Father Saturnino Urios University

Management Advisory Services- AIR

DIFFERENTIAL COST ANALYSIS and COST-VOLUME-PROFIT ANALYSIS

DIFFERENTIAL COST ANALYSIS

Decision Making- choosing from at least two alternatives.
1. Short-term non-routine cases
a. Accept or reject a special order or a business proposal
b. Sell or process further a product line
c. make or buy a part, subassembly or product line
d. continue operating or close a business segment
e. product combination
f. utilization of scarce resources
g. change in profit factors
2. Long-term cases e.g. capital investment decisions
The Decision making process:
a. defining the problem
b. setting of criteria
c. identifying the alternative courses
d. determination of possible consequences of the alternatives
e. evaluating the alternatives
f. choosing the best alternative and making the decision.
Approaches in solving decision making problems:
Total Approach- the total revenues and costs are determined for each alternative, and the
results are compared to serve as bases for making decisions
Differential Analysis- involves the most profitable alternative by analyzing the differential
revenues and costs
Exercises:
1. The Summer Bowling Center was asked to host a bowling tournament for the Hots Company. The
tournament would require the center to be closed to normal business for one day. This would be
feasible since the tournament is on a Monday and the center is not heavily used on Mondays. The Hots
Company has offered a flat fee of P5,000. Additional expenses for the day are estimated by the center
manager to be P400, the cost of hiring some additional casual workers to help clean up the center after
the tournament. The manager has estimated that the loss of fees due to closing of the center to normal
business would be about P2,000. There would be some cost savings (estimated at P500) because several
hourly-paid employees would not work that day. The manager feels that there would be no loss of
future business as a result of closing for one Monday.
Required: 1. What is the opportunity cost of closing the Bowling Center to normal business?
2. Calculate the additional profit or loss from hosting the tournament.
2. A and B each operate local French fry shops. A’s place is called Autofries and is highly automated. A
pours potatoes into one end of an expensive machine, and fries come out at the other end. A’s cost are
P10,000 per month plus P0.10 per box of fine fries. B’s place is called Human Touch Fries. B uses manual
peelers and frypersons. B’s costs are P2,000 per month plus P0.30 per box of fine fries.
Required: At what volume of boxes would the cost be the same for both?
3. After several years producing and selling at capacity (50,000 units), Pepa Company faced a year with
projected sales and production of 38,000 units. A potential customer offered to purchase 7,000 units at
a price of P18 each. The normal sales price is P30 each. Unit cost information is as follow:
Direct materials P9.00
Direct labor 6.50
Variable Overhead 2.00
Fixed Overhead 3.75
Total P21.25
Pepa also pays a sales commission of P1.75. The commission would have to be paid on this order.
Required: 1. Should Pepa accept the special order? By how much will profit increase or decrease if the
order is accepted?

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DIFFERENTIAL COST ANALYSIS and COST-VOLUME-PROFIT ANALYSIS
2. Suppose that Pepa does not have to pay the sales commission on the special order. Should
Pepa accept the special order? BY how much will profit increase or decrease if the order is accepted?
4. Patotii Company has been approached by a new customer with an offer to purchase 34,ooo units of
Patotii’s product at a price of P24 each. The new customer is geographically separated from Patotii’s
other customers, and there would be no effect on existing sales. Patotii normally produces 400,000 units
but plans to produce and sell only 360,000 in the coming year. The normal sales price is P30 per unit.
Unit cost information is as follows:
Direct materials P8.00
Direct Labor 10.00
Variable Overhead 4.00
Fixed Overhead 3.40
Total P25.40
If Patotii accepts the order, no fixed manufacturing activities will be affected because there is sufficient
excess capacity.
Required: 1. Should Patotii accept the special order? By how much will profit increase or decrease if the
order is accepted?
2. Suppose that Patotii’s distribution center at the warehouse is operating at full capacity and
would need to add capacity costing P6,000 for every 5,000 units to be packed and shipped. Should
Patotii accept the special order? BY how much will profit increase or decrease if the order is accepted?
5. CPA Company is selling 80,000 units of a product at P10 per unit. The variable cost is P6 per unit, and
the annual fixed cost is P120,000. A discount house has offered to buy 10,000 additional units of the
product which would slightly be modified, but the modifications would not affect production cost. The
discount house will pay P7 per unit.
Required: 1. If the two markets can be distinguished, should the order be accepted (assuming capacity
exists and has no other use)?
2. The manager feels that the two markets might not be distinguished and that the lower
price would cause regular sales to fall by 5,000 units. Should CPA accept the discount house offe?
3. If the discount house offer is raised to P9 per unit and competition resulting from the
special sale causes the regular price to drop to P9.50 to maintain the same regular sales volume, should
CPA accept the discount house offer?
6. Sherwood Company is currently manufacturing part Z911, producing 40,000 units annually. The part is
used in the production of several products made by Sherwood. The cost per unit for Z911 is as follows:
Direct materials P9.00
Direct labor 3.00
Variable overhead 2.50
Fixed Overhead 4.00
Total P18.50
Of the total fixed overhead assigned to Z911, P88,000 is direct fixed overhead (the lease of production
machinery and salary of a production line supervisor- neither of which will be needed if line is dropped).
The remaining fixed overhead is common fixed overhead. An outside supplier has offered to sell the part
to Sherwood for P16. There is no alternative use for the facilities currently used to produce the part.
Required: 1. Shoud Sherwood Company make or buy part Z911?
2. What is the most Sherwood would be willing to pay an outside supplier?
3. If Sherwood bought the part, by how much would income increase or decrease?
4. Now suppose that all of the fixed overhead is common fixed overhead.
a. Should Sherwood Company make or buy part Z911?
b. What is the most Sherwood would be willing to pay an outside supplier?
c. If Sherwood bought the part, by how much would income increase or decrease?
7. Happy Company sells Pdbato, a special model of calculator, at a price of P800 per unit. Happy’s costs
per unit are:
Materials P240
Labor 80
Variable factory overhead 120
Fixed factory overhead 160

