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ACG 2071
Managerial Accounting
Chapter M 8
Differential Analysis and Product Pricing
Costs:
Relevant - estimated costs and revenues that are important in
the decision making process.
Sunk costs – that have been incurred in the past are not relevant
to the decision.
Differential revenue:
Is the amount of increase or decrease in revenue expected from a
course of action as compared with an alternative?
Differential cost:
Is the amount of increase or decrease in cost that is expected from a
course of action as compared with an alternative?
Differential income or loss:
Is the difference between the differential revenue and the differential
costs?
Differential analysis:
Focuses on the effect of alternative courses of action on the relevant
revenues.
Types of Decision-making:
1. Lease or sell: management may have a choice between leasing or
selling a piece of equipment that is no longer needed in the business.
The relevant factors to be considered are the differential revenues and
differential costs associated with the lease or sell decision.
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Spring 2001-2
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ACG 2071
Managerial Accounting
Example 1: A corporation can sell an asset for $200,000 less a 6%
selling commission. An alternative would be to lease the asset for
five years at $40,000 per year less $35,000 in costs over the five
years. Which decision would you make?
Example 2: A corporation can sell an asset for $180,000 less a 4%
selling commission. An alternative would be to lease the asset for
three years at $70,000 per year less $50,000 in costs over the three
years. Which decision would you make?
2. Discontinue a segment or product
When a product or a department, branch, territory, or other segment of
a business is generating losses, management may consider eliminating
the product or segment.
It is often assumed, sometimes in error, that the total income from
operations of a business would be increased if the operating loss could
be eliminated.
Discontinuing the product or segment usually eliminates all of the
product or segment’s variable costs.
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Spring 2001-2
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ACG 2071
Managerial Accounting
However, if the product or segment is a relatively small part of the
business, discontinuing it may not decrease the fixed costs.
If contribution margin > 0 then continue production
Example 3:
Sales
Cost of
goods sold
Variable
Fixed
Total CGS
Gross profit
Operating
expenses
Variable
Fixed
Total
Income
Shampoo
$500,000
Conditioner
$400,000
Lotion
$100,000
Total
$1,000,000
$220,000
$120,000
340,000
160,000
$200,000
$80,000
280,000
$120,000
$60,000
$20,000
80,000
$20,000
$480,000
$220,000
700,000
$300,000
$95,000
$25,000
$120,000
$40,000
$60,000
$20,000
$80,000
$40,000
$25,000
$6,000
$31,000
$(11,000)
$180,000
$51,000
$231,000
$69,000
Should we discontinue the production of Lotion?
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Spring 2001-2
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ACG 2071
Managerial Accounting
Example 4: A condensed income statement for Fresh Kola indicated the
following:
Sales
$250,000
Cost of goods sold
$175,000
Gross profit
$50,000
Operating expenses
$60,000
Income
$(10,000)
Variable costs of goods sold are $120,000 and variable operating was
$15,000. Should we discontinue the production of Fresh Kola?
3. Make or Buy
 The assembly of many parts is often a major element in
manufacturing some products, such as autos.
 The product’s manufacturer may make these parts or they may be
purchased.
 Management uses differential costs to decide whether to make or buy
a part.
 Only variable costs are considered.
 Must have unused capacity in the factory.
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Spring 2001-2
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ACG 2071
Managerial Accounting
Example 5: A factory has unused capacity and is considering the
production of a part for its product. The cost of making a part is Direct
materials $80, direct labor $80, variable factory overhead $52 and fixed
factory overhead $68. The cost of purchasing the product is $240 a unit.
Should we make or buy?
Example 6: A factory has unused capacity and is considering the
production of a part for its product. The cost of making a part is Direct
materials $5, direct labor $3, variable factory overhead $2 and fixed factory
overhead $8. The cost of purchasing the product is $9 a unit. Should we
make or buy?
4. Replace Equipment
 The usefulness of fixed assets may be reduced long before they are
considered to be worn out.
 Equipment may no longer be efficient for the purposes for which it is
used.
 On the other hand, the equipment may not have reached the point of
complete inadequacy.
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Spring 2001-2
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ACG 2071
Managerial Accounting
 Decisions to replace usable fixed assets should be based on relevant
costs.
 The relevant costs are the future costs of continuing to use the
equipment versus replacement
 The book values of the fixed assets being replaced are sunk costs and
are irrelevant.
Example 7: The business is considering the disposal of a machine with
book value of $100,000 and an estimated remaining live of five years. The
old machine can be sold for $25,000. The new machine has a cost of
$250,000. The new machine would have a life of five years and no residual
value. Analysis indicates that the estimated annual reduction in variable
manufacturing costs from $225,000 with the old machine to $150,000 per
year with the new machine. Should we buy the new machine?
Example 8: Francis is considering purchasing a lathe. The old machine
cost $250,000 and has book value of $50,000 with three years left. It has a
disposal value of $10,000. The new machine has a cost of $350,000 for five
years and no residual value. The new machine will decrease cost by $75,000
for the next three years. Should we buy the new machine?
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Spring 2001-2
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ACG 2071
Managerial Accounting
5. Process or Sell
 When a product is manufactured, it progresses through various stages
of production.
 Often a product can be sold at an intermediate stage of production, or
it can be processed further and then sold.
