Fundamentals of Cost Analysisfor Decision Making

Chapter 4

Acc 355 4 - 1

Learning Objectives

L.O. 1 Use differential analysis to analyze decisions.

L.O. 2 Understand how to apply differential analysisto pricing decisions.

L.O. 3 Understand several approaches for establishingprices based on costs for Full cost pricing decisions.

L.O. 4 Understand how to apply differential analysis toproduction decisions.

L.O. 5 Understand the theory of constraints.

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Differential Analysis

L.O. 1 Use differential analysis to analyze decisions.

Differential analysis:The process of estimating revenues and costs

of alternative actions available to decision makersand of comparing these estimates to the status quo

Short run:The period of time over which capacity will be

unchanged, usually one year

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Differential Costs

With two or more alternatives, costs that differamong or between alternatives

Costs that change in response to an alternativecourse of action

Differential costs differ between actions.

Alternative A Alternative B

LO1

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Sunk Costs

Costs incurred in the past that cannot bechanged by present or future decisions

A sunk cost is NOT relevant for making decisions.

LO1

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Differential Costsversus Total Costs

Sales revenueVariable costsContribution marginFixed costsOperating profit

$750 (250)$500 (350)$150

$900 (300)$600 (350)$250

$150 (50)$100 -0- $100

Status Quo DifferenceAlternative

• Information presented to management canshow the detailed costs that are included formaking a decision, or it can show just thedifferences between alternatives, as follows.

LO1

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Differential Analysisand Pricing Decisions

L.O. 2 Understand how to apply differentialanalysis to pricing decisions.

Variable costs mustalways be covered.

Fixed costs must becovered in the long run.

Activity Level

Co

st

Activity Level

Co

st

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Special Order versus Full costPricing Decisions

Special Orderpricing decision:

No additional fixed cost

Pricing a one-timespecial order.

Full costpricing decision:

Additional Fixed Costs

Pricing a new product.

Year

0 1

LO2

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Special Orders

• An order that will not affect other salesand is usually a one-time occurrence

Value ofoption 1

Value ofoption 2

Acceptspecialorder?

Isoption 1

> option 2?

Option 1

Option 2

Status quo: Reject special order

Alternative: Accept special order

LO2

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Special Orders

• U-Develop has received a one-time offer for 500 printsat a special price of 40¢ per print ($200).

• The regular price is 50¢ and they haveenough idle capacity in the week to take the offer.

Sales for the week (5,000 prints at 50¢) $2,500Variable costs, including paper, maintenance,

and usage payment to machine owner(5,000 copies at 20¢) 1,000

Total contribution margin $1,500Fixed costs (supplies, plus allocated costs

of the print shop) 1,200Operating profit for the week $ 300

LO2

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Special Orders

Comparison of TotalsSales revenueVariable costsTotal contributionFixed costsOperating profit

Alternative Presentation: Differential AnalysisDifferential sales, 500 at 40¢Less: Differential costs, 500 at 20¢Differential operating profit (before taxes)

$2,500 (1,000)$1,500 (1,200)$ 300

$2,700 (1,100)$1,600 (1,200)$ 400

$ 200 100$ 100

$200 (100)$100 -0- $100

StatusQuo:

RejectSpecial

Offer

Alternative:AcceptSpecial

Offer Difference

Analysis of Special Order: U-Develop

LO2

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Full Cost Pricing Decisions

L.O. 3 Understand several approaches for establishingprices based on costs for Full cost pricing decisions.

• Full cost is the total cost to produce and sell a unit.

• Full costs are relevant for the long-term pricing decisions.

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Cost Analysis for Pricing

• In the long run an organization mustcover all variable and fixed costs –both manufacturing and selling.

LO3

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Life-Cycle ProductCosting and Pricing

• Product life-cycle is concerned with coveringcosts in all categories of the life cycle.

R & D Design Manufacturing

Marketing anddistribution

Customerservice

Take back(disposal)

LO3

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Target Costing fromTarget Pricing

• Target price:The price based on customers’ perceivedvalue for the product and the price thatcompetitors charge

• What would a customer pay?

• How much profit do I need?

• Can I make it at this cost?

Target price – Desired profit = Target cost

LO3

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Use of Differential Analysisfor Production Decision

L.O. 4 Understand how to apply differentialanalysis to production decisions.

Make or buyDecision to make goods or services

internally or purchase them externally

Add or dropa segment

Decision to add or drop a productline or close a business unit

Productchoice

Decision on what products or services to offer (product mix)

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Make-or-Buy Decisions

• U-Develop’s current costs of developing prints:

Costs directly traceable:Direct materialsDirect laborVariable manufacturing overheadFixed manufacturing overheadCommon costs allocated to this product lineTotal costs

$0.05 0.12 .03

$ 5,000 12,000 3,000 4,000 10,000$34,000

Per unit100,000prints

• This year’s expected volume is 100,000 prints,so the full cost of processing a print is$34,000 ÷ 100,000 = $0.34

LO4

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Make-or-Buy Decisions

• U-Develop received an offer from an outsidedeveloper to process any number of printsfor 25¢ each.

