The following points highlight the top seven practical applications of differential cost. The practical applications are: 1. Determination of the most Profitable Level of Production and Price 2. Acceptance of Offer at a Lower Price or Offering a Quotation at Lower Selling Price in Order to Increase Capacity 3. Accept or Reject Decisions 4. Make or Buy Decisions 5. Sell or Process Decisions and Others.
Differential Costs: Application # 1.
Determination of the most Profitable Level of Production and Price:
When it is required to determine the most profitable level of production which gives the maximum profit, the selling prices expected to absorb at various levels of activity are assessed by means of market research. The estimated revenue is calculated by multiplying the expected output at that level with the estimated price.
The differential or incremental revenue is calculated by deducting the sales value at one level from the sales of previous level. Similarly differential cost is calculated and is matched against the differential revenue in order to determine the best price and optimum level of production.
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As long as the differential revenue is more than the differential cost, level of production is increased. But when differential cost is more than the differential revenue, that level is not beneficial to the concern and level prior to this will be the optimum level of production. This will be more clear from the following Illustrations.
Illustration 1:
Modern Sewing Machines Co. manufactures hand-operated sewing Machines. Prepare a schedule showing the differential costs and incremental revenue at each stage from the following data. At what volume the company should set its level of production?
Solution:
It is in the interest of a firm to increase the output so long as incremental revenue exceeds differential cost. But if the differential cost is more than the incremental revenue, it is not advisable to increase the output because it will reduce the profitability. The company should set its level of output at 3.0 lakh units because up-to this level incremental revenue exceeds differential cost.
Illustration 2:
Assuming that the rated capacity of the factory is 50,000 units, what should be the most profitable level of output?
Solution:
The most profitable level of output can be determined by comparing incremental revenues and differential costs as given on the next page.
Incremental revenues and differential costs are equal at 40,000 and 50,000 units of outputs, so it is not advisable to increase the output to these levels as there will be no addition to restrict the output to 25,000 units as it will give profit of Rs.25,000 (i.e. total sales value Rs.1,00,000- Total cost Rs.75,000
Differential Costs: Application # 2.
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Acceptance of Offer at a Lower Price or Offering a Quotation at Lower Selling Price in Order to Increase Capacity:
Sometimes the management is interested to increase the capacity but the increased production can be sold only at a reduced selling price. Under such a situation, the differential cost is calculated by deducting the cost of present capacity from the cost of new capacity.
The differential cost is divided by the increased units of production to calculate the minimum price. Any price above the minimum price will add to the revenue of the concern. This will be more clear from the following Illustration.
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Illustration 3:
A company is at present working at 90% of its capacity and producing 13,500 units per annum. It operates a flexible budgetary control system. Following figures are obtained from its budget:
Labour and material cost per unit is constant under present conditions. Profit margin is 10 per cent.
(а) You are required to determine the differential cost of producing 1,500 units by increasing capacity to 100 per cent.
(b) What would you recommend for an export price for these 1,500 units taking into account that overseas prices are much lower than indigenous prices.
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Solution:
Differential cost analysis is as follows:
At this minimum price there is no addition to profit. Hence, any price above Rs.64.78 per unit is acceptable so that there may be some addition to profit.
The minimum price of Rs.64.78 is acceptable only if:
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(i) There are no export charges.
(ii) Surplus capacity of 10% cannot be utilized for production of some other more profitable products.
(iii) Export price will have no effect on the indigenous market where the product will continue to be sold at the old price.
Illustration 4:
Ram Dass Pvt. Ltd., Nasik, is currently operating at 80 per cent capacity.
The Profit and Loss Account shows the following:
The Managing Director has been discussing an offer from Middle East of a quantity which will require 50 per cent capacity of the factory. The price is 10 per cent less than the current price in the local market. Order cannot be split. You are asked by him to find out the most profitable alternative. The factory capacity can be augmented by 10 per cent by adding facilities at an increase of Rs.40 lakhs in fixed cost.
Solution:
If the offer from Middle East is accepted then 50% of the production capacity will be utilized for processing this order. The balance of 50% (i.e. 100 – 50) capacity plus 10% augmented capacity at an additional cost of Rs.40 lakhs will be available for local sales. The incremental revenue and differential costs are compared below to know whether order should be accepted or not.
Incremental revenue of Rs.200 lakhs exceeds differential cost of Rs.160 lakhs by Rs.40 lakhs, so offer from Middle East should be accepted. It may be remembered that offer should be accepted only if there is a prospect of receiving similar orders in future also; otherwise the cost of additional facilities added to augment the output will become a burden on the future profit.
