Unit COSTING FOR MANAGERS (MBA-MU)

III

DIFFERENTIAL
COST ANALYSIS

Semester 2

PREPARED & COMPILED BY:

JEET KAKKAD
Unit - III Differential Cost Analysis

INDEX

1. BASICS CONCEPTS ............................................................................................................................. 3

1.1 Differential Cost .......................................................................................................................................................... 3
1.2 Decision-Making ......................................................................................................................................................... 3
1.3 Differential Costing / Short-term Decision Making................................................................................. 3

2. SHORT-TERM DECISION-MAKING ............................................................................................... 4

2.1 Make or Buy Decision / In-house Processing or Outsourcing Decision ....................................... 4
2.2 Pricing Decision .......................................................................................................................................................... 4
2.3 Dropping a Product Line Decision .................................................................................................................... 5
2.4 Replacement Decision ............................................................................................................................................. 5
2.5 Special Order Decision ............................................................................................................................................ 5
2.6 Shut-Down Decision .................................................................................................................................................. 6
2.7 Sales-Mix Decision ..................................................................................................................................................... 6
2.8 Key or Limiting Factor Decision ......................................................................................................................... 7

3. QUESTION BANK................................................................................................................................ 8
Question-1: Make or Buy Decision ........................................................................................................................... 8
Question-2: Make or Buy Decision ........................................................................................................................... 8
Question-3: Make or Buy Decision ........................................................................................................................... 8
Question-4: Make or Buy Decision ........................................................................................................................... 9
Question-5: Pricing Decision - Single Product Pricing .................................................................................. 9
Question-6: Pricing Decision - Single Product Pricing .................................................................................. 9
Question-7: Pricing Decision - Multi Product Pricing .................................................................................... 9
Question-8: Special Order Decision ...................................................................................................................... 10
Question-9: Dropping a Product Line Decision & Sales Mix Decision................................................ 10
Question-10: Shut-down Decision ............................................................................................................................ 11
Question-11: Pricing Decision - Single Product Pricing ............................................................................... 12

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Unit - III Differential Cost Analysis

1. BASICS CONCEPTS

1.1 Differential Cost

o A differential cost is the difference in cost among various alternatives. Incremental cost is the
increase in cost due to the decision while decremental cost is the decrease in total cost. Differential
Cost is also known as Incremental Cost.

o Differential Cost refers to changes in total costs that occur due to changes in volume of
production or sales, product system, product mix or from the adoption of an alternative course
of action.

o Characteristics of Differential Cost:

 It is a relevant cost.
 It is an estimated future cost.
 It includes only those costs which change as a result of the decision making being considered.

1.2 Decision-Making

o Managerial decision making follows different process than personal decision making as it requires
more focus on systematic and specialised way of operations.

o Decision making is a difficult process. The main obstacles in the process are inadequate information,
conflicting motives and changing circumstances. A solid decision making process is integral to good
management as it helps in optimum allocation of resources and accomplishment of objectives.

1.3 Differential Costing / Short-term Decision Making

o Differential Costing / Short-term decision-making deals with decisions concerning the

allocation of scarce resources as part of a short-term future course of action, within an existing
framework of capital investment and cost structure.

o Decision making is a difficult process. The main obstacles in the process are inadequate information,
conflicting motives and changing circumstances.

o In the case of differential costing, incremental / decremental revenue is the main criteria for
decision making.

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Unit - III Differential Cost Analysis

2. SHORT-TERM DECISION-MAKING

Make or Buy Decision

Single Product Pricing
Pricing Decision
Multi-Product Pricing
Dropping a Product Line Decision
Short-term Decision

Replacement Decision
Making

Special Order Decision

Complete or Permanent
Shut-Down
Shut-Down Decision
Partial or Temporary
Shut-Down
Sales Mix Decision

Key or Limiting Factor Decision

2.1 Make or Buy Decision / In-house Processing or Outsourcing Decision

o A firm may buy or manufacture components and spare parts. Marginal costing techniques may be used
to determine which course of action is more beneficial for the firm. For this purpose, the marginal cost
of manufacturing is compared with the purchase price from the market. The firm may choose to
manufacture the product if its marginal cost is lower than the purchase price.

o Other factors such as capacity utilisation should also be taken into account while making such
decision.

o In case of unused capacity, only variable costs should be compared with market price while if the firm
is working at full capacity the opportunity costs (or, additional fixed costs) should also be taken into
account.

