Fundamentals of Cost Analysis
for Decision Making
Chapter 4
McGraw-Hill/Irwin
Copyright ©2008 The McGraw-Hill Companies, Inc. All rights reserved.
Learning Objectives:
1. Use differential analysis to analyze decisions.
2. Understand how to apply differential analysis to
pricing decisions.
3. Understand several approaches for establishing
prices based on costs for long-run pricing
decisions.
4. Understand how to apply differential analysis to
production decisions.
5. Understand the theory of constraints.
4-2
Differential Analysis
LO1
Use differential analysis to analyze decisions.
Differential Analysis
The process of estimating revenues and costs
of alternative actions available to decision
makers and of comparing these estimates to
the status quo.
Short Run
The period of time over which capacity will
be unchanged, usually one year.
4-3
Differential Costs
Costs that change in response to
an alternative course of action.
Differential costs differ between actions.
4-4
Sunk Costs
Costs incurred in the past that cannot be
changed by present or future decisions.
A sunk cost is NOT relevant for making decisions.
4-5
Differential Analysis and Pricing Decisions
Understand how to apply differential analysis to
pricing decisions.
Variable costs
Must always be
covered.
Cost $
LO2
Fixed costs
Must be covered
in the long run.
Cost $
Activity Level
Activity Level
4-6
Full Cost and Pricing Decisions
Full cost of manufacturing and selling a product.
Variable costs
Necessary to manufacture
and sell the product.
and
Fixed costs
Share of organization’s fixed
costs.
Ultimately full costs must be recovered.
4-7
Short-run vs Long-run
Variable costs
Must always be
covered.
Must be included
in both Short and
Long-run Pricing
Decisions
Fixed costs
Must be covered Long-run Pricing
in the long run.
Decisions
4-8
Short-run vs Long-run Pricing Decisions
Year
0
1
Short-run
Pricing Decision
Long-run
Pricing Decision
Shorter than
one year
Longer than
one year
Pricing a one-time
special order.
How much material
is required?
Pricing a new
product.
Do I need a
new plant?
4-9
Short-run Pricing Decisions:Special Orders
An order that will not affect other
sales and is usually a one-time
occurrence.
Option 1
Value of
Option 1
Status Quo: Reject special offer
Accept
Special
Order?
Is Option 1
>
Option 2?
Alternative: Accept special offer
Option 2
Value of
Option 2
4-10
Example: Special Order
Analysis of Special Order U-Develop
Status Quo:
Comparison of Totals
Reject Special Order
Alternative:
Accept Special Order
Difference
Sales revenue
$2,500
$2,700
$200
Variable costs
(1,000)
(1,100)
(100)
Total contribution
$1,500
$1,600
$100
Fixed costs
(1,200)
(1,200)
$300
$400
Operating profit
0
$100
Alternative Presentation: Differential Analysis
Differential sales, 500 at 40¢
Less differential costs, 500 at 20¢
Differential operating profit (before taxes)
$200
100
$100
4-11
Cost Analysis for Pricing
LO3
Understand several approaches for establishing prices
based on costs for long-run pricing decisions.
In the long run an organization must cover
all variable and fixed costs – both
manufacturing and selling.
Life-cycle product costing
and pricing
Target costing for Target
pricing
4-12
Life-cycle Product Costing and Pricing
Product life-cycle
R&D
Cradle
The time from initial research and
development to the time that
support to the customer ends.
Manufacturing
Design
Customer
Service Take Back
Marketing &
(Disposal)
Distribution
Grave
To
Life-cycle Costing
Concerned with covering
costs in all categories of
the life cycle.
4-13
Target Costing from Target Pricing
Target price:
The price based on customers’
perceived value for the product
and the price that competitors
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
4-14
Other Costing Issues
Predatory Pricing:
Dumping
Practice of setting price below cost
with the intent to drive competitors
out of business.
Exporting a product to another
country at a price below domestic
cost.
Price Discrimination
Practice of selling identical goods to
different customers at different prices.
Peak-load Pricing
Practice of setting prices highest when
the quantity demanded for the
product approaches capacity.
Price Fixing
Agreement among businesses to set
prices at a particular level.
4-15
Differential Analysis for Production Decisions
LO4
Understand how to apply differential analysis to
production decisions.
Make or buy?
Decision to make goods or services
internally or purchase them
externally.
Add or drop a
segment?
Decision to add or drop a product line
or close a business unit.
Product choice
Decision on what products or services
to offer (Product Mix).
4-16
Example: Make or Buy
Make or buy?
Decision to make goods or
services internally or
externally.
Per Unit
100,000 prints
$0.05
$5,000
Direct labor
0.12
12,000
Variable manufacturing overhead
0.03
3,000
Cost directly traceable
Direct materials
Fixed manufacturing overhead
Common costs allocated to this product line
4,000
10,000
$34,000
4-17
Make or Buy, Continued. . .
