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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.
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Chapter Overview
I. DIFFERENTIAL ANALYSIS
• Differential Costs versus Total Costs
• Differential Analysis and Pricing Decisions
o The Full-Cost Fallacy in Setting Prices
• Short-Run Versus Long-Run Pricing Decisions
• Short-Run Pricing Decisions: Special Orders
• Long-Run versus Short-Run Pricing: Is There a Difference?
• Cost Analysis for Pricing
o Life-Cycle Product Costing And Pricing
o Target Costing From Target Pricing
II. LEGAL ISSUES RELATING COSTS AND SALES PRICES
• Predatory Pricing
• Dumping
III. USE OF DIFFERENTIAL ANALYSIS FOR PRODUCTION DECISIONS
• Make-It or Buy-It Decisions
• Make-or-Buy Decisions Involving Differential Fixed Costs
• Opportunity Costs Of Making
• Decision to Add or Drop a Product Line or Close a Business Unit
o Nonfinancial Considerations of Closing a Business Unit
• Product Choice Decisions
IV. THE THEORY OF CONSTRAINTS
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Chapter Outline
LO 4-1 Use differential analysis to analyze decisions.
DIFFERENTIAL ANALYSIS
• Common decisions about pricing and production 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. (See Business Application box “Cost Analysis and the Choice
of Office Space for a Small Business.”)
• 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.
o Every decision that a manager makes requires comparing one or more proposed
alternatives with the status quo.
o 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,
usually one year.
▪ Both short-run and long-run decisions are concerned with the amount of cash flow.
• Short-run decisions affect cash flow for such a short period of time that the time
value of money is immaterial and hence ignored. Thus, the amount of cash flows
o Differential costs change in response to alternative courses of action. With two or more
alternatives, the differential costs are those that differ among or between alternatives.
▪ Both variable and fixed costs may be differential costs.
• Variable costs are differential when a decision involves possible changes in
volume.
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o Sunk costs are costs incurred in the past that cannot be changed by present or future
decisions.
▪ Sunk costs are not differential.
• Differential Costs versus Total Costs
o Although we are focusing on differential costs, the information presented to management
can show the detailed costs that are included for making a decision, or it can show just
the differences between alternatives
▪ The total format includes the two columns that show the total operating profit under
the status quo and the alternative and a third column that shows the difference.
• Advantages of the total format:
▪ The differential format includes a column that shows only the differences.
• 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.
• Differential Analysis and Pricing Decisions
o Prices are determined by supply and demand.
o Managers make pricing decisions in part to determine whether they wish to participate in
the market, that is, whether to make their products and services available.
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o The Full-Cost Fallacy in Setting Prices
▪ Full cost (or full product cost) is 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:
• The use of full cost for some short-run decisions will erroneously render the
alternative option less attractive.
Sometimes decision makers use these full costs, mistakenly thinking that they
are variable costs, and fall victim to the full-cost fallacy
• For short-run decisions (such as whether to accept special orders), the fixed cost
component generally is not differential and, as such, should not be considered.
See Demonstration Problem 1
• In the long run, all costs must be covered or the company will fail.
▪ A special order is an order that will not affect other sales and is usually a short-run
occurrence.
• Short-Run Versus Long-Run Pricing Decisions
o The time horizon of the decision is critical in computing the relevant costs in a pricing
decision.
▪ Short-run pricing decisions cover a period shorter than one year and include:
• Pricing for a one-time-only special order with no long-term implications.
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• Long-run decisions include pricing a main product in a large market in which
there is considerable leeway to set prices.
• Short-Run Pricing Decisions: Special Orders
o Exhibit 4.1 provides a framework for decision making in this context; the option that
provides the highest economic value should be chosen:
▪ Status quo (reject special order)
▪ Alternative (accept special order)
o Exhibit 4.2 illustrates two approaches to analyzing a special order; both result in the same
differential operating profit:
See Demonstration Problem 2
▪ The differential approach to pricing works well for special orders, but some criticize
its use for pricing a firm’s regular products.
