential revenues and expenses of two summer jobs.
Chapter 24(10) Differential Analysis and Product Pricing 436
Use the second Group Learning Activity to illustrate additional applications of differential analysis.
Emphasize that your students should concentrate on understanding the broad concept of differential
analysis rather than memorizing specific examples of how it is applied.
Wrap-up this objective by asking your students to give examples of decisions that should be evaluated
using differential cost techniques. Also encourage them to consider the qualitative factors influencing
business decisions through a Writing Exercise.
GROUP LEARNING ACTIVITY—Introduction to Differential Analysis
Transparency Master (TM) 24(10)-1 presents information concerning two summer jobs: one in an office
and one at an amusement park. Divide your class into small groups and ask them to determine which job
they would choose. Have each group record their choice and the supporting analysis.
Ask a few groups to present their answers in front of the class. Although the groups will probably reach
the same conclusion, there may be significant variation in how they obtained this answer. Show TM
24(10)-2, which presents a differential analysis report in the format used by the text. This problem is
solved by comparing differential revenues to differential costs.
After reviewing the quantitative analysis, remind students that qualitative factors must be considered as
well. Ask students to name qualitative factors that might influence them to take the amusement park job
even though it pays less.
GROUP LEARNING ACTIVITY—Differential Analysis
Handout 24(10)-1 presents four differential analysis problems similar to those presented in the text.
Divide the class into small groups to work on these problems.
Rather than asking each group to do all four problems, you may want to assign only one problem to each
group. After giving the groups enough time to solve their problems, ask them to present their solutions to
the class. This will give your students the opportunity to teach an example to the class.
As an alternative, ask the members of each small group to “count off” using the numbers one through
four. Ask all the ones to gather in one corner of the room, all the twos in another corner, and so on.
Assign each of these four large groups a problem to solve. After the groups are finished solving their
problems, break up the large groups and ask the class to reassemble in their original small groups. Group
member number one is then responsible for teaching the solution to problem one to his or her group.
Continue this until all solutions have been taught. In this exercise, each group member becomes an expert
on one type of differential analysis and shares his or her expertise with the group.
A solution to Handout 24(10)-1 is provided in TM 24(10)-3 through TM 24(10)-7.
Chapter 24(10) Differential Analysis and Product Pricing 437
CLASS DISCUSSION—Differential Analysis
Ask your students to identify decisions from their personal experiences that fit under each of the
categories of differential analysis presented in the text. For example, a decision to cook dinner or order a
pizza is essentially a “make or buy” decision. Deciding whether to go to work or go on to graduate school
after finishing a baccalaureate degree is a “sell or process further” decision.
WRITING EXERCISE—Qualitative Factors in Decision Making
To emphasize that any decision encompasses qualitative, as well as quantitative, factors, ask your
students to write an answer to one or more of the following questions [see TM 24(10)-8]:
1. A diversified food company is considering the closing of its condiment division. What qualitative
Possible response: Since the business is a diversified food company, closing a division could adversely
2. An automobile manufacturer has decided to allow outside suppliers to bid on all parts necessary to
Possible response: When outside suppliers are considered to replace internal manufacturing, the
3. What are the qualitative factors you might consider when determining whether or not to replace your
car?
Possible response: One qualitative factor to consider is that you know the history of how your car was
cared for versus the history of a replacement (used) car. An additional consideration is whether you like
your car and if it provides you the functionality you require. Other qualitative factors might include the
sentimental value of the existing car and whether a different car would provide a change and the
excitement of something new and different.
OBJECTIVE 2
Determine the selling price of a product, using the product cost concept.
