CHAPTER 7
INCREMENTAL
ANALYSIS
Managerial Accounting, Fifth Edition
Chapter
7-1
Management’s Decision-Making Process
Decision-making is an important management
function that does not always follow a set pattern.
Steps in management’s decision-making process:
Illustration 7-1
Accounting helps management in making decisions by
evaluating possible courses of action (step 2) and
reviewing results (step 4).
Chapter
7-2
SO 1: Identify the steps in management’s decision-making process.
Management’s Decision-making Process
Both financial and nonfinancial information are
considered in decision-making.
Decisions vary in scope, urgency and importance.
Financial information includes revenues and costs
as well as their effect on profitability.
Nonfinancial information relates to factors such
as: the effect of the decision on employee
turnover, the environment, or company image.
Chapter
7-3
SO 1: Identify the steps in management’s decision-making process.
Incremental Analysis Approach
Decisions involve a choice among alternative courses
of action.
Financial data relevant to a decision are the data
that vary in the future among alternatives.
Both costs and revenues may vary,
or
Only revenues may vary,
or
Only costs may vary.
Chapter
7-4
SO 2: Describe the concept of incremental analysis.
Incremental Analysis
Process used to identify the financial data that
change under alternative courses of action.
Identifies the probable effects of decisions on
future earnings.
Involves estimates and uncertainty.
Incremental analysis is also called differential
analysis because it focuses on differences.
Chapter
7-5
SO 2: Describe the concept of incremental analysis.
Incremental Analysis
GATHERING DATA MAY
INVOLVE:
MARKET ANALYSTS
ENGINEERS
ACCOUNTANTS
NEED TO PRODUCE THE
MOST RELIABLE
INFORMATION AVAILABLE
AT THE TIME THE DECISION
MUST BE MADE.
Chapter
7-6
How Incremental Analysis Works
BE 7-2
Marlowe Company is considering two alternatives.
Revenues
Costs
Net Income
Alternative A
$150,000
$100,000.
$50,000
Alternative B
$185,000
$125,000.
$60,000
$35,000
($25,000)
$10,000
Compare Alternative A to Alternative B showing incremental
revenues, cost and net income.
Illustration 7-2
Comparing alternative B to A, the net income differences
between the two are $35,000 with less net income under
alternative A. A $25,000 incremental cost saving will be
realized with alternative A. However, alternative B will produce
$10,000 more net income than A...
Chapter
7-7
SO 2: Describe the concept of incremental analysis.
How Incremental Analysis Works
Uses Three Important Cost Concepts:
Relevant Cost:
Opportunity Cost:
Sunk Cost:
Illustration 7-3
Chapter
7-8
SO 2: Describe the concept of incremental analysis.
Types of Incremental Analysis
Accept an order at a special price.
Make or buy components or finished
products.
Sell products or process further.
Retain or replace equipment.
Eliminate an unprofitable business
segment.
Allocate limited resources.
Chapter
7-9
SO 2: Describe the concept of incremental analysis.
Accept an Order at a Special Price
Obtain additional business by
making price concessions to a
specific customer.
Assumes sales of the product
in other markets would not be
affected by this special order.
Assumes company is not
operating at full capacity.
Chapter
7-10
SO 3: Identify the relevant costs in accepting an order at a special price.
Accept an Order at a Special Price E7-3
Shandling Company manufactures toasters. For the first 8
months of 2011, the company reported the following
operating results while operating a 75% of plant capacity
a) Prepare an
incremental analysis
for the special order
b) Should Shandling
Company accept the
special order? Why or
why not?
Cost of goods sold was 70% variable and 30% fixed; operating
expenses were also 70% variable and 30% fixed
Sales (350,000 units)
Cost of goods sold
Gross Profit
Operating Expenses
Net Income
Chapter
7-11
$4,375,000
2,500,000
1,875,000
875,000
1,000,000
In September, Shandling Company received a special order for
15,000 toasters at $7.50 each from Bierko Company of Mexico
City. Acceptance of the order would result in an additional
$3,000 of shipping costs but no increase in fixed operating
expenses.
Accept an Order at a Special Price E 7-3
a)
Reject Order
Revenues
(15,000 X $7.50)
Cost of goods sold
Operating Expenses
Net Income
$0
0
0
0
Accept Order
Net Income
$112,500
75,000*
29,250**
$ 8,250
$112,500
(75,000)
(29,250)
$ 8,250
Cost of Goods Sold:
Variable cost: 2,500,000 X .70 = 1,750,000 ($5/unit)
$5. X 15,000 = $75,000*
Operating Expenses:
Variable cost: 875,000 X .7 = 612,500
612,500 / 350,000 = $1.75
$1.75 X 15,000 = 26,250+$3,000(shipping)=29,250**
Chapter
7-12
b) Shandling
should accept
the special
order.