2.2 Pricing Decision

o Determining of selling price is a critical managerial decision. Various factors such as market conditions
and regulations also impact this decision.

o Following are the various circumstances under which management may have to take such decisions:

 Pricing under normal conditions,

 During stiff competition,

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Unit - III Differential Cost Analysis

 During trade depression,

 For accepting special bulk orders,
 For accepting additional orders utilising idle capacity, and
 For accepting foreign orders and exploring new markets.

o Pricing Decision are further classified into two categories:

 Single Product Pricing

 Multi-Product Pricing

2.3 Dropping a Product Line Decision

o A firm may redesign its product mix by "adding" or "dropping" a product. The firm may also stretch
its product line up or down. Stretching up involves use of better technology while stretching down
involves the inverse. These decisions may be undertaken in response to structural changes in the
market.

o In a multi-product environment, the managerial decision to add a new product may lead to higher
sales and associated costs while dropping a product may cause inverse. For such decisions, the
management may compare the differential costs and incremental revenue.

2.4 Replacement Decision

o The business must consider the costs and benefits involved in replacing existing equipment with new
equipment.

o For example, a business may be considering whether to try to improve efficiency by purchasing new
production machinery and getting rid of the existing, old machinery.

2.5 Special Order Decision

o Sometimes a decision regarding acceptance of a special order is to be made. This, however, depends
on the availability of spare capacity. The contribution available from such an order helps in making
such a decision.

o Additionally, in case of Special Order Decisions, there can be two situations, which are as follows:

 In case there is availability of spare / idle capacity to accommodate the special order, then we
only need to consider the variable costs.

 But, if the special order cannot be accommodated within the spare / idle capacity, then we not
only need to consider the variable costs but the opportunity costs (or, additional fixed costs)
should also be taken into account.

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Unit - III Differential Cost Analysis

2.6 Shut-Down Decision

o In case of firms operating on loss for some time, the management needs to take decision about its
shutdown.

o Shut-down decision can be put into two categories:

(i) - Complete or Permanent Shut-Down:

 The firm decides to shut-down without any intention of reviving the business. This decision is
taken in the following situations:
 When selling price goes below the variable cost.
 The demand for the output is low and is not expected to be picked up in the future.

 In case of complete shut-down, the company saves on the fixed cost of running the firm.

(ii) - Partial or Temporary Shut-Down:

 Such decisions are temporary in nature and the management intends to start production in future.
The firm continues to incur fixed expenses such as salaries and remuneration. The savings from
such shut down should be carefully evaluated.

 The shutdown decision should only be taken if the savings are substantial as reviving a business
is a tedious process. Such decisions may also entail additional costs such as extra payments for
repairing the equipment, training of the new employee, etc. Thus, the savings and costs should be
considered for making a final decision.

2.7 Sales-Mix Decision

o A sales mix is the collection of all of the products and services a company offers. It considers each
individual item a company sells, and the profit margin each product earns. While every product may
have a different profit margin, the sales mix considers the profit margin of all of the items combined.

o By analyzing the sales mix, a company can determine which products should receive the most focus
and priority, based on the earning capacity, demand, and the resources needed to produce a product.

o The sales mix is a calculation that determines the proportion of each product a business sells
relative to total sales.

o The sales mix is significant because some products or services may be more profitable than others,
and if a company's sales mix changes, its profits also change. Managing sales mix is a tool to maximize
company profit.

o Analysts and investors use a company's sales mix to determine the company's prospects for
overall growth and profitability. If profits are flat or declining, the company can de-emphasize or
even stop selling a low-profit product and focus on increasing sales of a high-profit product or service.

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Unit - III Differential Cost Analysis

2.8 Key or Limiting Factor Decision

o A key factor may be defined as, "a factor which may limit production or profit of a firm".

o Sale is the most common limiting factor. The firm's production is generally limited by its capacity
to sale. Other limiting factors may be materials, labour, capital or plant capacity. In such cases,
the management may need to decide which products to be produced and in which quantity.

o A Limiting factor is anything which limits the activity of an entity. The factor is a key to
determine the level of sale and production, thus it is also known as Key Factor.

o In the absence of any limiting factor, the firm will decide its production strategy on the basis of P/V
ratio. However, if there are limiting factors, then the decision is made using contribution per unit of
limiting factor. In the presence of a limiting factor, the profit may be maximised by making a
contribution analysis for that factor.

o For e.g., if labour is the limiting factor, then the labour hours required for each product must be
calculated. The contribution is then expressed in terms of rupees per labour hours. The products with
higher contribution per labour hour should be chosen for maximising profits.

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Unit - III Differential Cost Analysis

3. QUESTION BANK

Question-1: Make or Buy Decision

o TPCL Ltd., is producing 30,000 units of a component at a cost of Rs. 60 per unit. Fixed cost at this level
of output is Rs. 20 per unit. 40% of fixed cost is avoidable. TPCL Ltd. can buy the component from
outside at Rs. 40 per unit. Should the company produce or buy?

