# Accounting26th ch 25

CHAPTER

25

Differential Analysis,
Product Pricing, and
Activity-Based Costing

Warren
Reeve
Duchac

human/iStock/360/Getty Images

Accounting
26e

Differential Analysis
(slide 1 of 4)

Managerial decision making involves choosing between
alternative courses of action.
Although the managerial decision-making process varies by the
type of decision, it normally involves the following steps:
o

o
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o
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Step 1. Identify the objective of the decision, which is normally
maximizing income.
Step 2. Identify alternative courses of action.
Step 3. Gather information and perform a differential analysis.
Step 4. Make a decision.
Step 5. Review, analyze, and assess the results of the decision.

Differential Analysis
(slide 2 of 4)

Differential analysis, sometimes called incremental analysis,
analyzes differential revenues and costs in order to determine
the differential impact on income of two alternative courses of
action.
o

o
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Differential revenue is the amount of increase or decrease in revenue
that is expected from a course of action compared to an alternative.
Differential cost is the amount of increase or decrease in cost that is
expected from a course of action as compared to an alternative.
Differential income (loss) is the difference between the differential
revenue and differential costs.
 Differential income indicates that a decision is expected to increase income.
 A differential loss indicates that a decision is expected to decrease income.

Differential Analysis
(slide 3 of 4)

The differential analysis is prepared in three columns,
where positive amounts indicate the effect is to
increase income and negative amounts indicate the
effect is to decrease income.
o

o
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The first column is the revenues, costs, and income for
maintaining floor space for tables (Alternative 1).
The second column is the revenues, costs, and income for
using that floor space for a salad bar (Alternative 2).
The third column is the difference between the revenue,
costs, and income of one alternative over the other.

Differential Analysis
(slide 4 of 4)

In this chapter, differential analysis is illustrated for
the following common decisions:
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Leasing or selling equipment
Discontinuing an unprofitable segment
Manufacturing or purchasing a needed part
Replacing fixed assets
Selling a product or processing further
Accepting additional business at a special price

Lease or Sell

Management may lease or sell a piece of equipment
that is no longer needed.
In making a decision, differential analysis can be
used.
Only the differential revenues and differential costs
associated with the lease-or-sell decision are included
in the differential analysis.
o

The book value of the equipment is a sunk cost and is not
considered in the differential analysis.
 Sunk costs are costs that have been incurred in the past, cannot be
recouped, and are not relevant to future decisions.

Discontinuing a Segment or Product

A product, department, branch, territory, or other segment of a
business may be generating losses. As a result, management
may consider discontinuing (eliminating) the product or segment.
Discontinuing the product or segment usually eliminates all of
the product’s or segment’s variable costs such as direct
materials direct labor, variable factory overhead, and sales
commissions.
However, fixed costs such as depreciation, insurance, and
property taxes may not be eliminated.
o

Thus, it is possible for total company income to decrease rather than
increase if the unprofitable product or segment is discontinued.

Companies that manufacture products made up of
components that are assembled into a final product,
such as automobile manufacturers, must decide
whether to make a part or purchase it from a
supplier.
Differential analysis can be used to decide whether to
make or buy a part.

Replace Equipment

The usefulness of a fixed asset may decrease before
it is worn out as it may be less efficient.
Differential analysis can be used for decisions to
replace fixed assets such as equipment and
machinery.
o

The analysis normally focuses on the costs of continuing to
use the old equipment versus replacing the equipment.
 The book value of the old equipment is a sunk cost and, thus, is
irrelevant.

The revenue that is forgone from an alternative use of
an asset, such as cash, is called an opportunity cost. It
is useful in analyzing alternative courses of action.

Process or Sell

During manufacturing, a product normally progresses through
various stages or processes. In some cases, a product can be
sold at an intermediate stage of production, or it can be
processed further and then sold.
Differential analysis can be used to describe whether to sell a
product at an intermediate stage or to process it further.
o
o

In doing so, the differential revenues and costs from further processing
are compared.
The costs of producing the intermediate product do not change,
regardless of whether the intermediate product is sold or processed
further.

Accept Business at a Special Price

A company may be offered the opportunity to sell its products
at prices other than normal prices.
o

For example, an exporter may offer to sell a company’s products
overseas at special discount prices.

Differential analysis can be used to decide whether to accept
business at a special price.
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The differential revenue from accepting the additional business is
compared to the differential costs of producing and delivering the
product to the customer.

o

If the company is operating at less than full capacity, then the additional
production does not increase fixed manufacturing costs.
– However, selling and administrative expenses may change because of the

Setting Normal Product Selling Prices
(slide 1 of 3)

The normal selling price is the target selling price to
be achieved in the long term.
The normal selling price must be set high enough to
cover all costs and expenses (fixed and variable) and
provide a reasonable profit.