• Criticisms of the use of the differential approach decisions regarding special
orders include:
Following the differential approach in the short run leads to underpricing in
the long run because the contribution to covering fixed costs and generating
profits will be inadequate.
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• Responses to these criticisms include:
The differential approach does lead to correct short-run pricing decisions.
LO 4-3 Understand several approaches for establishing prices based on costs
for long-run pricing decisions.
• Long-Run Pricing Decisions
o Most firms rely on full-cost information reports when setting prices.
▪ Full cost is the total cost to produce and sell a unit; it includes all costs incurred by
the activities that make up the value chain.
▪ Pricing decisions based on full cost may be appropriate in three circumstances:
• The firm enters into a long-term contractual relationship to supply a product.
• Long-Run versus Short-Run Pricing: Is There a Difference?
o When used in pricing decisions, the differential costs required to sell and/or produce a
product provide a floor. In the short run, differential costs may be very low.
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• Cost Analysis for Pricing
o Differential analysis is useful for short-run and long-run pricing decisions.
o Several other approaches are used to establish prices based on costs. In general, these
approaches are especially useful in making long-run pricing decisions.
▪ Life-Cycle Product Costing And Pricing
• The product life cycle covers the time from initial research and development to
the time at which support to the customer ends.
Managers estimate the revenues and costs for each product from its initial
research and development to its final customer support.
▪ Target Costing From Target Pricing
• Target costing is the concept of “price–based costing” instead of “cost-based
pricing.”
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LEGAL ISSUES RELATING COSTS AND SALES PRICES
• Predatory Pricing
o 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.
o Example: Two companies, P(redator) and C(ompetitor), produce similar products while
employing similar technologies. The variable cost per unit is $5.10 for both.
• Dumping
o 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
• Price Discrimination
o 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.
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• Peak-Load Pricing
o 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
o Price fixing is the agreement among business competitors to set prices at a particular
level.
▪ Generally, the idea is to “fix” prices at a level higher than the equilibrium prices in
LO 4-4 Understand how to apply differential analysis to production
decisions.
USE OF DIFFERENTIAL ANALYSIS FOR PRODUCTION DECISIONS
• Make-It or Buy-It Decisions
o Make-or-buy decision is any decision by a company to acquire goods or services
internally or externally.
▪ The make-or–buy decision is often part of a company’s long-run strategy.
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▪ Aside from strategic issues, the 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.
• Make-or-Buy Decisions Involving Differential Fixed Costs
o In make-or-buy decisions, the differential costs include:
o Make-or-buy decisions are sensitive to volume.
▪ When the cost information can be separated into variable and fixed components in the
▪ Above or below that volume, the decision will be reversed. That is, setting VX + F =
PX will lead to:
o Exhibit 4.3 illustrates the analysis of a make-or-buy decision involving two different
o Exhibit 4.4 illustrates a graphical analysis of make-or-buy analysis; (VX + F) represents
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• Opportunity Costs of Making
o Opportunity costs are the forgone returns from not employing a resource in its best
alternative use.
▪ Theoretically, determining opportunity cost requires considering every possible use of
the resource in question.
• Determining opportunity cost is typically very difficult and involves considerable
subjectivity.
▪ If the company has no alternative beneficial use for its facilities, the opportunity cost
is zero, in which case the previous analysis would stand.
o Exhibit 4.6 extends the make-or-buy analysis to consider the opportunity cost of
alternative facility use.
See Demonstration Problem 3
• Decision to Add or Drop a Product Line or Close a Business Unit
o Managers often must decide whether to add or drop a product line or close a business unit.
• Exhibit 4.8 illustrates a differential analysis with columns for the status quo (keep
the product line or business unit), alternative (drop the product line or business
unit), and difference.
See Demonstration Problem 4
• Product Choice Decisions
o In general, firms face constraints, which are activities, resources, or policies that limit or
bound the attainment of an objective.
o The following exhibits illustrate a product choice decision:
▪ Exhibit 4.9 provides the revenue and cost information.
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LO 4-5 Understand the theory of constraints.
