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AMIS 3300

Chapter 11
DIFFERENTIAL COSTS AND REVENUES

Bill is currently employed as a lifeguard, but he has been offered a


job in an auto service center in the same town. The differential
revenues and costs between the two jobs are listed below:

Auto Differential
Life- Service costs and
guard Center revenues

Monthly salary $1,200 $1,500 $300

Monthly expenses:
Commuting 30 90 60
Meals 150 150 0
Apartment rent 450 450 0
Uniform rental 0 50 50
Union dues 10 0 (10)
Total monthly expenses 640 740 100
Net monthly income $ 560 $ 760 $200
Identifying Relevant Costs
Automobile Costs (based on 10,000 miles driven per year)
Annual Cost Cost per
of Fixed Items Mile
1 Annual straight-line depreciation on car $ 2,800 $ 0.280
2 Cost of gasoline 0.050
3 Annual cost of auto insurance and license 1,380 0.138
4 Maintenance and repairs 0.065
5 Parking fees at school 360 0.036
6 Total average cost $ 0.569

Some Additional Information


7 Reduction in resale value of car per mile of wear $ 0.026
8 Round-trip train fare $ 104
9 Cost of hotel in New York $ 200
10 Cost of putting dog in kennel while gone $ 40
11 Benefit of having car in New York ????
12 Hassle of parking car in New York ????
13 Per day cost of parking car in New York $ 25
Total and Differential Cost Approaches

The management of a company is considering a new laborsaving


machine that rents for $3,000 per year. Data about the company’s
annual sales and costs with and without the new machine are:
Situation Differential
Current With New Costs and
Situation Machine Benefits
Sales (5,000 units @ $40 per unit) $ 200,000 $ 200,000 -
Less variable expenses:
Direct materials (5,000 units @ $14 per unit) 70,000 70,000 -
Direct labor (5,000 units @ $8 and $5 per unit) 40,000 25,000 15,000
Variable overhead (5,000 units @ $2 per unit) 10,000 10,000 -
Total variable expenses 120,000 105,000 -
Contribution margin 80,000 95,000 15,000
Less fixed expense:
Other 62,000 62,000 -
Rent on new machine - 3,000 (3,000)
Total fixed expenses 62,000 65,000 (3,000)
Net operating income $ 18,000 $ 30,000 12,000
Make or Buy
Let’s take a look at another decision faced by many businesses.

We need a particular component for our


manufacturing process. Do you think we should
make or buy this particular item?

W
Make or Buy
Han Products manufactures 30,000 units of part S-6 each year
for use on its production line. At this level of activity, the cost
per unit for part S-6 is as follows:

Direct materials $3.60


Direct labor 10.00
Variable manufacturing overhead 2.40
Fixed manufacturing overhead 9.00
Total cost per part $25.00
Make or Buy (continued)
An outside supplier has offered to sell 30,000 units of part S-6
each year to Han Products for $21 per part. If Han Products
accepts this offer, the facilities now being used to manufacture
part S-6 could be rented to another company at an annual
rental of $80,000. However, Han Products has determined that
two-thirds of the fixed manufacturing overhead being applied to
part S-6 would continue even if part S-6 were purchased from
the outside supplier.

Prepare computations showing how much profits will increase


or decrease if the outside supplier’s offer is accepted.
Analysis of Special Pricing Decisions
Let’s take a look at another decision faced by many businesses:

Another firm has offered to pay us $10 for a product


that normally sells for $25. Do you think we should
accept this special order?