Answer:
Alternative-01: Produce the component in-house | Total Cost = Rs. 18,00,000
Alternative-02: Buy the component from outside | Total Cost = Rs. 15,60,000

Decision: TPCL Ltd. should opt for Alternative-02 as it saves a cost of Rs. 2,40,000.

Question-2: Make or Buy Decision

o You are producer and seller of plastic products. You are producing 10,000 buckets at a fixed cost of Rs.
3,00,000 and variable cost of Rs. 50 per bucket, i.e., at an average cost of Rs. 80 per bucket. You can
buy buckets from outside at a price of Rs. 65 per bucket. The capacity so vacated can be used for
producing 7,000 drums at a variable cost of Rs. 40 per drum plus an additional fixed cost of Rs.
1,00,000. Each drum can be sold @ Rs. 90 per drum. Will you continue producing buckets or instead
produce drums and buy buckets from outside?

Answer:
Alternative-01: Produce Buckets | Total Cost = Rs. 8,00,000
Alternative-02: Produce Drums & Buy Buckets | Total Cost = Rs. 7,00,000

Decision: We should opt for Alternative-02 as it saves a cost of Rs. 1,00,000.

Question-3: Make or Buy Decision

o A Ltd., is producing 1,000 units of a component at a cost of Rs. 900 per unit. Fixed cost at this level of
output is Rs. 360 per unit. 25% of fixed cost is avoidable. A Ltd. can buy the component from outside
at Rs. 700 per unit. Should the company produce or buy?

Answer:
Alternative-01: Produce the component in-house | Total Cost = Rs. 9,00,000
Alternative-02: Buy the component from outside | Total Cost = Rs. 9,70,000

Decision: A Ltd. should opt for Alternative-01 as it saves a cost of Rs. 70,000.

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Question-4: Make or Buy Decision

o You are producer and seller of electronic products. You are producing 10,000 Mobile Phones at a fixed
cost of Rs. 1,50,00,000 and variable cost of Rs. 3,500 per Mobile Phone, i.e., at an average cost of Rs.
5,000 per Mobile Phone. You can buy Mobile Phones from outside at a price of Rs. 5,500 per Mobile
Phone. The capacity so vacated can be used for producing 15,000 Accessories at a variable cost of Rs.
400 per accessory plus an additional fixed cost of Rs. 10,00,000. Each Accessory can be sold @ Rs.
1,000 per Accessory. Will you continue producing Mobile Phones or instead produce Accessories and
buy Mobile Phones from outside?

Answer:
Alternative-01: Produce Mobile Phones | Total Cost = Rs. 5,00,00,000
Alternative-02: Produce Accessories & Buy Mobile Phones | Total Cost = Rs. 6,20,00,000

Decision: We should opt for Alternative-01 as it saves a cost of Rs. 1,20,00,000.

Question-5: Pricing Decision - Single Product Pricing

o The P/V Ratio of a company is 85%. Marginal cost of the product is Rs. 60. Determine the selling price
of the product.

Answer: Selling Price = Rs. 400

Question-6: Pricing Decision - Single Product Pricing

o The P/V Ratio of a company is 60%. Marginal cost of the product is Rs. 160. Determine the selling price
of the product.

Answer: Selling Price = Rs. 400

Question-7: Pricing Decision - Multi Product Pricing

o Pesso Goods Ltd., manufactures pesticides. The accounts of the company show an expected profit of
Rs. 15,00,000 from the manufacture of pesticides after charging fixed costs of Rs. 12,00,000. The
pesticide is sold for Rs. 60 per cup and has a variable unit cost of Rs. 20.

o Market fluctuations have the following responses to price changes:

Alternatives Reduction in Selling Price Increase in Sales Qty.

P 5% 10%
Q 7% 20%
R 10% 25%

o Evaluate these alternatives and state which, on profitability consideration, should be adopted for the
forthcoming year, assuming cost structure remains unchanged.

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Unit - III Differential Cost Analysis

Answer:
Current Situation: Contribution = Rs. 27,00,000 | Profit = Rs. 15,00,000
Alternative-P: Contribution = Rs. 27,47,250 | Profit = Rs. 15,47,250
Alternative-Q: Contribution = Rs. 28,99,800 | Profit = Rs. 16,99,800
Alternative-S: Contribution = Rs. 28,68,750 | Profit = Rs. 16,68,750

Decision: Pesso Goods Ltd. should opt for Alternative-Q as it is the most profitable.