U-Develop
100,000 Prints
Process Prints
Outsource
Processing
Difference
Direct Costs
Direct Materials
$5,000
$25,000a
$20,000 Higher
Labor
12,000
-0-
12,000 Lower
Variable Overhead
3,000
-0-
3,000 Lower
Fixed Overhead
4,000
-0-
4,000 Lower
Common Costs
10,000b
10,000b
Total Costs
$34,000
$35,000
-0$1,000 Higher
Differential costs increase by $1,000, so reject alternative to
buy.
a
100,000 units purchased at $.25 = $25,000.
These common costs remain unchanged for these volumes. Because they do not change,
they could be omitted from the analysis.
b
4-18
Example: Make or Buy, Continued. . .
U-Develop
50,000 Prints
Process Prints
Outsource
Processing
Difference
Direct Costs
$2,500c
$12,500d
$10,000 Higher
Labor
6,000
-0-
6,000 Lower
Variable Overhead
1,500
-0-
1,500 Lower
Fixed Overhead
4,000
-0-
4,000 Lower
Common Costs
10,000b
10,000b
Total Costs
$24,000
$22,500
Direct Materials
-0$1,500 Lower
Differential costs decrease by $1,500, so accept alternative to buy.
These common costs remain unchanged for these volumes. Because they do not
change, they could be omitted from the analysis
b
c
100,000 units purchased at $.25 = $25,000.
d
50,000 units purchased at $.25 = $12,500.
4-19
Example: Opportunity Cost of Making
U-Develop
Make or Buy Analysis with Opportunity Cost
Total Cost of 100,000 Prints
Opportunity cost of using facilities to
make covers
Total costs, incl. opportunity cost
Status
Quo
Alternative
Process
Prints
Outsource
Processing
Difference
$34,000
$35,000
$1,000
Highera
2,000
-0-
2,000
Lowera
$36,000
$35,000
$1,000
Lowera
Differential costs decrease by $1,000, so accept the alternative.
a These indicate whether the alternative is higher or lower than the status quo.
4-20
Example: Add or Drop
Add or drop a segment? Decision to add or drop a
product line or close a
business unit.
Fourth Quarter Product Line Income Statement, U-Develop
Total
Sales revenue
Prints
Cameras
Frames
$80,000
$10,000
$50,000
$20,000
53,000
_ 8,000
30,000
15,000
$27,000
$2,000
$20,000
$5,000
Rent
4,000
1,000
2,000
1,000
Salaries
5,000
1,000
2,500
1,500
_3,000
__500
_1,500
_1,000
$14,000
$1,500
Cost of sales (all variables)
Contribution margin
Less fixed costs:
Marketing and administrative
Operating profit (loss)
$15,000
$(500)
4-21
Example: Add or Drop, Continued. . .
Differential Analysis U-Develop
Sales revenue
Status Quo:
Alternative:
Keep Prints
Drop Prints
Difference
$80,000
$70,000
$10,000
decrease
53,000
45,000
_8,000
decrease
$27,000
$25,000
$2,000
decrease
Rent
4,000
4,000
0
Salaries
5,000
4,000
1,000
decrease
_3,000
_2,750
__250
decrease
$15,000
$14,250
$750
decrease
Cost of sales (all variables)
Contribution margin
Less fixed costs:
Marketing and administrative
Operating profit (loss)
Profits decrease $750 so keep prints.
4-22
Product Choice Decisions
Constraints
Activities, resources, or policies that
limit the attainment of an objective.
Contribution margin per unit of scarce resource
Contribution margin per unit of a particular
input with limited availability.
4-23
Example: Product Choice Decisions
U-Develop
Revenue and Cost Information
Metal
Wood
Frames
Frames
Price
$50
$80
Material
8
22
Labor
8
24
Overhead
4
4
$30
$30
Less: Variable Costs per
Unit
Contribution Margin per Unit
Fixed manufacturing costs: $3,000 per month
Fixed marketing and administrative costs: $1,500 per month
4-24
Example: Product Choice Decisions
U-Develop
Revenue and Cost Information
Metal
Frames
Wood
Frames
$30
$30
Machine Hours Required
.5
1
Contribution Margin per
Machine Hour
$60
$30
Per Unit
Contribution Margin
Metal Frames have a higher
contribution margin per
machine hour.
4-25
Example: Product Choice Decisions, Continued. . .
Suppose U-Develop has 200 machine hours
per month available.
Metal
Frames
Wood
Frames
Capacity
400
200
Contribution Margin per Unit
$30
$30
Total Contribution Margin
$12,000 $6,000
Less: Fixed Manufacturing Costs
3,000
3,000
Less: Fixed M&A Costs
1,500
1,500
Operating Profit
$7,500 $1,500
Selling metal frames will result in higher
profits than selling wooden frames.
4-26
Theory of Constraints
LO5
Understand the theory of constraints.
Theory of Constraints
Focuses on revenue and cost
management when faced with
bottlenecks
Bottleneck
Operation where the work required
limits production. The bottleneck is
the constraining resource
Throughput
Contribution
Sales dollars minus direct materials
costs and variables such as energy
and piecework labor
4-27
Chapter 4
4-28