Differential Costs: Application # 3.
Accept or Reject Decisions:
Sometimes, the management is interested to operate the concern at full capacity as there may be offer from the foreign country to purchase the goods but at less price than is available from the local market. Under such circumstances first of all incremental revenue is calculated by deducting the existing sales from the proposed sales.
Similarly incremental cost is calculated by deducting existing cost from the proposed cost. Incremental cost is matched against incremental revenue. If the incremental revenue is more than the incremental cost, the proposal should be accepted otherwise not.
Sometimes, a concern may receive special offers from its regular customers to sell its regular products. Special offers may be received from the home customers for one time quantity sales or sales to foreign customers. Such offers generally are received at lesser prices than the usual customary prices.
The decision to accept or reject special offer is based entirely on differential cost and the contribution margin approach. The point to be considered is whether incremental revenue is more than the differential cost to be incurred. The use of absorption costing is not preferred as it may show misleading results.
While deciding about special offers rejection or acceptance the following factors should be taken into consideration:
1. The impact on future earnings of temporarily reduction in the selling price.
2. The effect of reducing selling prices on the existing customers when it comes to their knowledge.
3. The possibility of selling additional units to the new customers beyond the special offer.
4. The reliability of cost estimates associated with the offer.
5. The effect on current and future capacity in terms of an expansion of plant, personnel, financial requirements and other capacity constraints.
Illustration 5:
Sports Specialists Ltd. is famous for specialized manufacture of quality chess boards sets. Presently, the company is working below its normal capacity of 1,000 units per month. The company sells chess boards’ sets in the national market at Rs.150 per unit. During April 2010, 600 units were sold which is the regular sales volume for each month all through the year.
The company has received an export order on 20-4-2010 for supply of 600 units to be dispatched by 30-6-2010. However the order stipulates the price per unit as Rs.100 only. The cost analysis indicated that the cost of direct material and direct labour that are to be incurred on the export order would be the same amount per unit as the regular one of production.
However an amount of Rs.2,000 will have to be incurred on special packing, labeling, get up etc. No additional factory, selling or administrative overhead costs would be incurred in executing the export order since the firm is operating below normal capacity.
Using differential cost analysis method, prepare the income statement for May and June, 2010 to show whether the acceptance of the export order would be profitable to the company. Assumptions and comments, if any, may be given separately.
Solution:
Notes:
(1) The monthly capacity is 1,000 units and the export order is received in April 2010. So the company can phase out the production of export order requirements in May & June 2010. This will not exceed the capacity of 1,000 unit’s p.m. The total quantity including export order for May & June 2010 would be only 1000 (2 x 600 + 600) against the capacity @ 1,000 units p.m. i.e., 2,000 units for 2 months.
(2) There will be no additional cost towards overheads by accepting the export order as there is spare capacity available. Hence, overheads are not relevant costs for export order.
(3) Special packing etc. charges of Rs.2,000 is a relevant cost.
Conclusion:
Since the export order generates additional profit of Rs.4,000, the same should be accepted.
Illustration 6:
X Ltd., having an installed capacity of 1, 00,000 units of a product is currently operating at 70% utilisation. At current levels of input prices, the FOB unit costs (after taking credit for applicable export incentives) work out as follows:
The Company has received three foreign offers from different sources as under:
Advise the company as to whether any or all the export orders should be accepted or not.
Solution:
It is clear from the above statement that it is advantageous for the company only when it accepts all the export orders. If the company accepts export orders only for one or two of the three sources, it will suffer a loss. Therefore, the company should accept export orders from all the three sources to earn additional profits
Differential Costs: Application # 4.
Make or Buy Decisions:
In assembly type concerns, different components parts are assembled in order to manufacture the product. Such component parts can be manufactured in the concern or these can be purchased from external suppliers. If the concern has idle capacity and idle workers that can be used to make component parts, it is preferable to make and realize cost savings.
If there is no idle capacity, the parts can be purchased from the outside. The other uses of idle capacity should be examined before reaching a final decision as the available facilities have to be put to best utilisation. Differential costing technique can be used for solving make or buy problem. Costs associated with buying and making is to be compared.
The sum of purchase price plus transportation, insurance and ordering cost represents the amount applicable to the buying alternative. On the other hand costs associated with the make alternative include the differential variables to make the component parts such as materials, labour and variable overheads.
Allocated fixed costs remain unchanged in aggregate when components are made, cannot be relevant to make or buy decisions.