Question-8: Special Order Decision

o Trishul Ltd. receives a special order from Quiral Ltd. for supply of 30,000 units of a product that usually
sells for Rs. 10 per unit. Quiral Ltd. offers Rs. 9 per unit for this product. Trishul Ltd. incurs Rs. 6 per
unit in variable costs to manufacture each item, plus Rs. 2 per unit for variable administrative cost.

o Total fixed manufacturing costs are Rs. 1,60,000. Other fixed cost amounts to Rs. 80,000 per year.
Productivity capacity is 2,10.000 units annually and sales volume through normal sales outlets will be
about 1,60,000 units of this year.

o Draw the marginal cost statement showing profitability and also advice whether to accept or reject
the offer.

Answer:
Current Situation: Production = 1,60,000 units | Profit = Rs. 80,000
Special Order: Production = 30,000 units | Contribution = Rs. 30,000
Proposed Situation: Production = 1,90,000 units | Contribution = Rs. 1,10,000

Decision: Trishul Ltd. should accept the Special Order, since the company will gain Rs. 30,000 by accepting
the Special Order.

Question-9: Dropping a Product Line Decision & Sales Mix Decision

o A manufacturer is thinking whether he should drop one item from his product line and replace it with
another. Given below are his present cost and output data:

Product Price Variable Cost per unit Sales Mix

Chairs 60 40 30%
Cupboard 100 60 20%
Tables 200 120 50%
Total Fixed Cost per year = Rs. 7,50,000 and Sales = Rs. 25,00,000

o The change under consideration consists of dropping the line of cupboards in favour of cabinets. If this
dropping and change is made, the manufacturer forecasts the following cost and output data:

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Unit - III Differential Cost Analysis

Product Price Variable Cost per unit Sales Mix

Chairs 60 40 50%
Cabinet 160 60 10%
Tables 200 120 40%
Total Fixed Cost per year = Rs. 7,50,000 and Sales = Rs. 26,00,000

o Should this proposal be accepted? Comment.

Answer:
Current Situation: Produce Chairs, Cupboads & Tables | Contribution = Rs. 9,50,000 & Profit = Rs. 2,00,000
Proposed Situation: Produce Chairs, Cabinets & Tables | Contribution = Rs. 10,11,834 & Profit = Rs.
2,61,834

Decision: The manufacturer should drop the product line of Cupboards & start producing Cabinets
instead, since it generates an additional contribution / profit of Rs. 61,834.

Question-10: Shut-down Decision

o The cost per unit of the three products M, S, T of a company are given below:

Particulars Product M Product S Product T

Direct Material 30 20 20
(+) Direct Labour 20 16 14
(+) Other Variable Costs 10 12 8
(+) Fixed Costs 8 8 6
Total Cost 68 56 48
(+) Profit 26 16 14
Selling Price 94 72 62

No. of Units Produced 12,000 6,000 10,000

o Production arrangements are such that if one product is dropped down, the production of the others
can be raised by 50%. The directors propose that 'T' should be drop down because the product has
the lowest selling price. Show analysis of the data indicating whether the proposal should be accepted.

Answer:
Alternative-01: Discontinue Product ‘M’ | Incremental Contribution = - (Rs. 2,36,000)
Alternative-02: Discontinue Product ‘S’ | Incremental Contribution = Rs. 1,60,000
Alternative-03: Discontinue Product ‘T’ | Incremental Contribution = Rs. 76,000

Decision: The proposal of the directors is incorrect. The company should not discontinue product ‘T’,
instead it should discontinue Product ‘S’, since it generates the highest incremental contribution of Rs.
1,60,000.

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Unit - III Differential Cost Analysis

Question-11: Pricing Decision - Single Product Pricing

o Calculate the Missing Values and complete the table:

Variable Cost Contribution per

P/V Ratio VC Ratio Selling Price
per Unit unit
(A) 72% Rs. 560
(B) 39% Rs. 1,220
(C) Rs. 375 Rs. 225
(D) Rs. 120 Rs. 360
(E) Rs. 220 Rs. 49.50
(F) 30% Rs. 90
(G) 65% Rs. 850

Answer:

Variable Cost Contribution per

P/V Ratio VC Ratio Selling Price
per Unit unit
(A) 72% 28% Rs. 2,000 Rs. 560 Rs. 1,440
(B) 61% 39% Rs. 2,000 Rs. 780 Rs. 1,220
(C) 60% 40% Rs. 375 Rs. 150 Rs. 225
(D) 75% 25% Rs. 480 Rs. 120 Rs. 360
(E) 77.5% 22.5% Rs. 220 Rs. 49.50 Rs. 170.50
(F) 70% 30% Rs. 90 Rs. 27 Rs. 63
(G) 65% 35% Rs. 850 Rs. 297.50 Rs. 552.50

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