SYNOPSIS
The normal selling price is the target selling price to be achieved in the long term. To determine selling
price, managers can use either the demand-based concept or the competition-based concept. The demand-
based concept sets the price according to the demand for the product. The competition-based concept sets
Chapter 24(10) Differential Analysis and Product Pricing 438
the price according to the price offered by competitors. Alternatively, managers can also use one of three
cost-plus methods to determine the selling price. These three methods are the product cost, total cost, and
variable costs methods. Cost-plus methods determine the normal selling price by estimating a cost amount
per unit and adding a markup, computed as follows: normal selling price = cost amount per unit +
markup. As illustrated in Exhibit 9, only the product costs of manufacturing the product are included in
the cost amount per unit to which the markup is added using the product cost concept. The markup is then
computed and added to the product per unit to determine the normal selling price. The cost per unit is
determined as follows: product cost per unit = total product cost/estimated units produced and sold. The
markup percentage is computed as follows: markup percentage = desired profit + total selling and
administrative expenses/total product cost. Product cost estimates may be used in computing the markup.
Make sure to use the attainable operating levels. Target costing, illustrated in Exhibit 10, is a method of
setting prices that combines market-based pricing with a cost-reduction emphasis. Using target costing, a
future selling price is anticipated, using the demand-based or the competition-based concepts. The target
Key Terms and Definitions
Competition-based method—A market based method to determine selling price according
to the price offered by competitors.
Demand–based method—A market based method to determine selling price according to
the demand for the product.
design and manufacture.
Relevant Check Up Corner and Exhibits
Exhibit 9—Product Cost Method
Exhibit 10—Target Cost Method
Check Up Corner 24(10)-2 – Setting Product Selling Prices
SUGGESTED APPROACH
Normal Selling Price = Cost + Markup
The text presents three different techniques for determining the selling price of the product: the total cost,
product cost, and variable cost concept. Emphasize that all three methods should lead a company to the
Chapter 24(10) Differential Analysis and Product Pricing 439
described in the Appendix. Use the following Demonstration Problem and Group Learning Activity to
illustrate how product cost is used to set product prices.
DEMONSTRATION PROBLEM—Product Cost Method
Variable Cost per Unit:
Direct Materials $ 4.00
Direct Labor 5.00
Factory Overhead 3.50
Selling and Admin 2.50
Total $16.00
Fixed Cost:
Factory Overhead $100,000
Selling and Admin Exp. 45,000
ball.
Solution:
Total Manufacturing Cost:
Variable Cost ($12.50 × 35,000) $437,500
Fixed Cost 100,000
Total $537,500
Cost per unit: $537,500/35,000 = $15.36
Markup Percentage = (80,000 + 45,000 + 87,500)/537,500 = .3953 or 40% rounded
Cost per unit $15.36
Markup (15.36 × 40%) 6.14
Selling price $21.50
GROUP LEARNING ACTIVITY—Product Cost Method
The formula to calculate the markup percentage under the product cost method is as follows:
Markup Percentage = Desired Profit + Total Selling & Administrative Expenses
Total Product Costs
Chapter 24(10) Differential Analysis and Product Pricing 440
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Ask your students to calculate the selling price of the product described in TM 24(10)-9 using the product
cost and variable cost methods. The correct solution is shown on TM 24(10)-10.
INTERNET ACTIVITY—Target Costing
Have your students explore “Target Costing” by performing an Internet search. At the time this manual
was written, the following Web site provided interesting information, including ten steps to install a
comprehensive target cost approach: http://www.npd-solutions.com/target.html.
OBJECTIVE 3
SYNOPSIS
A production bottleneck (constraint) is a point in the manufacturing process where the demand for the
company’s product exceeds the ability to produce the product. The theory of constraints (TOC) is a
manufacturing strategy that focuses on reducing the influence of bottlenecks on production processes.
Production can only proceed as fast as the slowest bottleneck. When there is a bottleneck, the best
the constraint.
Key Terms and Definitions
Production Bottleneck—A condition that occurs when product demand exceeds production
capacity.
Theory of Constraints (TOC)—A manufacturing strategy that attempts to remove the influence
of bottlenecks (constraints) on a process.
Relevant Check Up Corner and Exhibits
SUGGESTED APPROACH
discussion ideas.