Accounting: The Language of Business - Vol. 1 (Part 150)

In the business world, allegations of accounting irregularities is tantamount to yelling fire in a crowded theater, except, today, in our Internet world, instead of people running for the exit signs, they just push the button on their computer.

Jeffrey Skilling

 Differential Analysis and Product Pricing (Part D)

by

Charles Lamson

Process or Sell

When a product is manufactured, it progresses through various stages of production. Often a product can be sold at an intermediate stage of production, or it can be processed further and then sold. In deciding whether to sell a product at an intermediate stage or to process it further, differential analysis is useful. The differential revenues from further processing are compared to the differential costs of further processing. The costs of producing the intermediate product do not change, regardless of whether the intermediate product is sold or processed further. Thus, these costs are not differential costs and are irrelevant to the decision to process further.

To illustrate, assume that a business produces kerosene in batches of 4,000 gallons. Standard quantities of 4,000 gallons of direct materials are processed, which cost $0.60 per gallon. Kerosene can be sold without further processing for $0.80 per gallon. It can be processed further to yield gasoline, which can be sold for $1.25 per gallon. Gasoline requires additional processing costs of $650 per batch, and 20% of the gallons of kerosene will evaporate during production. Exhibit 8 summarizes the differential revenues and costs in deciding whether to process kerosene to produce gasoline:

The differential income from further processing kerosene into gasoline is $150 per batch. The initial cost of producing the intermediate kerosene, $2,400 (4,000 gallons * $0.60), is not considered in deciding whether to process kerosene further. This initial cost will be a incurred, regardless of whether gasoline is produced.

Accept Business at a Special Rate

Differential analysis is also useful and deciding whether to accept additional business at a special price. The differential revenue that would be provided from the additional business is compared to the differential costs of producing and declining the product to the customer. If the company is operating at full capacity, any additional production will increase both fixed and variable production costs. If, however, the normal production of the company is below full capacity, additional business may be undertaken without increasing fixed production costs. In this case, the differential costs of the additional production are the variable manufacturing costs. If operating expenses increase because of the additional business, these expenses should also be considered.

To illustrate, assume that the monthly capacity of a sporting goods business is 12,500 basketballs. Current sales and production are averaging 10,000 basketballs per month. The current manufacturing cost of $20 per unit consists of variable costs of $12.50 and fixed costs of $7.50. The normal selling price of the product in the domestic market is $30. The manufacturer receives from an exporter an offer for 5,000 basketballs at $18 each. Production can be spread over a three-month period without interfering with normal production or incurring overtime costs. Pricing policies in the domestic market will not be affected. Simply comparing the sales price of $18 with the present unit manufacturing cost of $20 indicates that the offer should be rejected. However, by focusing only on the differential cost, which in this case is the variable cost, the decision is different. Exhibit 9 shows the differential analysis report for this decision.

Proposals to sell a product to the domestic market at prices lower than the normal price may require additional considerations. For example, it may be unwise to increase sales volume in one territory by price reductions if sales volume is lost in other areas. Manufacturers must also conform to the Robinson-Patman Act, which prohibits price discrimination within the United States unless differences in prices can be justified by different costs of serving different customers. 

*WARREN, REEVE, & FESS, 2005, ACCOUNTING, 21ST ED., PP. 1,000-1,001

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Accounting: The Language of Business - Vol. 1 (Part 149)

There is no accounting for human beings.

Mark Twain

Differential Analysis and Product Pricing (Part C)

by

Charles Lamson 

Make or Buy

The assembly of many parts is often a major element in manufacturing some products, such as automobiles. These parts may be made by the product's manufacturer, or they may be purchased. For example, some of the parts for an automobile, such as the motor, may be produced by the automobile manufacturer. Other parts, such as tires, may be purchased from other manufacturers. In addition, in manufacturing motors, such items as spark plugs and nuts and tools may be acquired from suppliers.

Management uses differential cost [the difference between the cost of two alternative decisions (corporatefinanceinstitute.com)] to decide whether to make or buy a part. For example, if a part is purchased, management has concluded that it is less costly to buy the part than to manufacture it. Make or buy options often arise when a manufacturer has excess productive capacity in the form of unused equipment, space, and labor.