These are committed or such costs which will be spent irrespective of the alternative chosen. Two costs are compared and if we find that buying costs is more than the costs to make the component, then it will be prefers able to make the part in the factory, over-wise it should be purchased from the outside sources.
While making decision not only the present cost but projections for future costs are to be taken into consideration.
In addition to the quantitative factors discussed above, the qualitative factors which are taken into consideration to influence the make or buy decision are as follows:
(i) Quality of goods supplied by the supplier.
(ii) Uninterrupted supply by the supplier meeting the delivery dates.
(iii) If secrecy is to be maintained and manufacturing know-how is not to be passed on to the supplier of the component part, the decision will be to manufacture part even though the manufacturing cost may be more than the price to be charged by the supplier.
(iv) Any adverse effect on labour relations if it is decided to buy from outside instead of making.
(v) The facility of wider selection in case of buy-decision.
Illustration 7:
A factory produces a number of different products each having a number of components. Product X takes 10 hours to produce on a particular equipment which works at full capacity. The selling price and variable cost of Product X are Rs.200 and Rs.120 per unit respectively.
A component Wye-2010 can be made in the same equipment in four hours incurring a variable cost of Rs.20 per unit. The factory purchases the component at a price of Rs.50 per unit. Advise the factory Management whether they should buy the component Wye-2010. (You may make suitable assumptions, if necessary).
Solution:
... The advice should be:
Since the supplier’s price is less than the relevant cost of production, it is advisable to buy components Wye-2010 from outside suppliers.
Illustration 8:
Expansion Ltd. manufactures automobile accessories and parts. Following are the total costs of processing 1, 00,000 units:
The purchase price of the component is Rs.22. The fixed overhead would continue to be incurred even when the component is bought from outside although there would have been reduction to the extent of Rs.2,00,000.
Required:
(a) Should the part be made or bought considering that the present facility when released following buying decision would remain idle.
(b) In case the released capacity can be rented out to another manufacturer for Rs.1,50,000 having good demand, what should be the decision?
Solution:
Recommendations:
(i) For Decision in Situation (a) — Make the component,
(ii) For Decision in Situation (b) — Buy the component.
However, the non-cost factors vital to the long-term interest of the company must be kept in view.
Illustration 9:
Auto Parts Ltd. has an annual production of 90,000 units for a motor component.
The component’s cost structure is as below:
(а) The Purchase Manager has an offer from a supplier who is willing to supply the component at Rs.540. Should the component be purchased and production stopped?
(b) Assume the resources now used for this component’s manufacture are to be used to produce another new product for which the selling price is Rs.485. In the latter case, material price will be Rs.200 per unit. 90,000 units of this product can be produced at the same cost basis as above for labour and expenses.
Discuss whether it would be advisable to divert the resources to manufacture that new product, on the footing that the component presently being produced would, instead of being produced, be purchased from the market.
Extra amount to be spent (if component is purchased from the market) is Rs.40,50,000 (i.e. 4,86,00,000 − 4,45,50,000). Therefore, the company should not purchase the component from the market and also not stop the production of the component.
Thus there is saving of Rs.15 (i.e., Rs.60 – Rs.45) per unit if the company diverts its resources for production of another product. Therefore, it is advisable for the company to divert its resources to manufacture the new product and component should be purchased from the market instead of producing it as there will be saving of Rs.13,50,000 (i.e., 90,000 units x Rs.15).
Illustration 10:
Perfect Product Ltd. is currently buying a component from a local supplier at Rs.15 each. The supply is tending to be irregular. Two proposals are under consideration:
1. Buy and install a semi-automatic machine for manufacturing this component, which would involve an annual fixed cost of Rs.9 lakhs and variable cost of Rs.6 per manufactured component.
2. Buy and install an automatic machine for manufacturing this component, incurring an annual fixed cost of Rs.15 lakhs and a variable cost of Rs.5 per manufactured component.
Determine, with necessary computations:
1. The annual volume required, in each case, to justify a switch over from “outside purchase” to “own manufacture”.
2. The annual volume required to justify selection of the automatic machine instead of the semi-automatic machine.
3. If the annual requirement of the company for a year is expected to be 5,00,000 nos. and the volume is expected to increase rapidly thereafter, would you recommended the automatic or semi-automatic machine? Justify your recommendation.
Solution:
From the above, it is clear that semi-automatic machine is economical, if the annual requirement is 5,00,000 nos. If the volume is expected to increase, then automatic machine may be preferred as it will avoid the replacement cost of semi-automatic machine by automatic machine in future and will also reduce the cost of production.