W
Accept/Reject Special Orders
Polaski Company manufactures and sells a single product called a Ret.
Operating at capacity, the company can produce and sell 30,000 Rets
per year. Costs associated with this level of production and sales are
given below:
Unit Total
Direct materials $15 $450,000
Direct labor 8 240,000
Variable manufacturing overhead 3 90,000
Fixed manufacturing overhead 9 270,000
Variable selling expense 4 120,000
Fixed selling expense 6 180,000
Total cost $45 $1,350,000
The Rets normally sell for $50 each. Fixed manufacturing overhead is
constant at $270,000 per year within the range of 25,000 through
30,000 Rets per year.
Accept/Reject Special Orders (continued)
Assume that due to a recession, Polaski Company expects to sell
only 25,000 Rets through regular channels next year. A large
retail chain has offered to purchase 5,000 Rets if Polaski is
willing to accept a 16% discount off the regular price. There
would be no sales commissions on this order; thus, variable
selling expenses would be slashed by 75%.

However, Polaski Company would have to purchase a special


machine to engrave the retail chain’s name on the 5,000 units.
This machine would cost $10,000. Polaski Company has no
assurance that the retail chain will purchase additional units in
the future. Determine the impact on profits next year if this
special order is accepted.
Accept/Reject Special Orders (continued)
Refer to the original data. Assume again that Polaski Company
expects to sell only 25,000 Rets through regular channels next
year. The U.S. Army would like to make a one-time-only
purchase of 5,000 Rets. The Army would pay a fixed fee of
$1.80 per Ret, and it would reimburse Polaski Company for all
costs of production (variable and fixed) associated with the
units. Because the army would pick up the Rets with its own
trucks, there would be no variable selling expenses associated
with this order.

If Polaski Company accepts the order, by how much will profits


increase or decrease for the year?
Accept/Reject Special Orders (continued)
Assume the same situation as that described in the previous
slide, except that the company expects to sell 30,000 Rets
through the regular channels next year. Thus, accepting the
U.S. Army’s order would require giving up regular sales of
5,000 Rets.

If the Army’s order is accepted, by how much will profits


increase or decrease from what they would be if the 5,000 Rets
were sold through regular channels?
Utilizing a Constrained Resource
Let’s take a look at another decision faced by many businesses:

One of our machines is a constraint in the operation.


What products should we produce on this machine?

W
Scarce Resource Constraint

A company has two products: a plain cellular


phone and a fancier cellular phone with many
special features:

Plain Fancy
Phone Phone
Selling price $ 80 $ 120
Variable costs 64 84
Contribution margin $ 16 $ 36
Contribution-margin ratio 20% 30%
Scarce Resource Constraint

Which product is more profitable?

On which should the firm spend its resources?

It depends.

If sales are restricted by demand for only a limited number


of phones, fancy phones are more profitable.
Scarce Resource Constraint

Suppose annual demand for phones of both types is more than


the company can produce in the next year.

Only 10,000 hours of capacity are available

If in one hour plant workers can make either three plain


phones or one fancy phone, which phone is more profitable?
Scarce Resource Constraint

Plain Fancy
Phone Phone
1. Units per hour 3 1
2. Contribution margin per unit $ 16 $ 36

Contribution margin per hour

Total contribution for


10,000 hours
Analysis of Equipment Replacement Decisions

Let’s take a look at another decision faced by many businesses:

Should we replace a machine with a newer and more


efficient one?

W
Equipment Replacement Decision
A manager at White Co. wants to replace an old machine with a new, more
efficient machine:

NNeeww m maacchhiinnee::
LLiisstt pprriiccee $$ 9900,,000000
AAnnnnuuaall vvaarria
iabble
le eexxppeennsseess 8800,,000000
EExxppeecctteedd life
life inin yyeeaarrss 55
OOld
ld m
maacchhin inee::
OOrrig
igin
inaall ccoosstt $$ 7722,,000000
RReemmaaininin
ingg bbooookk vvaaluluee 6600,,000000
DDis
isppoossaall vvaalu
luee nnooww 1155,,000000
AAnnnnuuaall vvaarria
iabblele eexxppeennsseess 110000,,000000
RReemmaainininingg lilife
fe in
in yyeeaarrss 55
Equipment Replacement Decision
White’s sales are $200,000 per year
Fixed expenses, other than depreciation, are $70,000 per year

Should the manager purchase the new machine?