The differential analysis is similar whether management is considering making a part that is currently being purchased or purchasing a part that is currently being made. To illustrate, assume that an automobile manufacturer has been purchasing instrument panels for $240 a unit. The factory is currently operating at 80% of capacity, and no major increase in production is expected in the near future. The cost per unit of manufacturing an instrument panel internally, including fixed costs, is estimated as follows:

If the make price of $280 is simply compared with the price of $240, the decision is to buy the instrument panel. However, if unused capacity could be used in manufacturing the part, there would be no increase in the total amount of fixed factory overhead costs [Fixed overheads are costs that remain constant every month and do not change with changes in business activity levels. Examples of fixed overheads include salaries, rent, property taxes, depreciation of assets, and government licenses (corporatefinanceinstitute.com).]. Thus, only the variable factory overhead costs [costs that change as the volume of production changes or the number of services provided changes (investopedia.com)] need to be considered. The relevant costs are summarized in the differential report in Exhibit 6.

EXHIBIT 6 Differential Analysis Report---Make or Buy

Other possible effects of a decision to manufacture the instrument panel should also be considered. For example, capacity committed to the instrument panel may not be available for more production opportunities in the future. This decision may affect employees. It may also affect future business relations with the instrument panel supplier, who may provide other essential parts. The company's decision to manufacture instrument panels might jeopardize the timely delivery of these other parts. 

Replace Equipment

The usefulness of fixed assets may be reduced long before they are considered to be worn out. For example, equipment may no longer be efficient for the purpose for which it is used. On the other hand, the equipment may not have reached the point of complete inadequacy. Decisions to replace usable fixed assets should be based on relevant costs. The relevant costs are the future costs of continuing to use the equipment versus replacement. The book values of the fixed assets being replaced are sunk costs [A sunk cost, sometimes called a retrospective cost, refers to an investment already incurred that can't be recovered. Examples of sunk costs in business include marketing, research, new software installation or equipment, salaries and benefits, or facilities expenses (productplan.com)] and are irrelevant.

To illustrate, assume that a business is considering the disposal of several identical machines having a total book value of $100,000 and an estimated remaining life of 5 years. The old machines can be sold for $25,000. They can be replaced by a single high-speed machine at a cost of $250,000. The new machine that has an estimated useful life of 5 years and no residual value [the estimated value of a fixed asset at the end of its lease term or useful life (investopedia.com)]. Analyses indicate an estimated annual reduction in variable manufacturing costs from $225,000 with the old machine to $150,000 with the new machine. No other changes in the manufacturing costs or the operating expenses are expected. The relevant costs are summarized in the differential report in Exhibit 7.

EXHIBIT 7 Differential Analysis Report---Replace Equipment

Other factors are often important in equipment replacement decisions. For example, differences between the remaining useful life of the old equipment and the estimated life of the new equipment could exist. In addition, the new equipment might improve the overall quality of the product, resulting in an increase in sales volume. Additional factors could include the time value of money and other uses for the cash needed to purchase the new equipment.

The amount of income that is forgone from an alternative use of an asset, such as cash, is called an opportunity cost. For example, your opportunity cost of attending school is the income forgone from lost work hours. Although the opportunity cost does not appear as a part of historical accounting data, it is useful in analyzing alternative courses of action. To illustrate, assume that the cash outlay of $250,000 for the new equipment, less the $25,000 proceeds from the sale of the present equipment, could be invested to yield a 10% return. Thus, the annual opportunity cost related to the purchase of the new equipment is $22,500 (10% * $225,000). 

*WARREN, REEVE, & FESS, 2005, ACCOUNTING, 21ST ED., PP. 997-999*

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Katy Trail: Day 350 of 365 of Training for Trek across Missouri via the ...

Katy Trail: Day 349 of 365 of Training for Trek across Missouri via the ...

Accounting: The Language of Business - Vol. 1 (Part 148)

Accounting is a big subject and there are huge forces in play. The entire momentum of existing thinking and existing custom is in a direction that allows terrible follies to happen, and the terrible follies have terrible consequences.

Charlie Munger

 Differential Analysis and Product Pricing (Part B)

by

Charles Lamson

Lease or Sell

Management may have a choice between leasing or selling a piece of equipment that is no longer needed in the business. In deciding which option is best, management may use differential analysis. to illustrate, assume that Marcus Company is considering disposing of equipment that cost $200,000 and has $120,000 of accumulated depreciation to date. Marcus Company can sell the equipment through a broker for $100,000 less a 6% commission. Alternatively, Potamkin Company (the lessee) has offered to lease the equipment for five years for a total of $160,000. At the end of the fifth year of the lease, the equipment is expected to have no residual value [the estimated value of a fixed asset (a company-owned, long-term tangible asset, such as a form of property or equipment at the end of its lease term or useful life (investopedia.com)]. During the period of the lease, Marcus Company (the lessor) will incur repair, insurance, and property tax expenses estimated at $35,000. Exhibit 1 shows Marcus Company's analysis of whether to lease or sell the equipment.