Differential Costs: Application # 5.
Sell or Process Decisions:
A product can be sold by a company when it has been partially processed or of processing it further and then selling it. When a product passes through a series of manufacturing operations, it may be a saleable product at a number of different points along the way.
Thus a company has an option to sell the product at various physical stages of completion. For example in petroleum refinery, the refinement of oil can be stopped at several points during the process and can be sold as fuel oil, diesel oil, kerosene or gasoline as market exists for all these intermediate semi manufactured products.
In sell or process decisions incremental analysis provides the Solution. In all alternatives incremental revenue is to be compared with incremental costs after the decision point as all costs incurred before the sell or process further decision must be treated as sunk costs. The alternative which gives more benefit (incremental revenue—incremental cost) must be adopted.
Illustration 11:
The Hi-Tech Manufacturing Company is presently evaluating two possible processes for the manufacture of a toy and makes available to you the following information:
You are required to suggest:
(i) Which process should be chosen? Substantiate your answer.
(ii) Would you change your answer as given above if you were informed that the capacities of the two processes are: A—6,00,000 units, B—5,00,000 units? Why? Substantiate your answer.
Solution:
Differential cost analysis is also applied in order to assess whether it would be more profitable to sell a product as it is or to process it further into different products to be sold at an increased price. If incremental revenue as a result of further processing is more than the additional cost of processing, further processing is recommended.
Differential Costs: Application # 6.
Level of Activity Planning:
Marginal costing and differential cost analysis may be of great help to the management in planning the level of activity. Maximum contribution at a particular level of activity will show the position of maximum profitability.
Illustration 12:
A company has a capacity of producing 1,00,000 units of a certain product in a month. The Sales Department reports that the following schedule of sale price is possible:
The variable cost of manufacture between these levels is Rs.0.15 per unit and fixed cost Rs.40,000. At which volume of production will the profit be maximum.
Solution:
Contribution at 70% is maximum. Fixed cost being constant at all levels of production; profit is also maximum at 70% level of activity.
Differential Costs: Application # 7.
Purchasing or Leasing:
Sometimes, the management is required to take decision whether a particular as It say building is to be purchased or may be taken on lease basis. In this case the total cost of the two alternatives is to be compared in order to calculate the annual saving or extra cost involved if the building is purchased as compared to leasing. This will be more clear from the following Illustration.
Illustration 13:
GPC Ltd. has received an offer to either purchase a building for Rs.4 lakhs or takes it on lease for an annual rental of Rs.40,000. Cost composition of the building includes Rs.40,000 for land. If the building is purchased, renovation will cost another Rs.60,000. However, if the building is leased, GPC Ltd. has agreed to pay the property taxes and insurance, and make necessary repairs.
It is estimated that annual costs will be as follows:
Property Taxes Rs.8,000.
Insurance @ 1-11% (Rounded off to the nearest Rs.10) to be calculated on the value before renovation and is expected to remain constant at that level.
Repairs and Maintenance Rs.12,000.
The building has an estimated life of 20 years and to be depreciated on a straight line method. The salvage value would be equal to the cost of demolition. The amount required to purchase and remodel the building will yield 8% interest free of tax invested in good marketable securities.
You are required to prepare a statement showing the annual saving or extra cost involved if the building is purchased as compared to leasing.
Solution:
Statement Showing the Extra Annual Saving or Extra Cost in the Cost of Operation if the Building is purchased as against Leasing
Thus, if the building is purchased, the investment required will be Rs.4,60,000 which otherwise would have fetched Rs.36,800 by way of 8% interest. Hence total cost which GPC Ltd. has to incur will be Rs.81,800 (i.e. Rs.45,000 expenses plus Rs.36,800 loss of income) annually as against total cost of Rs.64,000 incurred if the building is taken on lease.
Thus the company will gain Rs.17,800 (i.e. Rs.81,800 – Rs.64,000) per year if the same is taken on lease. The only point in favour of purchase of building is that after 20 years the land would appreciate in value.
Other fields where differential cost analysis is made for facilitating managerial decisions are:
(а) Whether or not factory should operate at full capacity.
(b) Whether a change in production should be followed.
(c) Whether to make or buy a spare part.
(d) Whether a new product should be introduced or not.
(e) Whether a particular market should be tapped or not.
(f) Whether a product should be discontinued to avoid the present loss.
(g) Whether or not an investment in a particular asset will be worthwhile.
In these problems also, change from the present course is recommended only if the differential revenue exceeds the differential cost.