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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