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365
CHAPTER 12
DIFFERENTIAL ANALYSIS AND
PRODUCT PRICING
CLASS DISCUSSION QUESTIONS
1. a. Differential revenue is the amount of
increase or decrease in revenue ex-
pected from a particular course of action
compared with an alternative.
2. This decision is an example of a make-or-buy
decision. The company is focusing on its
comparative advantages, which include
marketing and distribution, while building
partnerships with other suppliers to actually
manufacture key elements of the product.
4. Assuming there is demand for the premium-
grade product, this would assume the differ-
ential price (premium less commodity)
exceeded the differential cost to process the
product to premium grade.
5. A business should only accept business at a
special price if the lower price will not con-
offering discount business to a customer
that may wish to order in the future.
6. Other issues to consider would be if the
$1.60 ($7.75 – $6.15). That is, if the elimi-
nated fixed cost were less than $1.60 per
unit, then the variable cost per unit would
exceed the supplier’s price, making the sup-
plier price more attractive. The company
must also consider the reliability of the sup-
value of the equipment and land (either in
cash or rental income) should be consid-
ered. For example, if the opportunity value
of the assets were $10,000 per month, then
the store would need to have a profitability
exceeding this amount to remain an attrac-
tive alternative.
8. In the long run, the normal selling price must
366
10. In setting prices, managers should also
11. The target cost concept begins with a price
that can be sustained in the marketplace,
then subtracts a target profit, thus determin-
ing the target cost. The cost is made to
conform to the price required in the market. In
12. The target cost concept is most appropriate
in highly competitive product markets, where
margins are under pressure and prices are
falling.
367
EXERCISES
E12–1
a. PIKE INDUSTRIES
Proposal to Lease or Sell Machinery
Differential Analysis Report
Differential revenue from alternatives:
Revenue from lease ................................................... $107,500
Proceeds from sale .................................................... (72,500)
Differential revenue from lease ........................... $ 35,000
b. Sell the machinery. The net loss from leasing is $1,375.
E12–2
a. YUKON BEVERAGES INC.
Proposal to Discontinue Whitehorse Cola
Differential Analysis Report
Differential revenue from annual sales of Whitehorse Cola:
Revenue from sales ..................................................... $ 1,875,000
Differential cost of annual sales of Whitehorse Cola:
Variable cost of goods sold ........................................ $900,000*
Variable operating expenses ....................................... 585,000** (1,485,000)
368
E12–3
a.
BLONDE ESPRESSO COMPANY
Product-Line Income Statement
Differential Analysis Report
Light Medium Dark
Roast Roast Roast
Differential revenue from monthly sales:
Revenue from sales ............................... $ 750,000 $1,175,000 $ 487,500
Computations:
1$450,000 × (100% – 40%) = $270,000
2$700,000 × (100% – 40%) = $420,000
b. The Dark Roast line should be retained. As indicated by the differential analy-
sis in part (a), the income would decrease by $130,500 (excess of differential
revenue over differential cost) if the Dark Roast line is discontinued.
369
E12–4
Note to Instructors: Many students may be unfamiliar with the financial services
industry. This exercise provides an opportunity to introduce students to some
basic terms and concepts used within the industry.
a. The “Investor (Retail) Services” segment serves the retail customer, meaning
b. Variable costs in the “Investor (Retail) Services” segment include:
1. Commissions to brokers
Fixed costs in the “Investor (Retail) Services” segment include:
1. Depreciation on brokerage offices
c.
Investor
(Retail) Advisor
Services Services
Operating income before taxes .................. $2,475 $1,175
Plus depreciation and amortization ........... 203 66
Estimated contribution margin .................. $2,678 $1,241
d. If one assumes that the fixed assets that serve advisory services (computers,
370
E12–5
The flaw in the decision was the failure to focus on the differential revenues and
costs, which indicate that operating income would be reduced by $42,500 if Half
Moon is discontinued. This differential income from sales of Half Moon can be de-
termined as follows:
E12–6
a. POST TECHNOLOGIES COMPANY
Manufacture Carrying Case
Differential Analysis Report
Purchase price of carrying case .................................. $ 13.00
Differential cost to manufacture carrying case:
Direct materials .......................................................... $4.00
371
E12–7
a. WISCONSIN ARTS OF MILWAUKEE
Purchase Outside Page Layout Services
Differential Analysis Report
Differential revenue:
Residual value of computer equipment ......................... $ 6,500
Differential cost of alternatives:
Cost to perform internally:
Salaries ......................................................................... $ 185,000
b. The benefit from using an outside service is shown to be $11,500 greater than
performing the layout work internally. The fixed costs (depreciation expens-
es) in the budget are irrelevant to the decision. Thus, based strictly on a fi-
nancial basis, the work should be purchased from the outside. In addition, the
c. Before electing to terminate the five employees, Wisconsin Arts should con-
sider the long-run impact of the decision. Specifically, future page layout
372
E12–8
a. Annual variable costs—old equipment ....................... $ 30,000
Annual variable costs—new equipment ...................... (9,000)
Annual differential decrease in cost ............................ $ 21,000
Number of years applicable .......................................... × 8
b. The sunk cost is the $185,000 book value ($315,000 cost less $130,000
accumulated depreciation) of the old equipment. The original cost and accumu-
lated depreciation were incurred in the past and are irrelevant to the decision
to replace the machine.