EXHIBIT 1 Differential Analysis Report---Lease or Sell

Note that in Exhibit 1, the $80,000 book value ($200,000 - $120,000) of the equipment is a sunk cost [an investment already incurred that can't be recovered (productplan.com)] and is not considered in the analysis. The $80,000 is a cost that resulted from a previous decision. It is not affected by the alternatives now being considered in leasing or selling the equipment. The relevant factors to be considered are the differential revenues [the difference in sales that will be generated by two different courses of action (accountingtools.com)] and differential costs [the difference in costs generated by two different courses of action) associated with the lease or sell decision. This analysis is verified by the traditional analysis in Exhibit 2.

EXHIBIT 2 Traditional Analysis

The alternatives presented in Exhibits 1 and 2 were relatively simple. However, regardless of the complexity, the approach to differential analysis is basically the same. Two additional factors that often need to be considered are (1) differential revenue from investing the funds generated by the alternatives and (2) any income tax differential. In Exhibit 1, there could be differential interest revenue related to investing the cash flows from the two alternatives. Any income tax differential would be related to the differences in the timing of the income from the alternatives and the differences on the amount of investment income. In an upcoming post, we will consider these factors on management decisions.

Discontinue a Segment or Product

When a product or a department, branch, territory, or other segment of a business is generating losses, management may consider eliminating the product or segment. it is often assumed, sometimes in error, that the total income from operations of a business would be increased if the operating loss could be eliminated. Discontinuing the product or segment usually eliminates all of the product or segment's variable costs (direct materials, direct labor, sales commissions, and so on). However, if the product or segment is a relatively small part of the business, the fixed costs (depreciation, insurance, property taxes, and so on) may not be decreased by discontinuing it. It is possible in this case for the total operating income of a company to decrease rather than increase by eliminating the product or segment. To illustrate, the income statement for Battle Creek Cereal Co. presented in Exhibit 3 is for a normal year ending August 31, 2023.

EXHIBIT 3 Income (Loss) by Product

Because Bran Flakes incurs annual losses, management is considering discontinuing it. Total annual operating income of $80,000 ($40,000 Toasted Oats + $40,000 Corn Flakes) might seem to be indicated by the income statement in Exhibit 3 if Bran Flakes is discontinued.

Discontinuing bran flakes, however, would actually decrease operating income by $15,000, to $54,000 ($69,000 - $15,000). This is shown by the differential analysis report in Exhibit 4, in which we assume that discontinued bran flakes would have no effect on fixed costs and expenses. The traditional analysis in Exhibit 5 verifies the differential analysis in Exhibit 4.

In Exhibit 5, only the short-term (1 year) effect of discontinuing Bran Flakes is considered. When eliminating a product or segment, management may also consider the long-term effects. For example, the plant capacity made available by discontinuing Bran Flakes might be eliminated. This could reduce fixed costs. Some employees may have to be laid off, and others may have to be relocated and retrained. Further, there may be a related decrease in sales of more profitable products to those customers who were attracted by the discontinued product. 

*WARREN, REEVE, & FESS, 2005, ACCOUNTING, 21ST ED. PP.994-997*

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Accounting: The Language of Business - Vol. 1 (Part 147)

I would argue that a majority of the horrors we face would not have happened if the accounting profession developed and enforced better accounting.

Charlie Munger

 Differential Analysis and Product Pricing (Part A)

by

Charles Lamson

Many of the decisions that you make depend on comparing the estimated costs of alternatives. The payoff from such comparisons is described in the following report from a University of Michigan study.

Richard Nevitt and two colleagues quizzed Michigan faculty members and University seniors on such questions as how often they walk out on a bad movie, refuse to finish a bad meal, start over on a week term paper, or abandon a research project that no longer looks promising. They believe that people who cut their losses this way are following sound economic rules: calculating the net benefits of alternative courses of action, writing off past costs that can't be recovered, and weighing the opportunity to use future time and effort more profitably elsewhere.

They find that among faculty members, those who use cost-benefit reasoning in this fashion being more likely to give up on research that isn't getting anywhere or using labor-saving devices as often as possible have higher salaries relative to their age and departments. Not surprisingly, economists are more likely to apply the approach than professors of humanities or biology. Among students, those who have learned to use cost-benefit analysis frequently are apt to have far better grades than their scholastic aptitude test scores would have predicted. Again, the more economics courses the students have the more likely they are to apply cost-benefit analysis outside the classroom.

