This document is partially blurred.
Unlock all pages and 1 million more documents.
Get Access
chapter
24(9)
Differential Analysis and
Product Pricing
______________________________________________
OPENING COMMENTS
This chapter covers (1) differential analysis, (2) methods of determining the selling price of a product
using a cost-plus markup approach, and (3) the effects of production bottlenecks. Learning Objective 1
examines six different managerial decisions that are facilitated by differential analysis. The cost-plus
approach to determining selling prices is described in Objective 2, while Objective 3 examines the impact
After studying the chapter, your students should be able to:
1. Prepare differential analysis reports for a variety of managerial decisions.
KEY TERMS
differential analysis
differential cost
differential income (loss)
differential revenue
opportunity cost
product cost concept
production bottleneck
sunk cost
434 Chapter 24(9) Differential Analysis and Product Pricing
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) –
Chapter 24(9) Differential Analysis and Product Pricing 435
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.
Relevant Example Exercises and Exhibits
• Example Exercise 24(9)-1 Lease or Sell
• Example Exercise 24(9)-2 Discontinue a Segment
• Example Exercise 24(9)-3 Make or Buy
• Example Exercise 24(9)-4 Replace Equipment
• Example Exercise 24(9)-5 Process or Sell
• Example Exercise 24(9)-6 Accept Business at Special Price
• Exhibit 1 – Differential Analysis—Bryant Restaurants
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.
436 Chapter 24(9) Differential Analysis and Product Pricing
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.
GROUP LEARNING ACTIVITY—Introduction to Differential Analysis
Transparency Master (TM) 24(9)-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.
GROUP LEARNING ACTIVITY—Differential Analysis
Handout 24(9)-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.
A solution to Handout 24(9)-1 is provided in TM 24(9)-3 through TM 24(9)-7.
Chapter 24(9) Differential Analysis and Product Pricing 437
CLASS DISCUSSION—Differential Analysis
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(9)-8]:
1. A diversified food company is considering the closing of its condiment division. What qualitative
factors should be considered before discontinuing a division or product line?
2. An automobile manufacturer has decided to allow outside suppliers to bid on all parts necessary to
make its vehicles. What qualitative factors should be considered by management in deciding whether
or not to turn over the production of a part to an outside supplier?
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
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
438 Chapter 24(9) Differential Analysis and Product Pricing
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
Key Terms and Definitions
• Product Cost Concept - A concept used in applying the cost-plus approach to product pricing in
which only the costs of manufacturing the product, termed the product cost, are included in the
cost amount to which the markup is added.
• Target Costing - The target cost is determined by subtracting a desired profit from a market
method determined price. The resulting target cost is used to motivate cost improvements in
design and manufacture.
Relevant Example Exercises and Exhibits
• Example Exercise 24(9)-7 Product Cost Markup Percentage
• Exhibit 9 – Product Cost Concept
• Exhibit 10 – Target Cost Concept
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,
Chapter 24(9) Differential Analysis and Product Pricing 439
DEMONSTRATION PROBLEM—Product Cost Concept
B Squared Inc. uses the product cost concept of applying cost plus approach to product pricing. The costs
of producing and selling 35,000 units of soccer balls are as follows:
Variable Cost per Unit:
Direct Materials $ 4.00
Direct Labor 5.00
B Squared desires a profit of equal to 20% of total assets of $400,000. Determine the selling price per
ball.
Solution:
Total Manufacturing Cost:
Cost per unit: $537,500/35,000 = $15.36
Markup Percentage = (Desired profit + Total Selling and Admin Expenses)/Total Manufacturing Cost
Markup Percentage = (80,000 + 45,000 + 87,500)/537,500 = .3953 or 40% rounded
Cost per unit $15.36
GROUP LEARNING ACTIVITY—Product Cost Concept
Some companies include only manufacturing costs in the cost reported for a product. In this case, the
markup added to the product cost must compensate for selling and administrative expenses, as well as the
desired level of profit. The product cost concept is well suited to manufacturers.
440 Chapter 24(9) Differential Analysis and Product Pricing
INTERNET ACTIVITY—Target Costing
Have your students explore “Target Costing” by performing an Internet search. At the time this manual
OBJECTIVE 3
Compute the relative profitability of products in bottleneck production processes.
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
Key Terms and Definitions
• Production Bottleneck - A condition that occurs when product demand exceeds production
capacity.
Relevant Example Exercises and Exhibits
• Example Exercise 24(9)-8 Bottleneck Profit
SUGGESTED APPROACH
Students might not be familiar with the concepts of production constraints (bottlenecks). As a first step,
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.