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DIFFERENTIAL COST ANALYSIS and COST-VOLUME-PROFIT ANALYSIS
Total Costs P600
A special order for 1,000 units was received from WILD, a well-known school in the country. Additional
shipping costs on the sale are P72 per unit.
Required: 1. If Happy has excess capacity, what is the minimum price per unit that should be set for the
WILD order?
2. If happy is operating at full capacity what is the minimum price per unit?
MC QUESTIONS. 1. Which of the following is not a characteristic of relevant costing information? It is

a. associated with the decision under consideration.

b. significant to the decision maker.

c. readily quantifiable.

d. related to a future endeavor.

2. A fixed cost is relevant if it is

a. a future cost.

b. Avoidable.

c. sunk.

d. a product cost.

3. Relevant costs are

a. all fixed and variable costs.

b. all costs that would be incurred within the relevant range of production.

c. past costs that are expected to be different in the future.

d. anticipated future costs that will differ among various alternatives.

4. Which of the following is the least likely to be a relevant item in deciding whether to replace an old
machine?

a. acquisition cost of the old machine

b. outlay to be made for the new machine

c. annual savings to be enjoyed on the new machine

d. life of the new machine

5. If a cost is irrelevant to a decision, the cost could not be

a. a sunk cost.

b. a future cost.

c. a variable cost.

d. an incremental cost.

6. Which of the following costs would be relevant in short-term decision making?

a. incremental fixed costs

b. all costs of inventory

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c. total variable costs that are the same in the considered alternatives

d. the cost of a fixed asset that could be used in all the considered alternatives

7. The term incremental cost refers to

a. the profit foregone by selecting one choice instead of another.

b. the additional cost of producing or selling another product or service.

c. a cost that continues to be incurred in the absence of activity.

d. a cost common to all choices in question and not clearly or feasibly allocable to any of
them.

8. A cost is sunk if it

a. is not an incremental cost.

b. is unavoidable.

c. has already been incurred.

d. is irrelevant to the decision at hand.

9. Most___________ are relevant to decisions to acquire capacity, but not to short-run decisions
involving the use of that capacity.

a. sunk costs

b. incremental costs

c. fixed costs

d. prime costs

10. Irrelevant costs generally include

Sunk costs Historical costs Allocated costs

a. yes yes no

b. yes no no

c. no no yes

d. yes yes yes

11. In deciding whether an organization will keep an old machine or purchase a new machine, a
manager would ignore the

a. estimated disposal value of the old machine.

b. acquisition cost of the old machine.

c. operating costs of the new machine.

d. estimated disposal value of the new machine.

12. The potential rental value of space used for production activities

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a. is a variable cost of production.

b. represents an opportunity cost of production.

c. is an unavoidable cost.

d. is a sunk cost of production.