Let’s Review
It costs a company $14 of variable costs and $6 of
fixed costs to produce product Z200 that sells for
$30. A foreign buyer offers to purchase 3,000 units
at $18 each. If the special offer is accepted and
produced with unused capacity, net income will:
a.
decrease $6,000.
b. increase $6,000.
c.
increase $12,000.
d. increase $9,000.
Chapter
7-13
$18 - $14= $4
$4 × 3,000 units = $12,000
SO 3: Identify the relevant costs in accepting an order at a special price.
Make or Buy
Management must decide whether to make or buy
components.
Chapter
7-14
SO 4: Identify the relevant costs in a make-or-buy decision.
The decision should be to make the part.
Make or Buy – Continued BE 7-4
Lafleur Manufacturing incurs unit costs of $7.50 ($4.50 variable cost and
$3 fixed cost) in making a sub-assembly part for its finished product. A
supplier offers to make 10,000 of the assembly part at $5 per unit. If the
offer is accepted, Lafleur will save all variable costs but no fixed costs.
Prepare an analysis showing the total cost saving, if any, Lafleur will
realize by buying parts.
Variable manufacturing
costs
Fixed manufacturing costs
Purchase price
Total annual cost
Chapter
7-15
Net Income
Increase
(Decrease)
Make
Buy
$45,000
$ –0–
$ 45,000
30,000
30,000
0
–0–
50,000
(50,000)
$75,000
$80,000
($ (5,000)
Make or Buy
Opportunity Costs
Definition: The potential benefits that may be
obtained from following an alternative course of
action.
Suppose that LaFluer had the opportunity to
generate an additional $20,000 in income by
purchasing the assembly parts and using their
machinery to assemble a completely different
product.
If Lafleur continues making this product the
income is lost.
Chapter
7-16
SO 4: Identify the relevant costs in a make-or-buy decision.
Make or Buy – Opportunity Cost Example
This Opportunity cost, this lost income, is
added to the “Make” column as an additional
“cost” for comparative purposes.
It is now more advantageous to purchase the
assembly parts for Lafleur.
LaFleur would be better off by $15,000 to
purchase in this scenario.
Make
Total Annual Cost
Opportunity Cost
Total Cost
Chapter
7-17
75,000
20,000
95,000
Buy
80,000
0
80,000
Net Income
Increase (Decrease)
(5,000)
20,000
15,000
SO 4: Identify the relevant costs in a make-or-buy decision.
Sell or Process Further
Many manufacturers have the option of selling a
product now or continuing to process hoping to sell
at a higher price.
Decision Rule:
Process further as long as
the incremental revenue from
such processing exceeds the
incremental processing costs.
Chapter
7-18
SO 5: Identify the relevant costs in determining whether
to sell or process materials further.
Sell or Process further? BE 7-5 EXAMPLE
Bolus Inc, makes unfinished bookcases that it
sells for $60. Production costs are $35 variable
and $10 fixed. Because it has unused capacity,
Bolus is considering finishing the book cases and
selling them for $70. Variable finishing costs are
expected to be $8 per unit with no increase in
fixed costs.
Instructions:
Prepare an analysis on a per unit basis showing
whether Bolus should sell unfinished or finished
bookcases.
Chapter
7-19
Sell or Process further? BE 7-5 EXAMPLE
Sales price
per unit
Cost per
unit
Variable
Fixed
Total
Net income
per unit
Chapter
7-20
Sell
Process
Further
Net Income
Increase
(Decrease)
$60.00
$70.00
$10.00
(
35.00
10.00
45.00
43.00
10.00
53.00
(8.00)
0
(
(8.00)
$15.00
$17.00
$ 2.00
The bookcases should be processed further because the incremental
revenues exceed incremental costs by $2.00 per unit.
Sell or Process Further - Example
Single-Product Case
Cost to manufacture one unfinished table:
Illustration 7-8
Selling price of unfinished unit is $50; unused capacity
can be used to finish the tables to sell for $60.
Relevant unit costs of finishing tables:
Direct materials increase $2; Direct labor increases $4.
Variable manufacturing overhead costs increase by $2.40
(60 percent of direct labor increase).
Fixed manufacturing costs will not increase.
Chapter
7-21
SO 5: Identify the relevant costs in determining whether
to sell or process materials further.
Sell or Process Further
Illustration 7-9
Incremental revenues ($10) exceed incremental costs
($8.40); Income increases $1.60 per unit.
Process further.
Chapter
7-22
SO 5: Identify the relevant costs in determining whether
to sell or process materials further .
Sell or Process Further
Multiple-Product Case
In many industries, a number of end-products are
produced from a single raw material and a common
production process.
Multiple end-products are commonly called joint
products:
Petroleum – gasoline, lubricating oil, kerosene.
Meat Packing – meat, hides, bones.