THE THEORY OF CONSTRAINTS
• The theory of constraints (TOC) is a management method for dealing with constraints; it
focuses on revenue and cost management when faced with bottlenecks.
o A bottleneck is an operation where the work required limits production.
o The theory of constraints focuses on three factors:
▪ The rate of throughput contribution
▪ Maximizing investments
o The objective of the theory of constraints is to maximize throughput contribution given
investments and operating costs.
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o Example: The following illustrates the manufacturing process in a factory. Every unit of
the finished product has to go through three departments as identified by the machines
used, A, B, and C. There are three “A” machines (capacity: 1,200 units each per hour),
one “B” machine (capacity: 3,000 units per hour), and two “C” machines (capacity: 1,600
units each per hour).
A
1,200 units
each
1,600 units
each
A
A
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Matching
A.
Bottleneck
G.
Price discrimination
B.
Differential analysis
H.
Product life cycle
C.
Full cost
I.
Special order
D.
Dumping
J.
Sunk cost
E.
Make-or-buy decision
K.
Target price
F.
Peak-load pricing
L.
Throughput contribution
_____ 1. Occurs when a company exports its product to consumers in another country at an
export price below its domestic price.
_____ 2. Sales dollars minus direct materials costs and other variable costs such as energy and
piecework labor.
_____ 3. Involves any decision concerning whether to make the needed goods internally or
purchase them from outside sources.
_____ 4. 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.
_____ 5. Represents an order that will not affect other sales and is usually a short-run
occurrence.
_____ 6. The sum of the fixed and variable costs of manufacturing and selling a unit.
_____ 7. Covers the time from initial research and development to the time at which support to
the customer ends.
_____ 8. The practice of selling identical goods or services to different customers at different
prices.
_____ 9. 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).
_____ 10. Operations where the work required limits production.
_____ 11. The price based on customers’ perceived value for the product and the price that
competitors charge.
_____ 12. Costs incurred in the past that cannot be changed by present or future decisions.
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Matching Answers
1. D
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Multiple Choice
1. Which of the following statements is correct?
a. Life-cycle costing tracking costs from start to finish.
b. Product life cycle ends when the product is delivered to customers.
c. Product price must be set to cover the costs of manufacturing activities only.
d. “Take–back” requirement for product recycle and disposal is customers’ responsibility.
2. A division has the following data: Sales $320,000, Variable costs $200,000, and Fixed costs
$140,000. If the division were eliminated, the fixed costs would be allocated to other
divisions. What the net impact on the company’s overall profit if the division is eliminated?
a. $20,000 increase.
b. $60,000 decrease.
c. $120,000 decrease.
d. Can not be determined from the data provided
3. Two alternative projects are under consideration:
Project A
Project B
Revenues
$360,000
280,000
Variable costs
210,000
180,000
Fixed costs
90,000
90,000
Which of the following is (are) relevant in choosing between the projects?
a. Revenues.
b. Variable costs.
c. Fixed costs.
d. Both a and b.
4. Which of the following statements is correct?
a. Predatory pricing is illegal.
b. Dumping hurts consumers in the long run.
c. Price discrimination requires market segmentation.
d. All of the above.
5. For differential analysis:
a. Differential costs are relevant costs.
b. No fixed costs are differential.
c. Most variable costs are differential.
d. Both a and c.
6. Full cost is:
a. The sum of variable and fixed cost per unit.
b. Always relevant for short-run decisions.
c. Useful for long-run pricing decisions.
d. Both a and c.
7. In a competitive market where firms are price takers:
a. Each firm can set its own prices.
b. Target pricing is appropriate.
c. Target cost must be achieved in the short run.
d. Cost-based pricing should be adopted.
Use the following information to answer questions 8 and 9:
Company B is considering whether to outsource Part#375 needed to produce finished products.
If manufactured internally, it will cost direct materials $2 per unit, direct labor $1.20 per unit,
variable overhead $1.50 per unit, and fixed overhead $18,000. An outside supplier is available to
provide between 5,000 and 50,000 units of Part#375 at $6.20 per unit.
8. At what volume will Company B become indifferent to the make-or-buy choice?
a. 8,000 units.
b. 12,000 units.
c. 20,000 units.
d. 31,000 units.
