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Differential Cost Analysis for Operating Decisions

CHAPTER 7

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LuAnn BeanLuAnn BeanProfessor of AccountingProfessor of AccountingFlorida Institute of TechnologyFlorida Institute of Technology

Managerial Accounting 11E

Maher/Stickney/Weil

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CHAPTER GOAL

This chapter explains how managers can use differential analysis to examine the effects on profits. Differential analysis helps managers answer relevant questions such as:What activities differ between the alternatives?How does that difference affect costs and profits?

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DIFFERENTIAL ANALYSIS: Definition

DIFFERENTIAL ANALYSIS: Definition

Is the analysis of differences among particular alternative

actions.

LO 1

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EXAMPLE: Ullman Educational Media

Ullman Educational Media (UEM) is a company that produces tutorial videos for primary and preschool use. UEM developed the following estimates:

LO 1

Continued

Units made and sold 800 per month

Maximum production and sales capacity 1,200 units per month

Selling price $ 30

UEM

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ACTIVITY & COSTS

Ullman Educational Media provides the following information about activities and costs:

LO 1

Continued

VC per unit FC per month

Manufacturing $ 17 $ 3,060

Marketing and Administrative 5 1,740

Total costs $ 22 $4,800

UEM

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LO 1

EXHIBITEXHIBIT 7.27.2

UEM

Profit decreases by $1,000.

Profit decreases by $1,000.

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CASH FLOW

Differential analysis focuses on cash flow because Cash is the medium of exchange in businessCash is a common objective measure of the costs

and benefits of alternatives

LO 1

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Pricing Decisions

LO 2

Customer

Demands

Competitors’ Actions

Cost of Products

Will raising prices lose customers

to a competitor

or cause them to

substitute cheaper goods?

Will raising prices lose customers

to a competitor

or cause them to

substitute cheaper goods?

MANAGERS WANT TO KNOW!

Managers must consider

competitors actions both

nationally and internationally.

Managers must consider

competitors actions both

nationally and internationally.

Internal focus on continuous improvements

is key to cutting costs.

Internal focus on continuous improvements

is key to cutting costs.

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SPECIAL ORDERS

Ullman has an opportunity for a one-time only special order to sell 100 units at $25 each. The regular price is $28. Should they accept the special order?

Ullman has an opportunity for a one-time only special order to sell 100 units at $25 each. The regular price is $28. Should they accept the special order?

LO 2MANAGERS WANT TO KNOW!UEM

Continued

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LO 2

EXHIBITEXHIBIT 7.37.3

Yes! Since normal

operations should be used to

cover FC, not special orders,

this special order adds $300 to the

bottom line.

Yes! Since normal

operations should be used to

cover FC, not special orders,

this special order adds $300 to the

bottom line.

UEM

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LO 2

EX

HIB

ITE

XH

IBIT

7.57.5

Full cost, used for long run decisions, is the total

cost of producing and selling a unit.

Full cost, used for long run decisions, is the total

cost of producing and selling a unit.

UEM

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PRICING DECISIONSUse of full cost in pricing decisions is justified

because In the long run, prices must cover all costs to surviveLong term contractual agreements must cover all costsPrices in regulated industries are often based on full

costAlthough full cost + profit may be used initially, short

term adjustments may reflect market conditions.

LO 2

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PRODUCT LIFE CYCLE: Definition

PRODUCT LIFE CYCLE: Definition

Covers the time from initial research and development to time support to customer is

withdrawn.

LO 2

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Predatory pricing: DefinitionPredatory pricing: Definition

Is when a business deliberately prices below its costs to drive out competitors.

LO 2

Dumping: DefinitionDumping: Definition

Occurs when a foreign company sells a product in the U.S. at a price below the

market value in the country of its creation.

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What is target cost?

Target cost is the target price less the target profit.

LO 3

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LO 3

EX

HIB

ITE

XH

IBIT

7.57.5

Value engineering is a systematic evaluation of

all aspects of the business.

Value engineering is a systematic evaluation of

all aspects of the business.

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Customer cost Activities

Cost to acquire customer Promote product; campaign to win lost customers; run advertising campaign

Cost to provide goods and services Process order; deliver product; process returns

Cost to maintain customers Bill customers; process payments; issue refunds

Cost to retain customers Follow-up calls

USING ACTIVITY-BASED COSTING: Analyze Profitability

LO 4

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THEORY OF CONSTRAINTS

The theory of constraints (TOC) acknowledges that businesses often have constraints or limits on what can be done. TOC encourages managers to identify where constraints arise and to develop methods to manage them. Three factors predominate:

1. Throughput contribution

2. Investments

3. Other operating costs

The theory of constraints (TOC) acknowledges that businesses often have constraints or limits on what can be done. TOC encourages managers to identify where constraints arise and to develop methods to manage them. Three factors predominate:

1. Throughput contribution

2. Investments

3. Other operating costs

LO 6

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BOTTLENECK: DefinitionBOTTLENECK: Definition

Is an operation in which the work to be performed equals or exceeds the available capacity.

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MANAGING THE BOTTLENECK

Recognize that the bottleneck resource determines throughput contribution of product

Search for, find bottleneckResource with large quantities of inventory waiting to be

worked on

Subordinate all non-bottleneck resources to the bottleneck resource

Increase bottleneck efficiency, capacityRepeat 4 steps for any new bottleneck

LO 6

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MAKE-OR-BUY

The make-or-buy decision is one where the firm must decide whether to meet its needs internally or to acquire goods or services externally. Both cost and non-quantitative factors are considered.

The make-or-buy decision is one where the firm must decide whether to meet its needs internally or to acquire goods or services externally. Both cost and non-quantitative factors are considered.

LO 7

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JOINT PRODUCTS

In some circumstances, multiple products can be produced from a single production process. The question for management is: What is the effect of additional processing/production on profits?

In some circumstances, multiple products can be produced from a single production process. The question for management is: What is the effect of additional processing/production on profits?

LO 8MANAGERS WANT TO KNOW!

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SPLITOFF POINT: DefinitionSPLITOFF POINT: Definition

Is the point up to which all costs are joint and after which additional processing costs are identified with other products.

LO 8

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ADD OR DROP

Managers must decide when to add or drop products; when to open or abandon sales territories. The differential principle involved can be stated:

If differential revenue from selling exceeds differential costs of product, the product is profitable and the firm should continue production.

Managers must decide when to add or drop products; when to open or abandon sales territories. The differential principle involved can be stated:

If differential revenue from selling exceeds differential costs of product, the product is profitable and the firm should continue production.

LO 9MANAGERS WANT TO KNOW!

Click the button to skip Example

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INVENTORY MANAGEMENT

Inventory has a direct affect on profit and must be carefully managed. Key questions for managers are:

1. How many units should be on hand for use or sale?

2. How often should the firm order an item and what is the optimal order size?

Inventory has a direct affect on profit and must be carefully managed. Key questions for managers are:

1. How many units should be on hand for use or sale?

2. How often should the firm order an item and what is the optimal order size?

LO 10MANAGERS WANT TO KNOW!

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JUST-IN-TIME (JIT)

JIT is a philosophy, not a tool, that dovetails with total quality management (TQM) in that TQM requires reliable processing systems and disallows defective units. Flexible manufacturing that reduces both setup and inventory levels also enhances JIT.

JIT is a philosophy, not a tool, that dovetails with total quality management (TQM) in that TQM requires reliable processing systems and disallows defective units. Flexible manufacturing that reduces both setup and inventory levels also enhances JIT.

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LINEAR PROGRAMMING

Linear programming: (a) finds the product mix that will maximize profits given the constraints, (b) provides opportunity costs of constraints, and (c) allows for sensitivity analysis.

Linear programming: (a) finds the product mix that will maximize profits given the constraints, (b) provides opportunity costs of constraints, and (c) allows for sensitivity analysis.

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ECONOMIC ORDER QUANTITY (EOQ)

The economic order quantity (EOQ) model is a mathematical model that gives the optimal amount of goods to order when demand reduces inventory to a level called the “reorder point.”

The economic order quantity (EOQ) model is a mathematical model that gives the optimal amount of goods to order when demand reduces inventory to a level called the “reorder point.”

LO 12

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End of CHAPTER 7