PRACTICE PROBLEMS:
1. Hey Chemical Company recently received an order for a product it does not normally produce. Since
the company has excess production capacity, management is considering accepting the order. In
analyzing the decision, the assistant controller is compiling the relevant costs of producing the order.
Production of the special order would require 8,000 kilograms of theolite. Hey does not use theolite for
its regular product, but the firm has 8,000 kilograms of the chemical on hand from the days when it used
theolite regularly. The theolite could be sold to a chemical wholesaler for P14,500. The book value of the
theolite is P2 per kilogram. Hey could buy theolite for P2.40 per kilogram.
Required: 1. What is the relevant cost of theolite for the purpose of analyzing the special order decision?
P14,500
2. Hey’s special order also requires 1,000 kilograms of genatope, a solid chemical regularly
used in the company’s products. The current stock of genatope is 8,000 kilograms at a book value of
P8.10 per kilogram. If the special order is accepted, the firm will be forced to restock genatope earlier
than expected, at a predicted cost of P8.70 per kilogram. Without the special order, the purchasing
manager predicts that the price will be P8.30, when normal restocking takes place. Any order of
genatope must be in 5,000 kilograms. What is the relevant cost of genatope? (1,000x8.70)+ [4,000x(8.7-8.3)]=
10,300
2.The Air Sole Shoe Company manufactures various types of shoes for sports and recreational use.
Several types of shoes require a built-in air pump. Presently, the company makes all of the air pumps it
requires for production. However, management is presently evaluating an offer from Air Supply Co. to
provide air pump at a cost of P3 each. Air sole management has estimated that the variable production
costs of the air pump are P2.50 per unit. The firm also estimates that it could avoid P20,000 per year in
fixed costs if it purchased rather than produced the air pumps.
Required: 1. If Air Sole requires 25,000 pumps per year, should it make them or buy them from Air
Supply Co. ? Buy advantage- P7,500
2. Id Air Sole requires 60,000 pumps per year, should it make them or buy them? Make
advantage- P10,000
3. Assuming all other factors are equal, at what level or production would the company be
indifferent between making and buying the pumps? P40,000
3. Andrei Company has a single product called a Dak. The company normally produces and sells 60,000
Daks each year at a selling price of P32 per unit. The company’s unit costs at this level of activity are
given below:

Direct Materials P10.00

Direct labor 4.50
Variable manufacturing overhead 2.30
Fixed manufacturing overhead 5.00 (P300,000 total)
Variable selling expenses 1.20
Fixed selling expenses 3.50 (P210,000 total)
Total cost per unit P26.50
A number of questions relating to the production and sale of Daks follow. Each question is independent.

a. Assume that Andrei Company has sufficient capacity to produce 90,000 Daks each year without any
increase in fixed manufacturing overhead costs. The company could increase its sales by 25% above the
present 60,000 units each year if it were willing to increase the fixed selling expenses by P80,000. Would
the increased fixed expenses be justified? Increase in profit- P130,000

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DIFFERENTIAL COST ANALYSIS and COST-VOLUME-PROFIT ANALYSIS
b. Assume again that Andrei Company has sufficient capacity to produce 90,000 Daks each year. A
customer in a foreign market wants to purchase 20,000 Daks. Duties on the Daks would be P1.70 per
unit, and costs for permits and licenses would be P9,000. The only selling costs that would be associated
with the order would be P3.20 per unit shipping cost. You have been asked by the president to compute
the per unit break-even price on this order. P22.15

c. The company has 1,000 Daks on hand that have some irregularities and are therefore considered to
be “seconds”. Due to the irregularities, it will be impossible to sell these units at the normal price
through regular distribution channels. What unit cost figure is relevant for a selling a minimum selling
price? P1.20

d. Due to a strike in its supplier’s plant, Andrei Company is unable to purchase more material for the
production of Daks. The strike is expected to last for two months. Andrei Company has enough material
on hand to continue to operate at 30% of normal levels for the two-month period. As an alterative,
Andrei could close its plant down entirely for the two months. If the plant were closed, fixed overhead
costs would be reduced by 20% while the plant was closed. What would the peso advantage or
disadvantage of closing the plant for the two-month period? P15,000 disadvantage

e. An outside manufacturer has offered to produce Daks for Andrei Company and to ship them directly
to Andrei’s customers. If Andrei company accepts this offer, the facilities that it uses to produce Daks
would be idle; however, fixed overhead costs would be reduced by 75% of their present level. Since the
outside manufacturer would pay for all the costs of shipping, the variable selling costs would be only 2/3
of their present amount. Compute the unit cost figure that is relevant for comparison to whatever
quoted price is received from the outside manufacturer. P20.95

COST-VOLUME-PROFIT ANALYSIS (CVP ANALYSIS)- examines the behavior of total

revenues, total costs, and operating income as changes occur in the output level, selling price, variable
cost per unit, or fixed costs of a product .

Break-Even Sales- that point of activity level (sales volume) where total revenues equal total costs, i.e.,
there is neither profit nor loss.

Exercises:
1. Loves Company’s controller prepared the following budgeted income statement for the coming year:
Sales(15,750 units) P315,000
Less: Variable expenses 126,000
Contribution margin P189,000
Less: Fixed Expenses 63,000
Profit before tax P126,000
Less: Taxes 37,800
Profit after taxes P 88,200
Required: a. What is Loves’ variable cost ratio? What is its contribution margin ratio? How much is the
contribution margin per unit?

b. Suppose Loves’ actual revenues are P46,000 more than budgeted. By how much will
before-tax profits increase? Give the answer without preparing a new income statement.

c. Compute the break even points in units and in pesos?

d. How much sales revenue must Loves generate to earn a before tax profit of P90,000?

e. How much sales revenue must Loves generate to earn an after tax profit of P73,500?

f. How many units must be sold to earn after tax profit of P50,400?

g. How much sales revenue must be generated to earn (a) before tax profit of 20% of sales?
(b) after tax profit of 28%?

