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CH 25 Differential Cost Analysis

This document discusses differential cost analysis and its application to various management decisions. It provides examples of how differential cost analysis can help evaluate whether to accept or reject orders, make or buy components, expand or reduce capacity, and discontinue underperforming products. The key aspects covered include calculating differential and incremental costs, determining cost thresholds for alternative choices, and only considering relevant variable costs for short-term decisions.

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1K views

CH 25 Differential Cost Analysis

This document discusses differential cost analysis and its application to various management decisions. It provides examples of how differential cost analysis can help evaluate whether to accept or reject orders, make or buy components, expand or reduce capacity, and discontinue underperforming products. The key aspects covered include calculating differential and incremental costs, determining cost thresholds for alternative choices, and only considering relevant variable costs for short-term decisions.

Uploaded by

Maimoona Asad
Copyright
© Attribution Non-Commercial (BY-NC)
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPT, PDF, TXT or read online on Scribd
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Differential Cost Analysis

Chapter 25

Management decisions

Accepting/Rejecting certain orders

Reducing the price of a single order


Making a price cut in a competitive market

Evaluating Make-or-buy alternatives


Expanding or reducing plant capacity

Increasing, curtailing or stopping production


Replacing present equipment

Spending additional amounts for sales promotion

Differential Cost

Difference between cost of alternative choices Marginal/Incremental cost Deals with determination of incremental revenue, costs and margins

Variable costs are significant


Fixed costs might be included

Example
Total cost at 60,000 units = $324,250 Total cost at 80,000 units = $423,400

Calculate total differential cost Calculate differential cost/unit

Solution
Differential cost = 423,400 324,250 = $99,150 Differential cost/unit = 99,150/20,000 = $4.96

Accepting Additional Orders

Differential cost must be considered involving a change in output Difference between the cost of producing present smaller output and that of the planned larger output Possibility of selling additional output at a figure lower or greater than the existing average unit cost New or additional business can be accepted as long as the variable cost is recovered

Example
Maximum capacity=100,000 units Normal capacity = 80,000 units Variable cost per unit = $5 Fixed cost= $100,000 Sales price per unit= $9 Profit at 80,000 and 81,000 units?

Solution

Present business $720,000 400,000 320,000 100,000 320,000

Additional business $9,000 5,000 4,000 _-0-____ 4,000

Total $729,000 405,000 324,000 100,000 224,000

Sales Variable cost Contribution Margin


Fixed cost Profit

Reducing the Price of a Special Order

At what minimum price the firm can afford to sell additional goods

Example

Company manufactures 450,000 units using 90% of its capacity Fixed factory overhead is $335,000 Variable factory overhead = $0.50/unit Direct materials = $1.80/unit Direct labor = $1.40/unit Each unit sells for $5

Example

Sales $2,250,000

Cost of goods sold: Direct materials(450,000*1.80) Direct labor(450,000*1.40) Variable factory overheads(450,000*0.50) Fixed factory overheads(450,000*0.67) Income from operations 283,500 301,500 810,000 630,000 225,000 1,966,500

Unabsorbed fixed factory overheads(500,000-450,000)*0.67] 33,500 Income from operations (adjusted) 250,000

Special Order

Additional fixed cost if special order of 100,000 units is accepted = $10,000 Sales price of a special order=$4.25

Solution
Sales (100,000 [email protected]) $425,000 Cost of goods sold: Direct materials(100,000units @1.80) 180,000 Direct labor (100,000units @ 1.40) 140,000 Variable factory overheads (100,000 units @0.50) 50,000 Additional fixed cost 10,000 380,000 Gain on the order $45,000

Exercise

The wood River plant of the Union Company has a normal capacity 0f 90,000 units per month. Monthly production costs are $12 variable cost per unit and $240,000 fixed. By increasing the fixed cost $10,000 a month, the plant can produce 95,000 units. Differential cost of the production between 80% and 90% of normal capacity. Differential cost of producing the 5,000 units above the normal capacity. Per unit total production cost of the 95,000 units Per unit differential production cost of the 5,000 units.

Solution

Differential cost of the production between 80% and 90% of normal capacity.
90,000 units *90% 90,000 units *80% 81,000 units 72,000 units 9,000 units

9,000 units *$12 = $108,000

Solution

Differential cost of producing the 5,000 units above the normal capacity. $60,000 10,000 70,000

5,000 units *12 Differential Fixed cost


Solution

Per unit total production cost of the 5,000 units

95,000 units *12 $1,140,000 Fixed costs(240,000+10,000) 250,000 1,390,000

Solution

Per unit differential production cost of the 5,000 units.

=$70,000/5,000 units = $14

Make-Or-Buy Decisions

Compare the cost of making the parts with the cost of buying them Costs for each of the alternatives must be based on the identical product specifications, quantities and quality standards

Decisions to Shut Down Facilities

In the short run, a firm seems to be better off operating than not operating if revenue > variable costs Shutting down of facilities
Does not eliminate all costs Loss of investment spent on training employees Recruiting and training costs after reopening Loss of losing established markets & customers

Decisions to Shut Down Facilities

If operations are continued


Certain expenses connected with the shutting down of the facilities can be saved Costs that would have to be incurred when a closed facility is reopened will be saved

Decisions to Discontinue Products

Requires careful analysis of relevant differential cost and revenue data Following benefits can be achieved with the correct decision:
Expanded sales Increased profits Reduced inventory levels Resources made available for more promising projects

Decisions to Discontinue Products

Not only the profitability of the products being analyzed be considered but also the extent to which sales of other products will be affected when one product is removed should be evaluated

Decisions to Discontinue Products

Management needs following signals to identify troubled products:


Declining sales volume Decreasing market share Malfunctioning of the product or introduction of a superior competitive product Expected future sales and market potential not favorable Return on investment below minimum acceptable level Variable costs approaching or exceeding revenue Price required to be constantly lowered to maintain sales

Other Cost Concepts

Opportunity costs
Measurable value of an opportunity bypassed by rejecting an alternative use to resources Measurement of sacrifices associated with alternatives

Imputed costs
Hypothetical costs representing the cost/value of a resource measured by its use value Interest on invested capital, rental value of companyowned properties, salaries of owners of sole proprietors Do not involve actual cash flows

Other Cost Concepts

Out-Of-Pocket Costs
Involves cash outlays Often identified as variable costs Helpful in deciding whether a particular venture will at least return the cash expenditures

Sunk Costs
Irrecoverable costs Not included in differential cost analysis

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