Chapter
7-23
SO 5: Identify the relevant costs in determining whether
to sell or process materials further.
Sell or Process Further
Multiple-Product Case
All costs incurred prior to the point at which the products are
separately identifiable (the split-off point) are called joint
costs.
Joint costs are (for purposes of determining product cost)
allocated to individual products on the basis of relative sales
value.
Joint costs are not relevant for any sell-or-process-further
decisions.
Joint product costs are sunk costs.
They have already been incurred and cannot be changed.
Chapter
7-24
SO 5: Identify the relevant costs in determining whether
to sell or process materials further.
Sell or Process Further - Example
Multiple-Product Case
Marais Creamery must decide whether to:
Sell cream and skim milk now,
or
Process each further before selling.
Illustration 7-10
Chapter
7-25
SO 5: Identify the relevant costs in determining whether
to sell or process materials further.
Sell or Process Further – Example Continued
The daily cost and revenue data for Marais Creamery are:
Illustration 7-11
Chapter
7-26
SO 5: Identify the relevant costs in determining whether
to sell or process materials further.
Sell or Process Further – Example Continued
Sell cream or process further into cottage cheese?
Illustration 7-12
Do not process cream further:
To do so will incur an incremental loss of $2,000.
Chapter
7-27
SO 5: Identify the relevant costs in determining whether
to sell or process materials further.
Sell or Process Further
Sell skim milk or process further into condensed milk?
Illustration 7-13
Marais should process the skim milk:
To do so will increase net income by $7,000.
Chapter
7-28
SO 5: Identify the relevant costs in determining whether
to sell or process materials further.
Retain or Replace Equipment BE 7-7
Management must decide whether a company should
continue to use an asset or replace it.
Example: Assessment of replacement of a factory
machine:
Russel Company has a factory machine with a book
value of $90,000 and a remaining useful life of 4
years. A new machine is available at a cost of
$250,000. This machine will have a 4 year useful life
with no salvage value. The new machine will lower
annual variable manufacturing costs from $600,000 to
$500,000. Prepare an analysis showing whether the
old machine should be retained or replaced.
Chapter
7-29
SO 6: Identify the relevant costs to be considered in
retaining or replacing equipment.
Retain or Replace Equipment – BE7-7
Variable Manufacturing
cost for 4 years
Ne w Machine Cost
Total
Retain
Equipment
Replace
Equipment
Net 4-year
Incr/(Decr)
$2,400,000
00,000,000
$2,400,000
$2,000,000
250,000
$2,250,000
$400,000
(250,000)
$ 150,000
The old factory machine should be replaced.
Replace the equipment - Lower variable manufacturing costs
more than offset cost of new equipment.
The book value of the old machine does not affect the
decision – it is a sunk cost.
However, any trade-in allowance or cash disposal value of
the old asset is relevant.
Chapter
7-30
SO 6: Identify the relevant costs to be considered in
retaining or replacing equipment.
Eliminate an Unprofitable Segment
Should the company eliminate an unprofitable
segment?
Key: Focus on relevant costs.
Consider effect on related product lines.
Fixed costs allocated to the unprofitable segment
must be absorbed by the other segments.
Net income may decrease when an unprofitable
segment is eliminated.
Decision Rule:
Retain the segment unless fixed costs eliminated
exceed the contribution margin lost.
Chapter
7-31
SO 7: Identify the relevant costs in deciding whether
to eliminate an unprofitable segment.
Other Considerations in Decision Making
Many decisions involving incremental analysis have
important qualitative features that must be
considered in addition to the quantitative factors.
Example – cost of lost morale due to outsourcing or
eliminating a plant.
Incremental analysis is completely consistent with
activity-based costing (ABC).
ABC often results in better identification of relevant
costs and, thus, better incremental analysis.
Chapter
7-32
Chapter Review - Exercise 7-1
Identify each of the following statements as true or false.
1. The first step in management’s decision-making process is
“Determine and evaluate possible courses of action.”
2. The final step in management’s decision-making process is
to actually make the decision.
3. Accounting’s contribution to management’s decisionmaking process occurs primarily in evaluating possible
courses of action and in reviewing the results.
4. In making business decisions, management ordinarily
considers only financial information because it is
objectively determined.
Chapter
7-33
Chapter Review - Exercise 7-1 Continued
Identify each of the following statements as true or false.
5. Decisions involve a choice among alternative courses of
action.
6. The process used to identify the financial data that
change under alternative courses of action is called
incremental analysis.
7. Costs that are the same under all alternative courses of
action sometimes affect the decision.
8. When using incremental analysis, some costs will always
change under alternative courses of action, but revenues
will not.
9. Variable costs will change under alternative courses of
action, but fixed costs will not.
Chapter
7-34
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Chapter
7-35
ANY QUESTIONS
Chapter
7-36