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2. Income Statements for two different companies in the same industry are as follows:

YOU ME
Sales P500,000 P500,000
Less: Variable costs 400,000 200,000
Contribution margin P100,000 P300,000
Less:Fixed costs 50,000 250,000
Operating Income P 50,000 P 50,000

Required:
a. compute the degree of operating leverage for each company.
b. compute the break-even point for each company. Explain why the break even point for ME is higher.
c. Suppose that both companies experience a 50% increase in revenues. Compute the percentage
change in profits for each company. Explain why the percentage increase in ME’s profits is so much
larger than that of YOU?
3. Baby sells one of its products, a backpack, for P2,400. Variable cost per unit is P720, and monthly fixed
costs are P864,000. A combination of changes in the way Baby produces and sells this product could
increase variable cost per unit by P80 but decrease monthly fixed cost by P64,000.
Required: Determine the indifference point of the two alternatives.
4. The Pretty Company manufactures and sells pens. Currently, 5,000,000 units are sold per year at
P0.50 per unit. Fixed costs are P900,000 per year. Variable costs are P0.30 per unit.
Required: Consider each case separately:
1. a. What is the current annual operating income? P100,000
b. What is the present breakeven point in revenues? P2,250,000
Compute the new operating income for each of the following changes:

2. A P0.04 per unit increase in variable costs P (100,000)

3. A 10% increase in fixed costs and a 10% increase in units sold P110,000

4. A 20% decrease in fixed costs,a 20% decrease in selling price, a 10% decrease in variable cost
per unit, and a 40% increase in units sold P190,000

Compute the new breakeven point in units for each of the following changes:
5. A 10% increase in fixed costs 4,950,000 units
6. A 10% increase in selling price and a P20,000 increase in fixed costs 3,680,000 units
5. CVP analysis requires costs to be categorized as

a. either fixed or variable.

b. fixed, mixed, or variable.

c. product or period.

d. standard or actual.

6. With respect to fixed costs, CVP analysis assumes total fixed costs

a. per unit remain constant as volume changes.

b. remain constant from one period to the next.

c. vary directly with volume.

d. remain constant across changes in volume.

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7. CVP analysis relies on the assumptions that costs are either strictly fixed or strictly variable. Consistent
with these assumptions, as volume decreases total

a. fixed costs decrease.

b. variable costs remain constant.

c. costs decrease.

d. costs remain constant.

8. Which of the following will decrease the break-even point?

Decrease in Increase in direct Increase in

fixed cost labor cost selling price

a. yes yes yes

b. yes no yes
c. yes no no
d. no yes no
9. The following are projections about the two products of Dorine Company, baubles and trinkets, for the coming
year:

Baubles Trinkets
Units Amount Units Amount Total
Sales 10,000 P10,000 7,500 P10,000 P20,000
Costs
Fixed P 2,000 P 5,600 P 7,600
Variable 6,000 3,000 9,000
P 8,000 P 8,600 P16,600
Income before taxes P 2,000 P 1,400 P 3,400
Assuming that the customers purchase composite units of four baubles and three trinkets, the breakeven output
for the two products would be

A. B. C. D.
Baubles 6,909 6,909 5,000 5,000
Trinkets 6,909 5,182 8,000 6,000
Answer: B
WACM = (4/7 x 0.40)+(3/7 x 0.93 = P0.62857
BE units = 7,600/0.62857 = 12,091
Baubles = 12,091 x 4/7 = 6,909
Trinkets = 12,091 x 3/7 = 5,182
The sales mix for Dial Enterprise is as follows:
Product A: 12 units @ P5.25 sales price; P4.85 variable cost per unit.
Product B: 10 units @ P7.50 sales price; P6.95 variable cost per unit.
Product C: 6 units @ P12.25 sales price; P10.35 variable cost per unit.
Dial Enterprise's fixed costs are P75,950.
10. What are the composite break-even point?
A. 98,000 C. 3,500
B. 2,000 D. 4,000

Answer: C

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DIFFERENTIAL COST ANALYSIS and COST-VOLUME-PROFIT ANALYSIS
Total sales revenue per composite sales:
(12 x P5.25) + (10 x P7.50) + (6 x P12.25) P211.50
Total variable cost per composite sales:
(12 x P4.85) + (10 x P6.95) + (6 x P10.35) P189.80
Total contribution margin per composite sales
(P211.50 - P189.80) P 21.70
Composite breakeven point
P75,950 ÷ P21.70 3,500
Note: Total breakeven units: 3,500 x 28 = 98,000

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