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Chapter 24(10) Differential Analysis and Product Pricing 441
DEMONSTRATION PROBLEM—Simulating Production Constraints
Have five students line up in a row. Provide each student with two dice, except for the student in the third
position, who gets one die. Place four poker chips between each student, representing work in process.
position. Have a stack of poker chips (representing raw materials) in front of the first position. Ask the
students to roll the dice ten times on your count. When the simulation is finished, discuss the following
questions:
1. How many chips do you think were processed over the ten turns? (Have the output counted at this
over the ten turns, the expected output of the line is 35 chips.
2. What happened between positions 2 and 3, and why? Answer: Poker chips stacked up in front of
front of position 3.
3. Was the additional production from positions 1 and 2 “productive”? Answer: not really. These
inventory is not value added. Thus, the extra dice of capacity in positions 1 and 2 is a wasted
resource.
4. What is happening in positions 4 and 5? Answer: They are operating way below capacity. They are
5. How can these problems be avoided? Answer: Naturally, the firm would want to remove the
constraint at position 3 by purchasing another die. However, if this if not feasible, the theory of
constraints suggests that the bottleneck should be the drumbeat for the rest of the line. Therefore,
whatever position 3 rolls becomes the automatic roll for everybody else. In this way, the line
becomes balanced to the constraining resource. Notice that this does not solve the problem of the
wasted capacity in positions 1, 2, 4, and 5.
Chapter 24(10) Differential Analysis and Product Pricing 442
GROUP LEARNING ACTIVITY—Product Profitability in Constrained
Environments
Divide your class into groups. Provide each group with a copy of Handout 24(10)-2. This handout is a
problem where products must be processed through a bottleneck. Ask your students to answer the
questions provided in the handout. The solution is provided on TM 24(10)-11 and 24(10)-12.
ADM OBJECTIVE
Describe and illustrate the use of yield pricing for a service business.
SYNOPSIS
When compared with manufacturing or retail businesses, service businesses often have larger fixed costs
because they require significant property, plant, and equipment to deliver the service. This leads to many
service companies having low variable cost per unit. High-fixed-cost service businesses often charge
different prices to different customers, depending upon their utilization of fixed capacity. During periods
when the demand on fixed capacity is high, prices are higher and during periods when the demand for
fixed capacity is low, prices are lower.
Relevant Check Up Corner and Exhibits
Make a Decision – Yield Pricing in Service Businesses
APPENDIX—TOTAL AND VARIABLE COST
CONCEPTS TO SETTING NORMAL PRICE
SYNOPSIS
Under the total cost concept, manufacturing cost plus the selling and administrative expenses are included
in the total cost per unit. The markup per unit is then computed and added to the total cost per unit to
determine the normal selling price. This concept requires seven steps, as illustrated in the appendix. The
formulas used in this process are: total cost per unit = total cost/estimated units produced and sold,
markup percentage = desired profit/total cost, desired profit = desired rate of return × total assets, and
markup per unit = markup percentage × total cost per unit. Under the variable cost concept, only variable
costs are included in the cost amount per unit to which the markup is added. The seven steps are
illustrated in the appendix and include the following formulas: variable cost per unit = total variable
cost/estimated units produced and sold, markup percentage = (desired profit + total fixed costs and
expenses)/total variable cost, desired profit = desired rate of return × total assets, and markup per unit =
markup percentage × variable cost per unit.
Chapter 24(10) Differential Analysis and Product Pricing 443
Key Terms and Definitions
Total Cost Method—A concept used in applying the cost-plus approach to product pricing in
which all the costs of manufacturing the product plus the selling and administrative expenses are
included in the cost amount to which the markup is added.
Variable Cost Method—A concept used in applying the cost-plus approach to product pricing in
which only the variable costs are included in the cost amount to which the markup is added.
Relevant Exhibits
Exhibit 11—Total Cost Method
Exhibit 12—Variable Cost Method
SUGGESTED APPROACH
The normal selling price of any product can be expressed using the following formula:
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. Remind students that all three methods should lead a company to
the same selling price. Therefore, selecting a method depends on how a company accumulates and reports
product costs.
DEMONSTRATION PROBLEM—Total Cost Method
The total cost concept is the most convenient method for determining a product’s selling price if a
company includes all manufacturing, selling, and administrative costs associated with the product in its
reported cost. A markup is then added to achieve the firm’s desired profit.
For example, assume that the following costs are incurred to make 10,000 units of a product [see TM
24(10)-9]:
Variable manufacturing costs $5 per unit
Variable selling and administrative costs $2 per unit
Fixed factory overhead costs $80,000
Fixed selling and administrative expenses $30,000
Ask your students to calculate the total cost to make 10,000 units and the cost to make one unit.