Example 9: Assume that a business produces kerosene in batches of 4,000
Gallons. Standard quantities of 4,000 gallons of direct materials are
processed which cost $0.60 per gallon. Kerosene can be sold without further
processing for $0.80 per gallon. It can be processed further to yield
gasoline, which can be sold for $1.25 per gallon. Gasoline requires
additional processing costs of $650 per batch, and 20% of the gallons of
kerosene will evaporate during production. Should we sell or process
further?
Example 10: Environ produces Gecko. Production starts with 10,000
gallons of direct materials processed for $2 per gallon. It can be sold at $3
per gallon. Gecko can be further processed into Keyed for additional costs
of $1.50 per gallon with a cost of 10% of the product. The selling price of
Keyed is $4.50 per gallon. Should we process further?
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Managerial Accounting
6. Accept Businesses at a Special Price
 Differential analysis is also useful in deciding whether to accept
additional business at a special price.
 The differential revenue that would be provided from the additional
business is compared to the differential costs of producing and
delivering the product to the customer.
 If the company is operating at full capacity, any additional production
will increase both fixed costs and variable.

However, the normal production of the company is below full
capacity, additional business may be undertaken without increasing
fixed production costs.
Example 11: Assume that the monthly capacity is 12,500 units. Current
sales and production are 10,000 units. The current manufacturing costs of
$20 per unit with fixed costs of $7.50. The normal selling price of the
product is $30. The manufacturer receives from an exporter an offer for
5,000 units at $18 per unit. The production can be spread over three months.
Should we accept the special offer?
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Spring 2001-2
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ACG 2071
Managerial Accounting
Example 12: paramour has an offer for the sale of 6,000 units at $20 per
unit. Current sales price is $30 with costs of direct materials $10, direct
labor $5, variable factory overhead of $3 and fixed factory overhead of $4.
With the plant operating at 70% capacity should be accept?
Setting Normal Product Selling Prices
 Differential analysis may be useful in deciding to lower selling prices
for special short run decisions, such as whether to accept business at a
price lower than the normal price.
 The normal selling price must be set high enough to cover all costs
and expenses and provide a reasonable profit.
 The normal selling price can be viewed as the targeted selling price to
be achieved in the long run.
 The basic approaches to setting this price as follows:
Market Methods
Demand based
Competition based
Cost plus Methods
Total cost concept
Product cost concept
Variable cost concept
 Managers using the market methods refer to the external market to
determine the price.
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Spring 2001-2
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ACG 2071
Managerial Accounting
 Demand based methods set the price according to the demand for the
product.
 If there is high demand for the product, then the price may be set high,
while the lower demand may require the price to be set low.
 Managers using the cost plus methods price the product in order to
achieve a target profit.
 Managers add to the cost an amount called MARKUP.
Total Cost Concept
All the costs of manufacturing a product plus the selling and administrative
expenses are included in the cost amount to which the markup is added.
Steps:
1. Determine the total cost of manufacturing the product.
a. Includes the direct materials, direct labor, and factory overhead
2. Add the estimated selling and administrative expenses to the total cost
of manufacturing the product.
3. Cost per unit is then computed by dividing the total costs by the total
units expected to be produced and sold.
4. Markup percentage = Desired profit
Total cost
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Spring 2001-2
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ACG 2071
Managerial Accounting
Example 13: The desired profit is $161,000
Variable costs 10,000 units
Direct materials
Direct labor
Factory overhead
Selling and
administrative expenses
TOTAL variable costs
Fixed costs
Factory overhead
Selling and administrative
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Spring 2001-2
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Total Cost
$30,000
$100,000
$15,000
$15,000
$160,000
$50,000
$20,000
Unit Cost
$3
$10
$1.50
1.50
$16
ACG 2071
Managerial Accounting
Example 14: The desired profit is $200,000
Variable costs 15000 units
Direct materials
Direct labor
Factory overhead
Selling and
administrative expenses
TOTAL variable costs
Fixed costs
Factory overhead
Selling and administrative
Total Cost
Unit Cost
$5
$7
$2
4
$60,000
$40,000
Product Cost Concept
Only the cost of manufacturing the product termed the product cost, are
included in the cost amount to which the markup is added.
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Spring 2001-2
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ACG 2071
Managerial Accounting
Estimated selling expenses, administrative expenses, and profits are included
in the markup.
Markup % = Desired profit + Total selling and administrative exp
Total manufacturing costs
Example 15 The desired profit is $161,000 with production of 10,000 units.
Variable costs
Direct materials
Direct labor
Factory overhead
Selling and administrative
expenses
TOTAL variable costs
Fixed costs
Factory overhead
Selling and administrative
$3
$10
$1.50
1.50
$16
$50,000
$20,000
Example 16: Using the information from example 14. Compute using
product cost concept.
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Spring 2001-2
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Managerial Accounting
Variable Cost Concept
Emphasizes the distinction between variable and fixed costs in product
pricing.
Only variable costs are included in the cost amount to which the markup is
added
Markup % = Desired profit + Total fixed costs
Total variable costs
Example 17: The desired profit is $161,000 and production of 0,000 units
Variable costs
Direct materials
Direct labor
Factory overhead
Selling and administrative
expenses
TOTAL variable costs
Fixed costs
Factory overhead
Selling and administrative
$3
$10
$1.50
1.50
$16
$50,000
$20,000
Example 18: Using the information from example 14, compute using the
variable cost concept.
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Spring 2001-2
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Managerial Accounting
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