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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