(Answers: total cost = $180,000; unit cost = $18)
Next, state that this company wishes to price the product so that a profit of $27,000 will be made if all
10,000 units are sold. The company can determine the markup percentage that will be necessary to
achieve this profit using the following formula:
Chapter 24(10) Differential Analysis and Product Pricing 444
Desired Profit $27,000
Markup Percentage 15%
Total Costs $180,000
Ask your students to calculate the selling price of the product if it is marked up 15 percent above the total
cost. (Answer: $18 1.15 = $20.70)
Point out that the total cost concept would be used mostly by merchandising businesses.
In other cases, companies use the concept of variable costing when reporting a product’s cost. Under this
concept, all variable costs from manufacturing, selling, and administrative activities are included in
determining the product’s reported cost. When variable costing is used, the markup added to the product
cost must compensate for all fixed costs, as well as the desired level of profit.
The formula to calculate the markup percentage under the variable cost method is:
Desired Profit + Total Fixed Costs
Markup Percentage Total Variable Costs
Ask your students to calculate the selling price of the product described in TM 24(10)-9 using the variable
cost method. The correct solution is shown on TM 24(10)-13.
Handout 24(10)-1
Differential Analysis
1. Badonsky Manufacturing needs to obtain a gear-cutting machine, which can be purchased
for $75,000. Badonsky estimates that repair, maintenance, insurance, and property tax
will have no salvage value.
As an alternative, Badonsky can lease the machine for five years for $18,000 per year. If the
purchase or lease the machine.
2. Grayson Enterprises currently manufactures part A-14, one of the component parts used to
assemble the company’s main product. Specialty Parts has offered to make part A-14 for
$12.50 per unit.
Direct materials $5.00
Direct labor 6.00
Variable factory overhead 1.75
Fixed factory overhead 2.00
3. Apple Valley Orchards sells apples for $15.00 per bushel. The company has considered
Apple Valley Orchards should make the apple butter.
4. Gooding Foods makes Goody-Goody brand peanut butter. The cost to make each jar is
$2.05 and consists of the following:
Direct materials $1.00
Direct labor 0.25
Variable factory overhead 0.30
Fixed factory overhead 0.50
A grocery store chain wants to purchase a generic brand peanut butter from Gooding and is
willing to pay $1.50 per jar. The generic peanut butter will be made using a different recipe,
lowering the direct materials cost to $0.80 per jar. Gooding can produce this special order
using excess capacity; therefore, fixed costs will not increase. Use differential analysis to
determine whether Gooding should accept this special order.
Chapter 24(10) Differential Analysis and Product Pricing 446
Handout 24(10)-2
Profitability Analysis with Production Constraints
Bono Pasta Company makes three types of pasta: spaghetti, elbows, and shells. The
production process involves mixing, extruding, and drying. The drying operation is a
constraining resource in this operation. The contribution margins per unit for the three products
are shown below.
Spaghetti Elbows Shells
Sales price per unit $25 $30 $35
Variable cost per unit 15 18 20
Contribution margin per unit $10 $12 $15
The fixed costs are $100,000. The production volume and constraint usage information for the
three products are:
Spaghetti Elbows Shells
Drying hours per unit 0.50 0.25 0.10
Units produced (prior year) 8,000 4,000 2,000
Spaghetti Elbows Shells Total
Units of production 8,000 4,000 2,000
Revenues $200,000 $120,000 $70,000 $390,000
Less variable costs 120,000 72,000 40,000 232,000
Contribution margin 80,000 48,000 30,000 $158,000
Less fixed costs 100,000
Profit $ 58,000
Required: Answer the following questions.
b. If, during the upcoming year, Bono reduced spaghetti production by 2,000 units and
replaced the released capacity with the sale of shells, what would be the impact on total
profitability (fill in the table below)?
Spaghetti Elbows Shells Total
Units of production 6,000
Revenues
Less variable costs
Contribution margin
Less fixed costs 100,000
Profit
shells.
Type Item Description Video Excel CLGL LO(s) Difficulty Time Est BUSPROG AICPA
ACBSP - Primary Bloom's ADM Service Real World
Writing
Ethics
MC 1 1 Easy 5 min. Analytic FN - Measurement Incremental analysis Applying
MC 2 2 Easy 5 min. Analytic FN - Measurement Incremental analysis Applying
MC 3 2 Easy 5 min. Analytic FN - Measurement Incremental analysis Applying
MC 4 2 Easy 5 min. Analytic FN - Measurement Incremental analysis Applying
MC 5 3 Easy 5 min. Analytic FN - Measurement Incremental analysis Applying
LREX 1 Lease or sell x 1 Easy 10 min. Analytic FN - Measurement Incremental analysis Applying
LREX 2 Discontinue a segment x 1 Easy 10 min. Analytic FN - Measurement Incremental analysis Applying
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