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MAS-LECTURE NOTES ARMIN GLENN ARANETA, CPA

DIFFERNTIAL COST ANALYSIS

Decision Making - choosing from at least two alternatives.

1. Short term non-routine cases:

a) Accept or reject a special order or a business proposal
b) Sell or process further a product line
c) Make or buy a part, subassembly or product line
d) Continue operation or close a business segment
e) Product combination
f) Utilization of scarce resources
g) Change in profit factors

2. Long term cases. E.g., capital investment decisions.

The DECISISON MAKING PROCESS:

1. Defining the problem.
2. Setting of criteria.
3. Identifying the alternative courses.
4. Determination of possible consequences of the alternatives.
5. Evaluating the alternatives.
6. Choosing the best alternative and making the decision.

Qualitative and Quantitative Factors:

Qualitative Factors - those that cannot easily and accurately be expressed in terms of money or
any other numerical unit of measures.

Quantitative Factors - those that can more easily be expressed in terms of money or other units
of measure.

APPROACHES IN SOLVING DECISION MAKING PROBELMS:

1. Total approach - the total revenues and costs are determined for each alternative, and the
results are compared to serve as bases for making decisions.

2. Differential Analysis - involves finding the most profitable alternative by analyzing the
differential revenues and costs.

Definitions:

1. Relevant revenues/costs - future revenues/costs that are expected to be different under each
alternative course of action.

2. Differential Costs - the increases (incrementals) or decreases (decrements0 in total costs

between two alternatives.

3. Avoidable costs - costs that will be saved or those that will not be incurred if a certain decision
is made.

4. Out-of-pocket-Costs - costs tahta require current or near future cash outlays or incurring of a
liability for a decision at hand.

5. Postponable costs - costs that may be deferred or shifted to a future date or period of time
without adversely affecting current operations.
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6. Opportunity costs - the benefit lost by taking one action as opposed to another. The “other”
action is the best alternative available other than the one being contemplated.

7. Imputed costs - assumed or hypothetical costs representing the costs or value of a resource that
is utilized for a specific purpose.

8. Sunk costs - refer to the non-recoverable costs incurred in the past.

9. Joint costs - costs incurred in simultaneously processing or manufacturing two or more

products which are difficult to identify individually as separate types of products until a certain
processing stage known as the point of separation or split-off point.

Practice Problems:

Problem 1. Thinking of You Company currently produces 6, 000 units of its major product per
month. Financial data for last month are:
Sales P 240, 000
Variable costs 144, 000
Fixed costs 60, 000

The company would like to expand its operations to 7, 000 units per month. Fixed costs would
increase P 10, 000 because of the expansion.

Requirements: Prepare both a total analysis approach and an incremental analysis approach to
evaluate the decision. Compare the results.

Problem 2. Talagang Mahirap Company sells Product A for P30 per unit. TMC’s per unit cost on
the full capacity of 200, 000 units is:
Material P10
Labor 5
Overhead 12
Manufacturing costs P27

The manufacturing overhead is 1/3 variable.

A Japanese firm has offered to buy 20, 000 unit. Additional shipping costs of this order would be
P2 per unit. TMC has sufficient existing capacity to manufacture the additional units. The TMC
sales manager wants to earn an incremental profit of P 40, 000 from this sale.

Requirements: What is the minimum price per unit TMC should charge?

Problem 3. Mr. Sinto Two Times, Sales Manager for Paulit-ulit ang Sinasabi Mo Industries, has
been asked by a potential foreign customer to sell 10, 000 units of a certain gear for P10 pr unit.
The company sells this item for P15 per unit, but it has had some excess manufacturing capacity
in recent months. It is anticipated that this would be a one-time-only order from this customer.
The product unit cost report for this type gear is as follows:
Direct materials P3.00
Direct labor 2.50
Variable manufacturing overhead 1.25
Fixed manufacturing overhead 2.50
Variable selling and administrative expense 1.75
Fixed selling and administrative expense 2.25
Total per unit cost P13.25

After looking at the product cost report, Mr Sinto informs the customer, “I may not be an
accountant, but I am smart enough to know that I will lose P3.25 per unit if I make this sale.
Therefore, I must refuse your offer.”
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Requirements:
1. From the list of costs in the product cost report, which costs would be relevant to the decision
to sell at the special price?
2. What will be the amount of the total relevant cost per unit in regard to this order?
3. What would be the differential income (loss) to Paulit-ulit Industries if this order were
accepted?
4. Are there any nonfinancial factors that you would consider in making this decision?

Problem 4. Iniisip ko pa lang Di ko na Kaya Corporation makes steel blades for lawn mowers
that it heat treats, assembles, and sells. The cost accounting system gives the following data:

Prime costs P80, 000

Variable manufacturing overhead 60, 000
Fixed manufacturing overhead 90, 000
Units produced 100, 000 units

The company has an opportunity to purchase its 100, 000 blades from an outside supplier at a
cost of P2.20 per blade. Inspection of the purchased blades will cost an additional P5, 000 in the
Quality Assurance department. Certain leased equipment, which costs P 30, 000 and is included
in fixed overhead, can be avoided if the blades are purchased. The leased space could be used to
make a part that is now purchased, which would save the company P 46, 000.

Requirements: In quantitative terms, should the company buy the blades from the outside
supplier?