Chapter 24(9) Differential Analysis and Product Pricing 441
1. How many chips do you think were processed over the ten turns? (Have the output counted at this
time.) Answer: On average, the complete line can only move as fast as the slowest operation. Thus,
2. What happened between positions 2 and 3, and why? Answer: Poker chips stacked up in front of
position 3. There is no place for these chips to go. Positions 1 and 2 are paced at an average roll of 7,
3. Was the additional production from positions 1 and 2 “productive”? Answer: not really. These
positions produced chips that cannot get through the line. If position 3 does not receive any more
4. What is happening in positions 4 and 5? Answer: They are operating way below capacity. They are
rolling averages of 7 but can only move averages of 3.5 chips. In other words, they are starved for
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
GROUP LEARNING ACTIVITY—Product Profitability in Constrained
Environments
Divide your class into groups. Provide each group with a copy of Handout 24(9)-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(9)-11 and 24(9)-12.
442 Chapter 24(9) Differential Analysis and Product Pricing
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,
Key Terms and Definitions
• Total Cost Concept - 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
Relevant Example Exercises and Exhibits
• Exhibit 11 – Total Cost Concept
• Exhibit 12 – Variable Cost Concept
SUGGESTED APPROACH
The normal selling price of any product can be expressed using the following formula:
Normal Selling Price = Cost + Markup
Chapter 24(9) Differential Analysis and Product Pricing 443
DEMONSTRATION PROBLEM—Total Cost Concept
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(9)-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 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
Handout 24(9)-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
expense will be $20,000 for the machine’s five-year life. At the end of the machine’s life, it
will have no salvage value.
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.
Grayson’s per-unit cost to make part A-14 is $14.75, as follows:
3. Apple Valley Orchards sells apples for $15.00 per bushel. The company has considered
processing some of its apples into apple butter. Each bushel of apples will yield two dozen
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
Handout 24(9)-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.
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
The following profitability report has been prepared for the prior year’s sales levels:
Required: Answer the following questions.
a. Which product is the most profitable and should be emphasized in marketing efforts? Why?
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)?
c. Determine the price for spaghetti that would make spaghetti equal to the profitability of
shells.
Type Item Description LO(s) Difficulty Time Est BUSPROG AICPA ACBSP - APC Bloom's EE Excel GL SMH FAI Service Real World Writing Ethics Internet Group
DQ 1 1 Easy 5 min. Analytic Measurement Incremental analysis Knowledge
DQ 2 1 Easy 5 min. Analytic Measurement Incremental analysis Knowledge
DQ 3 1 Easy 5 min. Analytic Measurement Incremental analysis Knowledge
PE 5B Process or sell 1 Easy 10 min. Analytic Measurement Incremental analysis Application x
PE 6A Accept business at special price 1 Easy 10 min. Analytic Measurement Incremental analysis Application x
PE 6B Accept business at special price 1 Easy 10 min. Analytic Measurement Incremental analysis Application x
PE 7A Product cost markup percentage 2 Easy 10 min. Analytic Measurement Incremental analysis Application x
PE 7B Product cost markup percentage 2 Easy 10 min. Analytic Measurement Incremental analysis Application x
PE 8A Bottleneck profit 3 Easy 10 min. Analytic Measurement Incremental analysis Application x
PE 8B Bottleneck profit 3 Easy 10 min. Analytic Measurement Incremental analysis Application x
EX 15 Decision on accepting additional business 1 Moderate 20 min. Analytic Measurement Incremental analysis Application x x
EX 16 Accepting business at a special price for a service company Moderate 20 min. Analytic Measurement Incremental analysis Application x x
EX 17 Product cost concept of product pricing 2 Moderate 20 min. Analytic Measurement Incremental analysis Application x
EX 18 Product cost concept of product pricing 2 Moderate 20 min. Analytic Measurement Incremental analysis Application
EX 19 Target costing 2 Easy 15 min. Analytic Measurement Incremental analysis Application x x
EX 20 Target costing 2 Moderate 30 min. Analytic Measurement Incremental analysis Application
EX 21 Product decisions under bottlenecked operations 3 Moderate 20 min. Analytic Measurement Incremental analysis Application
EX 22 Product decisions under bottlenecked operations 3 Moderate 20 min. Analytic Measurement Incremental analysis Application
EX 23 Total cost concept of product pricing Appendix Moderate 30 min. Analytic Measurement Incremental analysis Application
EX 24 Variable cost concept of product pricing Appendix Moderate 20 min. Analytic Measurement Incremental analysis Application
PR 1A Differential analysis involving opportunity costs 1 Moderate 45 min. Analytic Measurement Incremental analysis Application x
PR 2A Differential analysis for machine replacement proposal 1 Moderate 1 hour Analytic Measurement Incremental analysis Application x x
HOMEWORK CHART WITH LEARNING OUTCOMES TAGGING
TAGGING
RESOURCES
FOCUS
Trusted by Thousands of
Students
Here are what students say about us.
Resources
Company
Copyright ©2022 All rights reserved. | CoursePaper is not sponsored or endorsed by any college or university.