Download - Ch 25 Differential Cost Analysis
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Differential Cost Analysis
Chapter 25
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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
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Differential Cost
Difference between cost of alternativechoices
Marginal/Incremental cost
Deals with determination of incrementalrevenue, costs and margins
Variable costs are significant
Fixed costs might be included
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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
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Solution
Differential cost = 423,400
324,250
= $99,150
Differential cost/unit = 99,150/20,000
= $4.96
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Accepting Additional Orders
Differential cost must be considered involving achange in output
Difference between the cost of producing
present smaller output and that of the plannedlarger output
Possibility of selling additional output at a figure
lower or greater than the existing average unitcost
New or additional business can be accepted as
long as the variable cost is recovered
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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?
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Solution
Present business Additional business Total
Sales $720,000 $9,000 $729,000
Variable cost 400,000 5,000 405,000
ContributionMargin 320,000 4,000 324,000
Fixed cost 100,000 _-0-____ 100,000
Profit 320,000 4,000 224,000
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Reducing the Price of a SpecialOrder
At what minimum price the firm canafford to sell additional goods
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Example
Company manufactures 450,000 units using90% 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
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Example
Sales
$2,250,000
Cost of goods sold:
Direct materials(450,000*1.80) 810,000
Direct labor(450,000*1.40) 630,000
Variable factory overheads(450,000*0.50) 225,000
Fixed factory overheads(450,000*0.67) 301,500 1,966,500
Income from operations
283,500
Unabsorbed fixed factory overheads(500,000-450,000)*0.67]33,500
Income from operations (adjusted)
250,000
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Special Order
Additional fixed cost if special order of100,000 units is accepted = $10,000
Sales price of a special order=$4.25
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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
mailto:[email protected]:[email protected]:[email protected]:[email protected] -
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Exercise
The wood River plant of the Union Company has anormal capacity 0f 90,000 units per month. Monthlyproduction 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% and90% of normal capacity.
Differential cost of producing the 5,000 units above thenormal capacity.
Per unit total production cost of the 95,000 units
Per unit differential production cost of the 5,000 units.
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Solution
Differential cost of the production between80% and 90% of normal capacity.
90,000 units *90% 81,000 units
90,000 units *80% 72,000 units
9,000 units
9,000 units *$12 = $108,000
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Solution
Differential cost of producing the 5,000units above the normal capacity.
5,000 units *12 $60,000
Differential Fixed cost 10,000
70,000
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Solution
Per unit total production cost of the5,000 units
95,000 units *12 $1,140,000
Fixed costs(240,000+10,000) 250,000
1,390,000
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Solution
Per unit differential production cost ofthe 5,000 units.
=$70,000/5,000 units
= $14
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Make-Or-Buy Decisions
Compare the cost of making the parts withthe cost of buying them
Costs for each of the alternatives must bebased on the identical productspecifications, quantities and qualitystandards
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Decisions to Shut Down Facilities
In the short run, a firm seems to be better offoperating 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
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Decisions to Shut DownFacilities If operations are continued
Certain expenses connected with the shuttingdown of the facilities can be saved
Costs that would have to be incurred when a
closed facility is reopened will be saved
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Decisions to Discontinue Products
Requires careful analysis of relevant differentialcost and revenue data
Following benefits can be achieved with the
correct decision: Expanded sales
Increased profits
Reduced inventory levels
Resources made available for more promisingprojects
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Decisions to DiscontinueProducts
Not only the profitability of the products beinganalyzed be considered but also the extent towhich sales of other products will be affectedwhen one product is removed should be
evaluated
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Decisions to DiscontinueProducts Management needs following signals to identifytroubled 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
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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 company-owned properties, salaries of owners of sole proprietors
Do not involve actual cash flows
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Other Cost Concepts
Out-Of-Pocket Costs Involves cash outlays
Often identified as variable costs
Helpful in deciding whether a particular venturewill at least return the cash expenditures
Sunk Costs
Irrecoverable costs Not included in differential cost analysis