• Should U-Develop accept this offer?

• The accounting department prepared costanalyses at volume levels of 50,000 and100,000 prints per year.

LO4

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Make-or-Buy Decisions

Direct costs:Direct materialsLaborVariable overheadFixed overheadCommon costsTotal costs

$ 5,000 12,000 3,000 4,000 10,000b

$34,000

$25,000a

-0- -0- -0-

10,000b

$35,000

Processprints

100,000prints

$20,000 higher 12,000 lower 3,000 lower 4,000 lower -0- $ 1,000 higher

Outsourceprocessing Difference

a 100,000 units purchased at $0.25 = $25,000b These common costs remain unchanged for these volumes.

Because they do not change, they could be omitted from the analysis.

• Differential costs increase by $1,000, so rejectalternative to buy.

LO4

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Make-or-Buy Decisions

Direct costs:Direct materialsLaborVariable overheadFixed overheadCommon costsTotal costs

$ 2,500 6,000 1,500 4,000 10,000b

$24,000

$12,500a

-0- -0- -0-

10,000b

$22,500

Processprints

50,000prints

$10,000 higher 6,000 lower 1,500 lower 4,000 lower -0- $ 1,500 lower

Outsourceprocessing Difference

a 50,000 units purchased at $0.25 = $12,500b These common costs remain unchanged for these volumes.

Because they do not change, they could be omitted from the analysis.

• Differential costs decrease by $1,500, so acceptalternative to buy.

LO4

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Opportunity Costs of Making

• Assume that the facilities used to process printscould be used to offer a new service that wouldprovide a $2,000 incremental contribution.

• Should U-Develop accept or reject the alternative?

• U-Develop’s expected volume is 100,000 prints.

LO4

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Opportunity Costs of Making

Total cost of 100,000 printsOpportunity cost of using

facilities to process printsTotal costs, including

opportunity costs

$34,000

2,000$36,000

$35,000

-0- $35,000

Status quo:Process

prints

$1,000 highera

2,000 lowera

$1,000 lowera

Alternative:Outsourceprocessing Difference

a These indicate whether the alternative is higher or lower than the status quo.

• Differential costs decrease by $1,000, so accept the alternative.

LO4

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Add or Drop Decisions

Sales revenueCost of sales (all variable)Contribution marginLess fixed costs:

RentSalariesMarketing and administrative

Operating profit (loss)

$80,000 53,000$27,000

4,000 5,000 3,000$15,000

$10,000 8,000$ 2,000

1,000 1,000 500$ (500)

$50,000 30,000$20,000

2,000 2,500 1,500$14,000

Total

$20,000 15,000$ 5,000

1,000 1,500 1,000$ 1,500

Prints Cameras Frames

U-DevelopFourth Quarter Product Line Income Statement

LO4

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Add or Drop Decisions

Sales revenueCost of sales (all variable)Contribution marginLess fixed costs:

RentSalariesMarketing and administrative

Operating profit (loss)

$80,000 53,000$27,000

4,000 5,000 3,000$15,000

$70,000 45,000$25,000

4,000 4,000 2,750$14,250

$10,000 decrease 8,000 decrease$ 2,000 decrease

-0- 1,000 decrease 250 decrease$ 750 decrease

Status quo:Keep prints

Alternative:Drop prints Difference

U-DevelopDifferential Analysis

• Profits decrease $750, so keep prints.

LO4

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Product Choice Decisions

• Constraints:Activities, resources, or policies that limit theattainment of an objective.

• Contribution margin per unit of scarce resource:Contribution margin per unit of a particular inputwith limited availability.

LO4

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Product Choice DecisionsU-Develop

Revenue and Cost Information

$50

8 8 4$30

PriceLess: Variable costs per unit

MaterialLaborOverhead

Contribution margin per unitFixed costs

ManufacturingMarketing and administrative

$80

22 24 4$30

Metalframes

Total$3,000 1,500$4,500

Woodframes

LO4

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Product Choice DecisionsU-Develop

Revenue and Cost Information

$ 30÷ 0.5$ 60

Per unit:Contribution marginMachine hours requiredContribution margin per machine hour

$ 30÷ 1.0$ 30

Metalframes

Woodframes

• Metal Frames have a higher contribution marginper machine hour.

LO4

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Product Choice Decisions

• Suppose U-Develop has 200 machine hoursper month available.

400 × $30

$12,000 3,000 1,500$ 7,500

CapacityContribution margin per unitTotal contribution marginLess: Fixed manufacturing costsLess: Fixed marketing and admin. costsOperating profit

200 × $30$6,000 3,000 1,500$1,500

Metalframes

Woodframes

• Selling metal frames will result in higher profitsthan selling wooden frames.

LO4

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The Theory of ConstraintsL.O. 5 Understand the theory of constraints.

• Theory of constraints:Focuses on revenue and cost managementwhen faced with bottlenecks

• Bottleneck:Operation where the work required limits productionThe bottleneck is the constraining resource.

• Throughput contribution:Sales dollars minus direct materials costs andvariables such as energy and piecework labor

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Using Excel SolverProduct Choice Decisions

Problem 4-59