Problem 5. Because of a monumental error committed by its purchasing department, Syempre

Kaya ko ‘to Grocery received 1, 000 heads of cabbage rather than the 100 that were actually
ordered. The company paid P25 per head for the cabbage. Although the management is confident
that 200 units can be sold through its regular sales, the market is not large enough to absorb the
other 800 heads. Management has identified two ways to dispose of the excess heads. First, a
wholesaler has offered to purchase them for P12 each. Second, a restaurant chain has offered to
purchase the heads if the company will agree to convert the heads into packaged coleslaw salad.
This option would require Syempre Kaya ko’to’s to additional costs of P 10, 000 for conversion
and the heads could then be sold for P24 each.

Requirements:
1. Which costs are sunk in this decision?
2. There are actually three alternatives Syempre’s can consider. Describe the alternative that is
not mentioned in the story.
3. What are the relevant costs of each decision alternative and what should the company do?

Problem 6. Nice Try Company manufactures jewelry cases. The firm is currently operating at
80% of its capacity of 7, 500 direct labor hours per month. The sales manager has been looking
for special orders to increase the use of capacity. Ringerbell Company has offered to buy 10, 000
cases at P7.50 per case provided the delivery is within two months. Per case cost data for the
order are as follows:
Materials P 2.50
Direct labor (1/2 hour at P6) 3.00
Manufacturing overhead 2.00
Total unit cost P 7.50

Variable manufacturing overhead is P1.50 per direct labor hour and the company allocates fixed
manufacturing overhead to units of product based on their direct labor time. Without the order,
Nice Try has enough business to operate at 6, 000 direct labor hours (80% of 7, 500) in each of
the next two months. The normal selling price of the jewelry case is P10.50. Ringerbell would
put its own label on the case. The production manager is concerned about the labor time that
making 10, 000 cases would require. She cannot schedule more than 7, 500 hours per month
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because Nice Try has a policy about overtime. Thus, the company would have to reduce some
regular-price sales of the jewelry case if it accepts the order. Ringerbell Company would not take
fewer than 10, 000 cases.

Requirements:
1. Determine whether Nice Try should accept the order.
2. Determine the price per case for the order that would make Nice Try indifferent between
accepting and rejecting the order (the price that would give Nice Try the same profit under both
alternatives)

Problem 7. Eber Company is selling 80, 000 units of a product at P10 per unit. The variable cost
is P6 per unit, and the annual fixed cost is P 120, 000. A discount house has offered to buy 10,
000 additional units of the product which would slightly be modified, but the modifications
would not affect production cost. The discount house will pay P7 per unit.

Requirements:
1. If the two markets can be distinguished, should the order be accepted (assuming capacity
exists and has no other use)?
2. The manager feels that the two markets might not be distinguished and that the lower price
would cause regular sales to fall 5, 000 units. Should Eber accept the discount house offer/
3. If the discount house offer is raised to P9 per unit and competition resulting from the special
sale causes the regular price to drop to P9.50 to maintain the same regular sales volume, should
Eber accept the discount house offer?

Problem 8. The Kanal Bowling Center was asked to host a bowling tournament for the Pinas
Company. The tournament would require the center to be closed to normal business for one day.
This would be feasible since the tournament is on Monday and the center is not heavily used on
Mondays. The Pinas Company has offered a flat fee of P 3, 000. Additional expenses for the day
are estimated by the center manager to be P1, 000, the cost of hiring some additional casual
workers to help clean up the center after the tournament. The manager has estimated that the loss
of fees due to the closing of the center to normal business would be about P1, 400. There would
be some cost savings (estimated at P400) because several hourly-paid employees would not work
that day. The manager feels that there would be no loss of future business as a result of closing
for one Monday.

Requirements:
1. What is the opportunity cost of closing the Bowling Center to normal business?
2. Calculate the additional profit or loss from hosting the tournament.

Problem 9. Sangsang Company sells 5G, a special model of smart phone, at price of P 13, 500
per unit. Sangsang’s costs per unit are:
Materials P 3, 000
Labor 1, 500
Variable factory overhead 2, 400
Fixed factory overhead 5, 100
Total Costs P 9, 600

A special order for 1, 000 units were received from TPARS, a well-known school in the country.
Additional shipping costs on the sales are P900 per unit.

Requirements:
1. If Sangsang is operating at full capacity, what is the minimum price per unit that should be set
for the TPARS order?
2. If Sangsang has excess capacity, what is the minimum price per unit?
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Problem 10. Data concerning four product lines are as follows:

Product line A R M N
Selling price per unit P300 P250 P130 P70
Variable cost per unit 250 80 50 40
Hours required for each unit 5 10 4 2
Maximum market potential (units) No limit 6, 000 8, 000 4, 000

Total fixed costs P 100, 000

Total hours available 96, 000 hours

Requirements:
1. Based on these data, choose the best product combination.
2. How would the answer change if the company were required to deliver 2, 000 units of each
product line to major distributor? The maximum market potential includes the distributor’s units.

Problem 11. Nuwebe Company produces four joint products at a joint cost of P 110, 000. The
company currently processes all products beyond the split-off point and the final products are
sold as follows:
Products Sales Further Processing Costs
A P450, 000 P360, 000
R 140, 000 70, 000
M 45, 000 10, 000
N 20, 000 25, 000

Nuwebe could sell the products at the split-off point for the following amounts: A, P120, 000; R,
P40, 000; M, P35, 000; N, zero.

Requirements;
1. Which product/s should Nuwebe sell at the split-off point?
2. What would Nuwebe’s profit be if it took most profitable action with respect to each of its
products?

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