Setting Normal Product Selling Prices
(slide 2 of 3)

Managers can use one of two market methods to
determine selling price:
o

Demand-based concept
 The demand-based concept sets the price according to the demand
for the product.
– If there is high demand for the product, then the price is set high.
– Likewise, if there is low demand for the product, then the price is set
low.

o

Competition-based concept
 The competition-based concept sets the price according to the price
offered by competitors.

Setting Normal Product Selling Prices
(slide 3 of 3)

Managers can also use one of three cost-plus methods
to determine the selling price:
o
o
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Product cost concept
Total cost concept
Variable cost concept

Product Cost Concept
(slide 1 of 3)

Cost-plus methods determine the normal selling price
by estimating a cost amount per unit and adding a
markup, computed as follows:

Under the product cost concept, only the costs of
manufacturing the product, termed the product costs,
are included in the cost amount per unit to which the
o
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Estimated selling expenses, administrative expenses, and
desired profit are included in the markup.
The markup per unit is then computed and added to the
product cost per unit to determine the normal selling price.

Product Cost Concept
(slide 2 of 3)

Step 1. Estimate the total product costs as follows:

Step 2. Estimate the total selling and administrative
expenses.
Step 3. Divide the total product cost by the number of
units expected to be produced and sold to determine
the total product cost per unit, computed as follows:

Product Cost Concept
(slide 3 of 3)

• Step 4. Compute the markup percentage as follows:

o

The desired profit is normally computed based on a rate of return on assets as
follows:

• Step 5. Determine the markup per unit by multiplying the markup
percentage times the product cost per unit as follows:

• Step 6. Determine the normal selling price by adding the markup per unit to
the product cost per unit as follows:

Target Costing

Target costing is a method of setting prices that
combines market-based pricing with a cost-reduction
emphasis.
Under target costing, a future selling price is
anticipated, using the demand-based or the
competition-based methods.
The target cost is then determined by subtracting a
desired profit from the expected selling price,
computed as follows:
Target costing tries to reduce costs.

Production Bottlenecks

A production bottleneck (or constraint) is a point in
the manufacturing process where the demand for the
company’s product exceeds the ability to produce the
product.
The theory of constraints (TOC) is a manufacturing
strategy that focuses on reducing the influence of
bottlenecks on production processes.
When a company has a production bottleneck in its
production process, it should attempt to maximize its
profits, subject to the production bottleneck.
o

In doing so, the unit contribution margin of each product per
production bottleneck constraint is used.

Activity-Based Costing Method

Activity-based costing (ABC) identifies and traces
costs and expenses to activities and then to specific
products.
The ABC method is an alternative approach for
allocating factory overhead when there are diverse
products and processes.
ABC uses multiple factory overhead rates based on
activities.
o
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Activities are the types of work, or actions, involved in a
manufacturing process or service activity.
ABC initially assigns estimated factory overhead costs to
activities, resulting in estimated activity costs.

Activity Rates

The estimated activity costs are allocated to products
using an activity rate.
Activity rates are determined as follows:
Estimated Activity Cost
Activity Rate =
Estimated Activity-Base Usage
o
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The activity base is a measure of physical activity for each
activity.
The activity-base usage is the number of setups estimated to
be used by the operations.

Dangers of Product Cost Distortion

The allocation of factory overhead affects the
accuracy of product costs. In turn, product costs are
used for decisions such as establishing product price
and determining whether to discontinue a product line.
Using an inappropriate factory overhead allocation
method can lead to distorted product costs.

Appendix: Total Cost Concept
(slide 1 of 3)

Under the total cost concept, manufacturing cost plus
the selling and administrative expenses are included
in the total cost per unit.
The markup per unit is then computed and added to
the total cost per unit to determine the normal selling
price.

Appendix: Total Cost Concept
(slide 2 of 3)

• Step 1. Estimate the total manufacturing cost as follows:

• Step 2. Estimate the total selling and administrative expenses.
• Step 3. Estimate the total cost as follows:

• Step 4. Divide the total cost by the number of units expected to be
produced and sold to determine the total cost per unit, as follows:

Appendix: Total Cost Concept
(slide 3 of 3)

• Step 5. Compute the markup percentage as follows:

o

The desired profit is normally computed based on a rate of return on assets as
follows:

• Step 6. Determine the markup per unit by multiplying the markup
percentage times the cost per unit as follows:

• Step 7. Determine the normal selling price by adding the markup per unit to
the cost per unit as follows: