Pages And Sources Of Differential Analysis Involves Knowing

3 Pagesapasources2differential Analysis Involves Knowing Which Costs

Differential analysis involves knowing which costs are relevant, i.e., future costs that vary among alternatives. It is important to know what information to use and not just how to execute the analysis. Herrestad Company receives an offer to make a new product, called C, for a new customer. The customer wants to buy 1,000 units. Product C has the same cost structure as product B with three exceptions.

The new customer is only willing to pay $150 per unit, direct materials costs will decrease by $12 per unit and Herrestad does not have to incur any variable selling and administrative expenses.

Paper For Above instruction

Introduction

In managerial accounting, relevant costs are crucial for making informed business decisions. Differential analysis, or incremental analysis, focuses on identifying costs and revenues that differ between alternatives, guiding managers to optimize outcomes. This paper examines the relevant costs involved in a proposal received by Herrestad Company to produce a new product, Class C, for a specific customer order. The analysis highlights how changes in costs and pricing influence the decision-making process, exploring whether to accept the order based on the financial implications and other qualitative considerations.

Identification of Relevant Costs

The first step involves identifying which costs are relevant for the decision. Since the offer entails producing 1,000 units of Product C with specific modifications, the relevant costs include those that will change if the order is accepted. These include direct materials costs, variable selling and administrative expenses, and any additional costs directly attributable to producing the new units.

Given that Product C shares the same cost structure as Product B, except for three differences—the selling price per unit, direct materials costs, and variable selling and administrative expenses—the relevant costs are primarily variable. Fixed costs, such as depreciation and fixed manufacturing overheads, are irrelevant because they will incur regardless of whether the order is accepted.

The direct materials cost per unit decreases by $12, representing a specific saving attributable to the order. Since Herrestad does not have to incur variable selling and administrative expenses, these costs are eliminated for the production of Product C, making them irrelevant for the analysis.

Calculation of Relevant Costs and Contribution Margin

Initially, assume that the standard direct materials cost per unit for Product B is known; let's say, for example, it is $40. With a reduction of $12, the new direct materials cost per unit becomes $28. The variable selling and administrative expenses, which are eliminated, previously amounted to, for example, $8 per unit.

The sales price offered is $150 per unit; however, this must be assessed against the total relevant costs to determine the contribution margin per unit.

Contribution margin per unit = Selling price per unit - Relevant costs per unit

Thus, contribution margin = $150 - ($28 + $8) = $150 - $36 = $114 per unit.

Total contribution from the order = $114 per unit × 1,000 units = $114,000.

This indicates a substantial positive contribution toward Herrestad’s profitability from accepting the order under current pricing conditions.

Impact of Price Reduction to $140 per Unit

If the company only receives $140 per unit, the contribution margin per unit decreases accordingly:

Contribution margin = $140 - $36 = $104 per unit.

Total contribution = $104 × 1,000 = $104,000.

Although reduced, the order still provides a positive contribution, which benefits the company's fixed cost coverage and profit margin. However, acceptance under this lower price warrants consideration of whether the contribution margin still justifies the opportunity cost and potential impact on regular sales price perceptions.

Qualitative Considerations

Beyond financial metrics, several qualitative factors influence the decision. These include capacity constraints—if production for the order displaces other profitable sales, the order may not be advantageous. Customer relationships, potential for future orders, and the competitive landscape are also relevant.

If the order uses excess capacity and does not interfere with regular business, accepting it could enhance customer goodwill and market presence. Conversely, if fulfilling the order strains resources or leads to lower quality or delivery issues, the decision may be unfavorable.

Conclusion

Based on the analysis, the relevant costs—namely, direct materials, and variable selling and administrative expenses—indicate that accepting the order at $150 per unit is profitable, contributing $114,000 in total. Even at the lower price of $140, the order remains profitable with a contribution of $104,000. Decisions should also consider qualitative factors such as capacity, strategic relationships, and long-term implications. Managers must weigh both quantitative and qualitative aspects to arrive at a balanced decision that aligns with overall corporate objectives.

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