 Hello and welcome to the session. This is Professor Farhad in which we would look at differential analysis pricing decisions. This recording is an introductory recording to these topics. We're going to go over more topics later on, but in this session we have to understand the basic terms because we're going to be using the basic terms later on and make or buy, drop a product or drop a division kind of decision. This topic is also covered on the CPABEC section as well as cost accounting. As always, I'm going to remind you to connect with me on LinkedIn if you haven't done so and subscribe to my YouTube channel where I have 1,800 plus accounting, auditing, tax, finance as well as Excel tutorials. If you like my lectures, please like them and share them. If they benefit you, it means they might benefit other people, share the wealth. Also, I do have a website farhadlectures.com where you will find additional resources to complement and supplement this course as well as other accounting and finance courses. I strongly suggest you check out my website. So what is differential analysis? Every manager or every person that's making a decision will always have to choose between two alternatives. And if we don't choose between two alternatives, then there's no decision to make. If you only have one option, then you're not really making a decision. Well, in other words, when you make a business decision, you have to look at the revenue and the cost. You don't have to look at all the revenues and all the cost. You have to look at revenues and cost that's gonna change among alternative. So the process of doing that is called differential analysis. Now, for differential analysis, we have to learn about terms, certain terms. The first term we're gonna look at is avoidable cost. What is avoidable cost? A avoidable cost as a cost is an expense that will not incur if a particular activity is not performed. So if you don't undertake a particular activity, you don't incur the cost. But if you do, you're going to incur the cost. So it's avoidable in a sense. Avoid that activity and you will avoid the cost. Don't produce the laptops. You don't need a microchip. You don't need a microphone. You don't need a speaker inside the desktop if you don't produce a desktop. But if you do, then you have to incur that cost. So avoidable cost is basically, it will not be incurred. You can avoid it. How can you avoid it? Don't undertake that product. Avoidable cost, primarily, primarily are variable costs. Hopefully we all know what variable costs they vary with your production and they can be removed from a business operation by stopping the activity. Unlike fixed costs, and you should know the difference between variable and fixed, fixed costs must be paid regardless of the activity of the level. So if you are producing desktop, you have to put a microchip in every desktop or if you're producing the laptop. Well, guess what? If you don't produce a laptop, you don't incur that cost. So the cost varies with your production. But you might have to pay the rent for the warehouse where you are producing those laptops. So the rent is a fixed cost, whether you produced or not. So the rent is, it cannot be avoided, but that microchip can be avoided. Well, unavoidable cost, well, cost that's still incurred even if the activity is not performed. Back to the, if you are producing tablets or laptops, whether you produce tablets or the laptop or not, you have to pay the insurance on the building. You have to pay for janitorial services, for security, so on and so forth. Those costs are unavoidable. That means you can't kind of run from them. You cannot avoid them. Some examples include depreciation on the equipment. If you have any depreciation, you have to pay your property tax, lease payment, interest expense, et cetera. These costs are often considered fixed costs. And by nature fixed, it means they cannot be avoided whether you undertake some activity or not. And those costs are irrelevant. So now we need to talk about what's relevant cost, because that's what we need to know, whether something is relevant or not. Well, relevant cost is an avoidable cost. So notice relevant is avoidable that is incurred only when making a specific business decision. So if a cost is relevant, it's avoidable. That means if you do it, you're gonna incur the cost. If you don't do it, you're not going to incur the cost. So avoidable costs are relevant costs. So the costs that will be affected by specific management decision being considered. So based on the decision, you're gonna incur that cost or not. It's relevant to your decision. So management use relevant costs and decision making. So we have to know which one is our relevant cost. This way we will find out based on our analysis, whether to close a business unit or to make or buy parts, labor, or whether to accept customer last minute special order. So based on those relevant costs, we can make those decision. Differential cost is very similar to relevant cost. Refer to differences between the cost of two alternatives. So if you have two different costs, then the cost must be relevant because if you undertake one option A versus option B, the cost is different. Therefore, differential cost is relevant. Relevant, of course, it's relevant. So the cost occurs when a business faces several option and a choice must be made by picking one option and dropping the other. Well, there's a difference between one option versus the other. Then it's a differential cost. Differential cost is also relevant. Opportunity cost is relevant. What is an opportunity cost? It's the cost that you give another cost. The benefit, the potential benefit that you give up by on choosing one alternative over another. For example, if you're listening to me this moment, you have an opportunity cost. What is your opportunity cost? What is your opportunity cost? What else can you do? What's the next best thing can you do rather than listening to my lectures? Well, you can be working at McDonald. You can be playing games. You could be making $100 an hour. I'm not sure, but the next best thing is what's your opportunity cost is. What are you giving up to undertake this, to undertake an activity, to make a product? Opportunity cost is unseen because people don't think about it and can be easily overlooked. And it's not recorded anywhere in the accounting system. So in the accounting system, you don't say, well, this is my opportunity cost. So an opportunity cost is basically something you have to think about when you're making an actual business decision. Basically, it is quantitative, but it can be non-quantitative if you want to think about it that way. But it is relevant. Opportunity cost is relevant to our decision. Some cost. What is a some cost? It's, first of all, it's irrelevant. In other words, if they tell you the sunk cost is $200,000, or you have to know what is a sunk cost. So first, you have to know what is a sunk cost. A sunk cost, that something already happened, it cannot be recovered. So if you bought a machinery five years ago and you paid for it a trillion dollar, you don't take that into account today. Why? Because the trillion dollar that you paid for it or whatever that amount is, it's not relevant. Why? Because it's already sunk. You cannot recover this. It's like, you know, you can cry about it, but there is nothing can be done. So it's a sunk cost. Sunk cost are irrelevant. Now, if you're going to be selling that machine, that it could be relevant under the decision-making, but the old cost is irrelevant. So those are basically basic terms that you need to be familiar with. Simply put, you need to know what's relevant. What's relevant? Well, a differential cost, a cost that differentiates between two alternatives is relevant. Avoidable cost is relevant. Opportunity cost is relevant. Why is that important? Because when we're going to be making decisions, we're going to be talking about relevant cost, avoidable cost, differential cost, and opportunity cost. They differ between decisions. So how do we make differential analysis? And by the way, about differential cost, we also have differential revenues. So if you're choosing between two alternatives, also you have to look at if they differ in terms of revenue. How do we make differential analysis? First, we analyze, look, relevant cost. We don't analyze all the cost and all the revenue. We only analyze relevant cost. That's why you might have a lot of factors, a lot of cost. You only look at the one that differ. If two costs are the same, you don't look at them. You don't examine them. You only look at the one that differ. And this is basically simplify the process. Then you compare your analysis to the status quo. You look at what you have now. You analyze the situation and you would look at what you have currently or what's the other alternative. You examine also non-quantitative factors. I mean, numbers are very helpful. But at the end of the day, you have to make a professional judgment and make a business decision. Then you make your decision. And usually what we're dealing with in cost accounting, we are dealing with pricing decision. So how do pricing decision happen? Well, prices, how do you determine your prices? The main factor is based on supply and demand. That's one of the main factor because if there's a lot of supply for a product and you cannot just say, well, it costs me more than what I can offer it in the market, if there's a lot of supply, you have to drop your prices. And if you can't compete, you get out. Okay, so supply and demand is important, but also what's important is to understand the full cost. And what is the full cost? It's basically you have to take into account all costs to make and sell the product. Like what? What's the full cost? Variable cost, producing and selling the product and organization fixed costs like HR and other support. So you have to take into account variable as well as fixed cost. Your share also of fixed cost. If you remember from the cost volume profit analysis, the full cost per unit is your fixed cost divided by that unit plus your variable cost divided by that unit. So it's your variable cost plus your fixed cost. Long term pricing basically simply put, your selling price in the long term must cover your full cost, must cover everything. Because if you don't, you would run out of resources because you'll be selling your product less than cost. And what happened in the long term, you go out of business. In the short term, you might be able to use only your variable cost. Using full cost, you could have what's called a full cost fallacy and would look at an example to see what this full cost fallacy is. It means sometimes you don't need to allocate certain fixed costs when you are making short term decision. This is what we mean. So how do we make a pricing decision? Let's take a look at basically the decision three. First, you have to understand when you are making a pricing decision for special order. What is a special order? A special order means somebody came to you and said, why don't you sell me your product for lower than what you're selling it to other customers? They might be a foreign customer. They might be a customer out of your sales network. So just they want a special price. The first thing you have to look at when you have a pricing decision is determine whether you have excess capacity. Excess capacity means you can produce the product to sell it to that person. Then you have to determine is your revenue greater than or equal than your variable cost. If your revenue is greater than or equal than your variable cost, you accept. You