9. If Company B needs 8,000 units of Part#375, and outsourcing saves only 25% of the fixed
overhead, then Company B’s make-or-buy decision and cost advantage are:
a. Make, $7,500.
b. Make, $6,000.
c. Buy, $2,000.
d. Buy, $4,000.
10. The theory of constraints (TOC):
a. Applies to long-run cost management.
b. Is concerned with improving bottleneck operations.
c. Tries to minimize throughput contribution.
d. Considers most salaries and wages, rent, utilities and depreciation to be variable costs.
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11. A company currently manufactures a subassembly for its main product. The unit costs for the
subassembly are:
Prime costs
$25
Variable overhead
$10
Fixed overhead
$8
The fixed overhead is an allocated amount shared by other operations. What is the relevant
cost of the subassembly?
a. $25.
b. $35.
c. $43.
d. $33.
12. Differential analysis is suitable for the following situations except:
a. Make-or-buy decisions.
b. Whether to close a business unit.
c. Cost behavior analysis.
d. Product mix decisions.
Multiple Choice Answers
1. a (LO3)
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Demonstration Problem 1
During a particular month, U-Develop Inc., 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
Required:
Should U-Develop accept or reject the special order? Why?
Demonstration Problem 1 – Solution
By unitizing the fixed cost, the full cost calculation gives the impression that the special order is
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Demonstration Problem 2
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
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 or reject the special order for 1,500 windows at $165
each? Why?
2. Assume, instead, that the contractor needs a total of 2,500 windows; all other information
remains the same. Should Nationwide accept or reject the special order for 2,500 windows at
$165? Why?
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Demonstration Problem 2 – Solution
Part 1
The special order for 1,500 windows at $165 each should be accepted because it generates the
additional profit of $10,500.
Status Quo:
Reject
Special Order
Alternative:
Accept
Special Order
Difference
Status Quo:
Reject
Special Order
$ 2,062,500
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Demonstration Problem 3
Cube Manufacturing usually produces its own parts for assembly. The following monthly data
are available for one of the parts, Part A31:
Manufacturing costs
Variable per unit
$ 6
Fixed costs
15,000
Nonmanufacturing costs
Variable per unit
1
Fixed costs
9,000
Cube needs 2,000 units of Part A31 every month. An outside supplier offers to deliver that part
for $11.5 each. By accepting the offer, Cube can save half of the fixed manufacturing costs and
all variable costs, but the fixed nonmanufacturing costs are not affected.
Required:
1. Should Cube Manufacturing accept the offer and outsource Part A31? Why?
2. If the facility used to produce Part A31 can be leased out to generate a monthly rental income
of $3,000, what should Cube Manufacturing do?
Demonstration Problem 3 – Solution
Part 1
Cube Manufacturing should reject the offer and continue to make the part itself, because the total
costs will be higher.
Status Quo:
Make Part
Alternative:
Buy Part
Difference
$14,000 lower
23,000 higher
$ 1,500 higher
Status Quo:
Make Part
Alternative:
Buy Part
Difference
$14,000 lower
23,000 higher
3,000 lower
$ 1,500 lower
Status Quo:
Make Part
Alternative:
Buy Part
Difference
23,000 higher
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Demonstration Problem 4
Cube Manufacturing produces three different products: Platinum, Gold, and Silver. The financial
statement from last quarter is shown below.
Platinum
Gold
Silver
Total
Sales
$ 500,000
$ 400,000
$ 200,000
$1,100,000
Variable costs
(350,000)
(300,000)
(160,000)
(810,000)
Contribution margin
150,000
100,000
40,000
290,000
Fixed costs
(80,000)
(60,000)
(50,000)
(190,000)
Operating profit (loss)
$ 70,000
$ 40,000
$(10,000)
$ 100,000
The general manager is thinking of eliminating the Silver product line to improve the financial
results. The cost accountant cautions that the fixed costs allocated to Silver have to be absorbed
by the remaining two products if the decision is finalized.
Required:
What should the general manager of Cube Manufacturing do and why?
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Demonstration Problem 4 – Solution
The general manager should keep the Silver product line.