Dr. Nesbitt concedes that for many Americans, cost-benefit rules often appear to conflict with such traditional principles as "never give up" and "waste not, want not." (Allen L Anton, "Economic Perspective Produces Steady Yields," from People Patterns, The Wall Street Journal, March 31, 1992, P. 81.)

Managers must also consider the effects of alternative decisions on their businesses. In the next several posts, we will discuss differential analysis, which reports the effects of alternative decisions on total revenues and costs. We will also describe and illustrate practical approaches to setting product prices. Finally, we discuss how production bottlenecks influence product mix and pricing decisions.

Differential Analysis

Planning for future operations involves decision making. For some decisions, revenue and cost data from the accounting records may be useful. However, the revenue and cost data for use in evaluating courses of future operations or choosing among competing alternatives are often not available in the accounting records and must be estimated.

Consider the decision by United Airlines to discontinue service to New Zealand (Warren, Reeve, & Fess, 2005). In this decision, the estimated revenues and costs were relevant. The relevant revenues and costs focus on the differences between each alternative. Costs that have been incurred in the past are not relevant to the decision. These costs are called sunk costs.

Differential revenue is the amount of increase or decrease in revenue expected from a course of action as compared with an alternative. To illustrate, assume that certain equipment is being used to manufacture calculators, which are expected to generate revenue of $150,000. If the equipment could be used to make digital clocks, which would generate revenue of $175,000, the differential revenue from making and selling digital clocks is $25,000.

Differential cost is the amount of increase or decrease in cost that is expected from a course of action as compared with an alternative. For example, if an increase in advertising expenditures from $100,000 to $150,000 is being considered, the differential cost of the price is $50,000. 

Differential income or loss is the difference between the differential revenue and the differential cost. Differential income indicates that a particular decision is expected to be profitable, while a differential loss indicates the opposite.

Differential analysis focuses on the effect of alternative courses of action on the relevant revenues and costs. For example, if a manager must decide between two alternatives, differential analysis would involve comparing the differential revenues of the two alternatives with the differential costs.

In the next two posts, we will discuss the use of differential analysis in analyzing the following alternatives:

1. Leasing or selling equipment.

2. Discontinuing an unprofitable segment.

3. Manufacturing or purchasing a needed part.

4. Replacing usable fixed assets.

5. Processing further or selling an intermediate product.

6. Accepting additional business at a special price. 

*WARREN, REEVE, FESS, 2005, ACCOUNTING, 21ST ED., PP. 993-994*

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Katy Trail: Day 344 of 365 of Training for Trek across Missouri via the ...

Adrian Berra & Lola Membrillo - De Regreso / (Sesiones de Otoño #3)

Accounting: The Language of Business - Vol. 1 (Part 146)

There are three cardinal rules - don't take somebody else's boyfriend unless you've been specifically invited to do so, don't take a drink without being asked, and keep a scrupulous accounting in financial matters.

W. H. Auden

Performance Evaluation for Decentralized Operations (Part E)

by

Charles Lamson

Transfer Pricing

When divisions transfer products or render services to each other, a transfer price is used to charge for the products or services. Since transfer prices affect the goals for both divisions, setting these prices is a sensitive matter for division managers. 

Transfer prices should be set so that overall company income is increased when goods are transferred between divisions. As we will illustrate, however, transfer prices may be misused in such a way that overall company income suffers.

In the following paragraphs, we discuss various approaches to setting transfer prices. Exhibit 8 shows the range of prices that results from common approaches to setting transfer prices. Transfer prices can be set as low as the variable cost per unit or as high as the market price. Often, transfer prices are negotiated at some point between variable cost per unit and market price.

EXHIBIT 8 Commonly Used Transfer Prices

Transfer prices may be used when decentralized units are organized as cost, profit or investment centers. To illustrate, we will use a packaged snack food company (Wilson Company) with no service departments and two operating divisions (Eastern and Western) organized as investment centers. Condensed divisional income statements for Wilson Company, assuming no transfers between divisions, are shown in Exhibit 9.

EXHIBIT 9 Income Statement---No Transfers Between Divisions

Market Price Approach

Using the market price approach the transfer price is the price at which the product or service transferred could be sold to outside buyers. If an outside market exists for the product or service transferred, the current market price may be a proper transfer price.

