Differential Analysis and Product Pricing

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Differential Analysis and Product Pricing

• Chapter 12

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Identification of Relevant Costs and Revenues for
Decision Making

• A relevant cost (revenue) is a cost (revenue)
  that can have an impact on a decision
• Characteristics of relevant costs (revenues)
• Cost (revenue) that varies between alternatives
• Incremental or differential cost (revenue)
• Occur in the future
• Opportunity costs
• Benefit given up when one alternative is chosen
  over another

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Identification of Relevant Costs and Revenues for
Decision Making

• Sunk cost
• A cost that has already been incurred
• Always irrelevant because it cannot be changed

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Differential or Incremental Analysis

• Analysis of the differences in revenues and costs
  between alternative courses of action
• Typical applications
• Sell an unused asset, or keep it and lease it to
  someone else
• Discontinue a product or segment, or continue it
• Make a component or purchase it from a supplier
• Keep existing equipment or replace it
• Sell a product as it is, or process it further
• Accept business at a special price

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Applications of Incremental Analysis

• Sell or lease
• Relevant items
• Sell alternative
• Potential sales price, if any
• Cost to dispose of the item
• Lease alternative
• Lease revenue
• Maintenance costs, insurance, property taxes,
  etc. if they will continue to be paid by us

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Applications of Incremental Analysis

• Discontinue a product or segment
• Relevant items
• Amount of revenue that will be lost if the
  product or segment is discontinued
• Amount of cost that can be avoided if the product
  or segment is discontinued
• If the amount of cost that can be avoided exceeds
  the lost revenue, it is financially wise to
  discontinue the product or segment

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Applications of Incremental Analysis

• Make or buy a component
• Relevant items
• Make alternative
• Incremental costs (direct materials, direct
  labor, variable overhead)
• Fixed overhead is irrelevant if it does not
  increase as a result of the additional production
• Buy alternative
• Purchase price from supplier
• Alternative uses for the manufacturing capacity
  that becomes available

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Applications of Incremental Analysis

• Keep existing equipment or replace it
• Relevant items
• Difference in operating costs between the
  existing and proposed equipment
• Any change in revenue that may result from
  increased (or decreased) capacity
• Purchase price of the new equipment (included in
  the operating costs as depreciation)
• Sales value, if any, of the current equipment
• The original cost of the current equipment is
  irrelevant as it has already been incurred

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Applications of Incremental Analysis

• Sell a product now or process further
• Relevant items
• Incremental cost to process the item further
• Incremental revenue if the item is processed
  further
• If the incremental revenue exceeds the
  incremental cost, it is financially wise to
  process the product further

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Applications of Incremental Analysis

• Accept business at a special price
• Relevant items
• Sales price to be received for the items
• Incremental costs to be incurred producing the
  items (direct materials, direct labor, variable
  overhead)
• Fixed overhead is irrelevant if it does not
  increase as a result of the greater production

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Product Pricing Under Production Constraints

• The contribution margin per unit provides some
  guidance as to which products should be produced
• Emphasis should be placed on the item with the
  largest contribution margin
• If there are production constraints (limited
  amount of resources), we must consider the
  demands each product places on the resources

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Product Pricing Under Production Constraints

• Produce those products that generate the greatest
  contribution per unit of the constraining
  resource