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Gail B. WrightGail B. WrightProfessor of AccountingProfessor of AccountingBryant UniversityBryant University

© Copyright 2007 Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star Logo, and South-Western are trademarks used herein under license.

CARL S. WARRENCARL S. WARREN

SURVEY OF ACCOUNTINGSURVEY OF ACCOUNTING

Chapter 12

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LEARNING OBJECTIVES

When you finish this chapter, you should be able to

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1. Prepare differential analysis report for 6 special decisions.

2. Determine selling price under 3 cost conditions.

3. Calculate relative profitability in bottleneck production environment.

LEARNING OBJECTIVESLEARNING OBJECTIVES

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LEARNING OBJECTIVELEARNING OBJECTIVE

1Prepare differential analysis report for 6 special decisions.

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DIFFERENTIAL ANALYSIS

Differential analysis looks at effects of different courses of action

Uses estimated revenues, costs

Focuses on relevant revenues, costs

Sunk costs are past costs that are not relevant

Differential analysis looks at effects of different courses of action

Uses estimated revenues, costs

Focuses on relevant revenues, costs

Sunk costs are past costs that are not relevant

LO 1

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DIFFERENTIAL ANALYSIS

Focuses on effect of alternative courses of action on relevant revenues and costs

LO 1

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DIFFERENTIAL REVENUE

Increase or decrease in revenue derived from a particular course of action compared to an alternative

LO 1

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DIFFERENTIAL COSTS

Increase or decrease in costs derived from a particular course of action compared to an alternative

LO 1

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6 SPECIAL DECISIONS

LO 1

Lease or sellDiscontinue product, segmentMake or buyReplace equipmentProcess or sellAccept business at special price

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LO 1

Marcus has equipment to dispose of.Cost = $200,000

Accumulated depreciation = $120,000Should Marcus lease ($160,000 less $35,000 repairs,

Taxes, etc.)Or sell ($100,000 less 6% commission)

the equipment?

Marcus has equipment to dispose of.Cost = $200,000

Accumulated depreciation = $120,000Should Marcus lease ($160,000 less $35,000 repairs,

Taxes, etc.)Or sell ($100,000 less 6% commission)

the equipment?

LEASE OR SELL: Problem Statement

LEASE OR SELL: Problem Statement

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Book value of equipment ($80,000) is a sunk cost and not considered.

Analysis focuses on differential revenues and differential costs

LEASE OR SELL: Analysis

LEASE OR SELL: Analysis

LO 1

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EXHIBIT EXHIBIT 11

Decision: Lease alternative provides $31,000 more income.

LO 1

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LO 1

Battle Creek Cereals produces & sells 3 cereals. Because Bran Flakes exhibits an operating loss,

Battle Creek is considering discontinuing production,sale of the product. If fixed costs remain unchanged,

Is this the right decision?

Battle Creek Cereals produces & sells 3 cereals. Because Bran Flakes exhibits an operating loss,

Battle Creek is considering discontinuing production,sale of the product. If fixed costs remain unchanged,

Is this the right decision?

TO DISCONTINUE: Problem Statement

TO DISCONTINUE: Problem Statement

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EXHIBIT EXHIBIT 33

LO 1

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Fixed costs do not relate to a particular product. We analyze the revenue and costs related to

Bran Flakes alone to determine whether Bran Flakes contributes to covering fixed costs in

making a discontinue decision.

TO DISCONTINUE: Analysis

TO DISCONTINUE: Analysis

LO 1

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EXHIBIT EXHIBIT 44

LO 1

Decision: Discontinuing Bran Flakes would reduce overall profit by $15,000, the amount that Bran Flakes

contributes to covering fixed costs.

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LO 1

MAKE OR BUY: Problem Statement

MAKE OR BUY: Problem Statement

Direct materials $80 Variable overhead $52

Direct labor 80 Fixed overhead 68

An automotive company has been buying a part for $240 that it now is considering producing.

Cost of production includes

Should the company make or buy?

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Focus the analysis on differential costs. If the automotive company has excess

factory capacity, fixed costs are not relevant to the decision since they will

not change.

MAKE OR BUY: Analysis

MAKE OR BUY: Analysis

LO 1

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EXHIBIT EXHIBIT 66

LO 1

Decision: By including only relevant costs in the analysis, there is a cost savings of $28 per part from

making the instrument panel.

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LO 1

REPLACE EQUIPMENT: Problem Statement

REPLACE EQUIPMENT: Problem Statement

A manufacturer is considering replacing several old machines with a total book value, $100,000,

remaining useful life, 5 years, with a new machine costing $250,000 less $25,000 proceeds from sale of

old equipment. Variable costs with new machine will be reduced from $225,000 to $150,000.

Should the company buy the new machine?

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Book value of equipment ($100,000) is a sunk cost and not considered.

Relevant costs include cost savings of more efficient equipment, product

quality.

REPLACE EQUIPMENT: Analysis

REPLACE EQUIPMENT: Analysis

LO 1

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EXHIBIT EXHIBIT 77

LO 1

Decision: Efficiencies achieved with new machine will produce an annual savings of $30,000.

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OPPORTUNITY COSTS

Measures the cost of an alternative choice that is foregone.

Ex.: Suppose the net outlay ($225,000) were invested & earned 10% ($22,500). It would still be more beneficial to replace equipment ($30,000).

LO 1

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LO 1

PROCESS OR SELL: Problem Statement

PROCESS OR SELL: Problem Statement

A company can produce a 4,000 gallon batch of kerosene with a selling price of $.80 per gallon from 4,000 gallons of raw material costing $.60 per gallon. Alternatively, the company can continue processing the raw material into gasoline selling for $1.25 at an additional cost of $650 per batch and losing 20% of

end product.

Should the company process or sell?

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Initial raw material cost will be incurred in both alternatives & is not considered.

Differential revenues from 2 alternatives are only relevant issues.

PROCESS OR SELL: Analysis

PROCESS OR SELL: Analysis

LO 1

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EXHIBIT EXHIBIT 88

LO 1

Decision: Processing further will result in an additional $150 per batch after considering product loss & additional

costs.

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LO 1

SPECIAL BUSINESS: Problem Statement

SPECIAL BUSINESS: Problem Statement

A company currently produces 10,000 basketballs on average each month, although the factory has a

capacity of `12,500 basketballs. Variable costs are $12.50, fixed costs are $7.50, and domestic selling

price is $30.An offer to sell 5,000 additional basketballs for $18 to

a foreign buyer & produced over 3 months is considered.

Should the company accept the business?

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The company has excess capacity and can produce additional product without incurring

additional fixed costs.

Whether differential revenue covers relevant costs and produces income is the issue.

SPECIAL BUSINESS: Analysis

SPECIAL BUSINESS: Analysis

LO 1

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EXHIBIT EXHIBIT 99

LO 1

Decision: This special business should be accepted because the additional revenue covers the variables costs

& increases income.

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LEARNING OBJECTIVELEARNING OBJECTIVE

2Determine selling price under 3 cost conditions.

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ROLE OF COST CONCEPT

Uses “cost +” to set selling price that provides sufficient profit.

LO 2

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3 COST DETERMINANTS

LO 2

Total cost conceptMarkup added to total cost

Product cost conceptMarkup added to product costs

Variable cost conceptMarkup added to variable costs

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COST INFORMATION

LO 2

VARIABLE COSTS*

Direct materials $ 3.00

Direct labor 10.00

Factory overhead 1.50

Selling & Admin Exp 1.50

Total $ 16.00

FIXED COSTS

Factory overhead $50,000

Selling & Admin Exp 20,000

*per unit

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MARKUP FORMULA:Total Cost

LO 2

Markup % =

Desired profit / Total cost

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BASIC INFORMATION:Total Cost

A manufacturer wants to earn a 20% return on assets valued at $800,000. 100,000 calculators

will be produced.

LO 2

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SELLING PRICE UNDER TOTAL COST

LO 2

Desired profit (800,000 * 20%) $160,000

Selling price {$16.70 + (160,000/100,000)} $18.30

CHECK: (100,000 * $18.30) - $1,670,000 =

$1,830,000 – 1,670,000 =

$160,000

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CALCULATING MARKUP:Total Cost

LO 2

Markup %

Desired profit / Total cost =

$160,000 / $1,670,000 =

9.6%

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MARKUP FORMULA:Product Cost

LO 2

Markup % =

(Desired profit + Selling, Administrative expense) /

Manufacturing cost

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BASIC INFORMATION:Product Cost

LO 2

MANUFACTURING COSTS (100,000 UNITS)

Direct materials $ 300,000

Direct labor 1,000,000

Factory overhead-var 150,000

Factory overhead-fix 50,000

Total $1,500,000

MANUFACTURING COSTS PER UNIT

($1,500,000/100,000) $15

Desired profit $160,000

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CALCULATING MARKUP:Product Cost

LO 2

Markup % =

(Desired profit + Selling, Administrative expense) / Manufacturing cost

{$160,000 + ($1.50*100,000) + $20,000} / $1,500,000

22%

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SELLING PRICE UNDER PRODUCT COST

LO 2

Desired profit (800,000 * 20%) $160,000

Selling price {$15.00 + ($15 * 22%)} $18.30

CHECK: {100,000 * ($15 + $3.30)} = $18.30

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MARKUP FORMULA:Variable Cost

LO 2

Markup % =

(Desired profit + Total fixed costs) / Variable costs

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BASIC INFORMATION:Product Cost

LO 2

VARIABLE COSTS

Direct materials $ 300,000

Direct labor 1,000,000

Factory overhead-var 150,000

Selling, Admin Exp 150,000

Total $1,600,000

VARIABLE COSTS PER UNIT

($1,500,000/100,000) $16

Desired profit $160,000

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CALCULATING MARKUP:Variable Cost

LO 2

Markup % =

(Desired profit + Total fixed costs) / Variable costs

{$160,000 + $50,000 + $20,000} / $1,600,000

14.4%

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SELLING PRICE UNDER PRODUCT COST

LO 2

Desired profit (800,000 * 20%) $160,000

Selling price {$16.00 + ($16 * 14.4%)} $18.30

CHECK: {100,000 * ($16 + $2.30)} = $18.30

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OTHER COST CONCEPTS

LO 2

Activity based costingIdentifies, traces costs to specific activities

Target cost conceptCombines market-based pricing with cost

containmentVariable cost concept

Markup added to variable costs

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LO 2

EXHIBIT EXHIBIT 1010

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LEARNING OBJECTIVELEARNING OBJECTIVE

3Calculate relative profitability in bottleneck production environment.

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PRODUCTION BOTTLENECKS

LO 3

A production bottleneck (constraint) occurs at a point in the production process where demand exceeds the

ability to produce the product.

Theory of constraints attempts to reduce influence of bottlenecks.

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ANALYZING PROFIT IN BOTTLENECK

LO 3

CM suggests large wrench

most profitable BUT

Small wrench produces most bottleneck profit.

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THE END

CHAPTER 12