To illustrate, assume that materials used by Wilson Company in producing snack food in the Western Division are currently purchased from an outside supplier at $20 per unit. The same materials are produced by the Eastern Division. The Eastern Division is operating at full capacity of 50,000 units and can sell all it products to either the Western Division or to outside buyers. A transfer price of $20 per unit (the market price) has no effect on the Eastern Division's income or total company income. The Eastern Division will earn revenues of $20 per unit on all its production and sales, regardless of who buys its product. Likewise, the Western Division will pay $20 per unit for materials the (the market price). Thus, the use of the market price as the transfer price has no effect on the Eastern Division income or total company income. In this situation, the use of the market price as the transfer price is proper. The condensed divisional income statements for Wilson Company in this case are also shown in Exhibit 9.

Negotiated Price Approach

If unused or excess capacity exists in the supplying division (the Eastern Division), and the transfer price is equal to the market price, total company profit may not be maximized. This is because the manager of the Western Division will be indifferent toward purchasing materials from the Eastern Division or from outside suppliers. Thus, the Western Division may purchase the materials from outside suppliers. If, however, the Western Division purchases the materials from the Eastern Division, the difference between the market price of $20 and the variable costs of the Eastern Division can cover fixed costs and contribute to company profits. When the negotiated price approach is used in this situation, the manager of the western division is encouraged to purchase the materials from the Eastern Division.

The negotiated price approach allows the managers of decentralized units to agree (negotiate) among themselves as to the transfer price. The only constraint on the negotiations is that the transfer price be less than the market price but greater than the supplying division's variable costs per unit.

To illustrate the same use of the negotiated price approach, assume that instead of a capacity of 50,000 units, the Eastern Division capacity is 70,000 units. In addition, assume that the Eastern Division can continue to sell only 50,000 units to outside buyers. A transfer price less than $20 would encourage the manager of the Western Division to purchase from the Eastern Division. This is because the Western Division's materials cost per unit would decrease, and its income from operations would increase. At the same time, a transfer price above the Eastern Division's variable cost per unit of $10 (from Exhibit 9) would encourage the manager of the Eastern Division to use the excess capacity to supply materials to the Western Division. In doing so, the Eastern Division's income from operations would increase.

We continue the illustration with the aid of Exhibit 10, assuming that Wilson Company's division managers agree to a transfer price of $15 for the Eastern Division's product. By purchasing from the Eastern Division, the Western Division's materials cost would be $5 per unit less. At the same time, the Eastern Division would increase its sales by $300,000 (20,000 units * $15 per unit) and increase its income by $100,000 ($300,000 sales - $200,000 variable costs).The effect of reducing the Western Division's materials cost by $100,000 (20,000 units * $5 per unit) is to increase its income by $100,000. Therefore, Wilson Company's income is increased by $200,000 ($100,000 reported by the Eastern Division and $100,000 reported by the Western Division), as shown in the condensed income statement in Exhibit 10.

EXHIBIT 10 Income Statements---Negotiated Transfer Price

In this illustration, any transfer price less than the market price of $20 but greater than the Eastern Division unit variable costs of $10 would increase each division's income. In addition, overall company profit would increase by $200,000. By establishing a range of $20 to $10 for the transfer price, each division manager has an incentive to negotiate the transfer of the materials.

Cost Price Approach

Under the cost price approach, cost is used to set transfer prices. With this approach, a variety of cost concepts may be used. For example, cost may refer to either total product cost per unit or variable product cost per unit. If total product cost per unit is used, direct materials, direct labor, and factory overhead are included in the transfer price. If variable product cost per unit is used, the fixed factory overhead component of total product cost is excluded from the transfer price.

Either actual costs or standard (budgeted) costs may be used in applying the cost price approach. If actual costs are used, and efficiencies of the producing division are transferred to the purchasing division. Thus, there is little incentive for the producing division to control costs carefully. For this reason, most companies use standard cost in the cost price approach. In this way, differences between actual and standard costs remain with the producing division for cost control purposes.

When division managers have responsibility for cost centers, the cost price approach to transfer pricing is proper and is often used. The cost price approach may not be proper, however, for decentralized operations organized as profit or investment centers. In profit and investment centers, division managers have responsibility for both revenues and expenses. The use of cost as a transfer price ignores the supplying division manager's responsibility for revenues. When a supplying division's sales are all intracompany transfers, for example, using the cost price approach prevents the supplying division from reporting any income from operations. A cost-based transfer price may therefore not motivate the division manager to make intracompany transfers, even though they are in the best interest of the company. 

*WARREN, REEVE, FESS, 2005, ACCOUNTING, 21ST ED., PP. 966-969*

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