373
E12–9
a. WHITE NOISE TECHNOLOGIES INC.
Replace Machine
Differential Analysis Report
Annual costs and expenses—present machine ................................ $ 432,500
Annual costs and expenses—new machine ...................................... (411,000)
Annual differential decrease in costs and expenses ........................ $ 21,500*
Decrease in direct labor costs ......................................... $ 50,000
Less: Increase in power and maintenance .................... $25,000
Increase in taxes, insurance, etc. ....................... 3,500 (28,500)
Annual differential decrease in costs and expenses ..... $ 21,500
b. The proposal should be accepted.
c. In addition to the factors given, consideration should be given to such factors
E12–10
a. Differential revenue: $415 – $320 = $95 per hundred board feet
374
E12–11
a. HAPPY HOUR COFFEE COMPANY
Process Columbian Coffee Further
Differential Analysis Report
Differential revenue from further processing per batch:
Revenue from sale of Decaf Columbian [(5,000
pounds – 150* pounds loss) × $9.50] .............................. $ 46,075
b. The differential revenue from processing further to Decaf Columbian is more
than the differential cost of processing further. Thus, Happy Hour Coffee Com-
pany should process further to Decaf Columbian.
c. The price of Decaf Columbian would need to decrease to $9.02 per pound in
order for the differential analysis to yield neither an advantage nor a disad-
vantage (indifference). This is determined as follows:
Revenue from sale of Columbian coffee
(5,000 pounds × $8.00) ..................................................... 40,000
Differential revenue .................................................................. $ 3,747
Differential cost per batch:
Additional cost of producing Decaf Columbian ................. (3,750)
Differential income from further processing:
375
E12–12
a. MADISON INDUSTRIES INC.
Sell to Story Mills Company
Differential Analysis Report
Differential revenue from accepting the offer:
Revenue from sale of 125,000 additional units at $41 ................ $5,125,000
Differential cost of accepting the offer:
Variable costs from sale of 125,000 additional units at $36 ....... (4,500,000)
Differential income from accepting the offer .................................... $ 625,000
E12–13
a. Budgeted cost per battery for June = Total manufacturing costs ÷ Budgeted
production
Budgeted cost per battery for June = $1,434,000 ÷ 60,000 batteries = $23.90
per battery
376
E12–14
a. RUBBER MEETS THE ROAD COMPANY
Sell to Cruising Motors
Differential Analysis Report
Per Unit Total
Differential revenue from accepting special offer ... $10.00 $ 200,000*
Differential costs from accepting special offer:
Direct materials ....................................................... $ 5.00
*$10 × 20,000 tires = $200,000
**2% × $20. The avoided sales commission should not be computed on the
basis of the $10 price to Cruising Motors, but on the existing domestic sales
price of $20.
***$9.20 × 20,000 tires = $184,000
b. Differential cost per tire for special order:
377
E12–15
a. $2,400,000 ($12,000,000 × 20%)
b. Total costs:
Variable ($240 × 200,000 units) ..................................................... $48,000,000
Fixed ($800,000 + $1,200,000) ....................................................... 2,000,000
d. Cost amount per unit .......................................................................... $250
Markup ($250 × 4.8%) ......................................................................... 12
Selling price ......................................................................................... $262
E12–16
a. The price will be set at the estimated average market price required to remain
competitive, or $26,000. Under the target cost concept, the market dictates
the price, not the markup on cost.
Since the estimated manufacturing cost of $22,000 exceeds the target cost of
$20,800, Toyota will try to remove $1,200 from its total costs in order to main-
tain competitive pricing within its profit objectives.
378
E12–17
a. Historical markup percentage on product cost: $200 -- $160
$160 = 25% or
b. Required cost reduction: $160.00 – $145.60 = $14.40
c.
1. Direct labor reduction: min. 60
min. 6 × $20 = $ 2.00
2. Additional inspection: min. 60
min. 9 × $20 = $(3.00)
Direct materials reduction: 7.25 4.25
The total savings exceeds the required target cost reduction by $0.65 ($15.05 –
$14.40). Thus, these improvements are sufficient to meet the target cost.
E12–18 Appendix
a. Total manufacturing costs:
Variable ($220 × 200,000 units) ..................................................... $44,000,000
Fixed factory overhead ................................................................. 800,000
Total ..................................................................................................... $44,800,000
Cost amount per unit: $44,800,000 ÷ 200,000 units = $224
379
c. Cost amount per unit .......................................................................... $224
Markup ($224 × 16.96%) ...................................................................... 38
Selling price ......................................................................................... $262
E12–19 Appendix
a. Total variable costs: $240 × 200,000 units ........................................ $48,000,000
c. Cost amount per unit .......................................................................... $240
Markup ($240 × 9.17%) ........................................................................ 22
Selling price ......................................................................................... $262