accept the offer. If your revenue is less than your variable cost, you reject. That's assuming you have excess capacity. Simply put, if the extra revenue cannot cover your variable cost, you'll be selling it at a loss. And we would look at an example in a moment. Now, if the firm does not have excess capacity, if you don't have that excess capacity for the special order, remember, if that's not the case, then you have to give up some other sales because to serve that customer, you have to give up other customers because you have a limited capacity, okay? So accept only if the revenue is greater than the variable cost plus the opportunity cost that you are given up. If that's the case, you will accept. Also, bear in mind, special orders also take into account non-quantitative factors such as qualitative factors. What's the importance of this customer? Maybe you are getting into a new market. We always wanted to do that. There's other factors that you will have to take into account. And let's take a look at an example to see how this all fits together. During a particular month, you develop increasing the special order from an out-of-town merchant who's willing to pay $4,000 for 10,000 photo prints developed or 40 cents per unit. An analysis of the you develop cost structure shows that incur variable cost equal to 36 pennies per print and 1,500 monthly fixed cost. You develop can handle the special order without affecting its regular business, AKA we have plenty of capacity. Should you develop, accept or reject the special order and why? Well, let's first let's take a look at our full cost. If we take into account our full cost, remember we have to recover our fixed cost plus our variable cost, which is 36 pennies times 10,000 divided by 10,000 unit, our full cost is 51 pennies. Now, should we accept or reject this order? Well, if they're paying us 40 pennies and our full cost is 51, at face value you're going to say, well, I should not do so. I should not do so because I'm gonna be losing 11 pennies. But are you really losing 11 pennies? And the answer is no, why not? Because you can factor out, you can not take into account the monthly fixed cost because you're going to pay that monthly fixed cost regardless whether you produce those additional units, 10,000 photo prints or not. Therefore, guess what? If they're paying you 40 pennies, your cost, your variable cost is only 36 pennies. Therefore, you are making four pennies per picture and you will accept because your incremental revenue, the additional revenue which is 40 pennies is greater than your variable cost, which is 36 pennies. You have plenty of capacity. Therefore, you would accept, you would accept or I could ask you, what is the minimum price you would accept? Let's assume I'd say, I did not give you a price of 36. I'd say, what's the minimum price you would accept? I need to cover my variable cost. My variable cost is 36 pennies. Anything the 36 pennies or above, I will accept. Let's take a look at another quick example. Let's assume desert adventure now offers self-guided tours in addition to its traditional guided tours they started with. So it's basically a tour company. At the current level of activity, the self-guided tour do not affect the company's ability to offer the guided tour. So there's plenty of capacity there. A local museum director asked desert adventure about offering discounted self-guided tours to museum members who donate above a certain level, basically part of advertisement. The museum expect that five members will want to do this. They want to take that tour. Desert adventure has idle capacity adequate for these additional five tours, which will not affect the demand from other self-guided tours. So we have plenty of capacity. The museum director asked Dianna to offer the members a special price of 700 for the tour and a discount off the regular $900. So they usually charge 900 for those self-guided. They say, let's see if we can do a $700. Let's see what we have for now. This is what we have for now. We provide 20 tours at $900. The total revenue is 18,000. The variable cost, including food, labor, and so on is 320 times 300, the $6,000. The contribution margin is 12,000. We should be familiar with all these computation from the CVP chapter. If not, please go to your CVP lecture. Fixed cost insurance depreciation other costs 5,400. Operating profit is 6,600. Now we're going to look at what happened with those five additional at $700. This is the status quo, 6,600. Now the alternative is we're going to have revenues of 21,500, why 21,500? Because to the 18,000, we're going to be adding 3,500. We have five members. In each one, we're going to charge them $500. Total revenue, 21,500. Variable costs will go up because we have five additional members times 300. So we're going to add 1,500 to the variable cost. It becomes 7,500. Our new contribution margin is 14,000. Notice fixed cost by nature is fixed. It stays the same. Our operating profit is 8,600. So the difference is in revenue. Revenue is a differential revenue. We have a differential cost. And therefore our operating profit will increase by 2,000. Should we accept? Yes, of course we will accept. Another way to do this is we're going to take an alternative way to compute this is we're going to have five tours at 700. And the only thing that's going to increase is our variable cost of five tours at 300. So we're going to have revenues of 3,500, more expenses of 1,500. Overall, we are 2,000, better off, we will accept. In the next session, we would look at legal issues relating to cost and sales prices. If you like this recording, please like it and share it. If it benefited you, it means it might benefit other people. And don't forget to visit my website, farhatlectures.com, study hard, good luck, and of course, stay safe.