Managerial Accounting

Weygandt • Kieso • Kimmel

CHAPTER 6
INCREMENTAL ANALYSIS
Prepared by
Dan R. Ward
Suzanne P. Ward
University of Louisiana at Lafayette

John Wiley & Sons, Inc. © 2005

 CHAPTER 6
INCREMENTAL ANALYSIS
Study Objectives
Identify the steps in management’s decision-ma
king process.
Describe the concept of incremental analysis.
Identify the relevant costs in accepting an order
at a special price.
Identify the relevant costs in a make-or-buy dec
ision.
Identify the relevant costs in determining wheth
er to sell or process further.
Study Objectives:
Continued
Identify the relevant costs to
be considered in retaining o
r replacing equipment.
Identify the relevant costs in
deciding whether to eliminat
e an unprofitable segment.
Determine sales mix when a
company has limited resour
ces.
 MANAGEMENT’S
DECISION-MAKING PROCESS
Study Objective 1

 Does not always follow a set pattern or process

 Decisions vary in scope
 Decisions vary in urgency and importance

 However some steps can be identified:

 MANAGEMENT’S
DECISION MAKING PROCESS
 Considers both financial
and nonfinancial inform
ation
 Financial information
• Revenues and costs
• Overall profitability
 Nonfinancial information
• Effect of decision on e
mployee turnover
• Environment
• Overall image of comp
any
MANAGEMENT’S DECISION-MAKING
Incremental Analysis Approach
Study Objective 2

 Decisions involve a choice among alternative actions

 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
 Incremental Analysis: Process to identify financial d
ata that change under alternative actions
 Identifies probable effects of decisions on future earni
ngs
MANAGEMENT’S DECISION MAKING
How Incremental Analysis Works
Example

Alternative Alternative Net Income

A B Increase (Decrease)
Revenues $125,000 $110,000 $(15,000)
Costs 100,000 80,000 20,000
Net income $ 25,000 $ 30,000 $ 5,000

Alternative B is being compared to Alternative A

 Incremental revenue is $15,000 less under Alternative B
 Incremental cost savings of $20,000 is realized
 Alternative B produces $5,000 more net income
MANAGEMENT’S DECISION MAKING
How Incremental Analysis Works
Uses three important cost concepts
 Let’s Review

Incremental analysis is the process of identif

ying the financial data that:

– Do not change under alternative courses of acti

on
– Change under alternative courses of action
– Are mixed under alternative courses of action
– None of the above
 Let’s Review

Incremental analysis is the process of identif

ying the financial data that:

– Do not change under alternative courses of acti

on
– Change under alternative courses of action
– Are mixed under alternative courses of action
– None of the above
MANAGEMENT’S DECISION MAKING
Types of Incremental Analysis
 Accept an order at a special pri
ce
 Make or buy component parts
or finished products
 Sell products or process furthe
r
 Retain or replace equipment
 Eliminate an unprofitable busi
ness segment
 INCREMENTAL ANALYSIS
Accept an Order at a Special Price
Study Objective 3

 Obtain additional business

by making price concession
s
 Assumes sales of the produ
cts in other markets would
not be affected by special or
der
 Assumes company is not op
erating at full capacity
 INCREMENTAL ANALYSIS
Accept an Order at a Special Price
Example
 Customer offers to buy a special order of 2,000 blender
s at $11 per unit from Sunbelt.
 No effect on normal sales; sufficient plant capacity
 Operating at 80 percent capacity = 100,000 units
 Current fixed manufacturing costs = $400,000 or $4 per unit
 Variable manufacturing cost = $8 per unit
 Normal selling prince = $20 per unit
 Based strictly on total cost of $12 per unit ($8 + $4), rej
ect offer as cost exceeds selling price of $11
 INCREMENTAL ANALYSIS
Accept an Order at a Special Price
Example (Continued)
No change in fixed costs since within existing capacity –
thus fixed costs are not relevant
Only total variable costs change – thus they are relevant

Net Income
Reject Order Accept Order Increase (Decrease)
Revenues $ -0- $22,000 $22,000
Costs -0- 16,000 (16,000)
Net income $ -0- $ 6,000 $ 6,000

Revenue increases $22,000; variable costs increase $16,000;

Thus, net income increases $6,000

Decision: Accept the offer – Income will increase by $6,000.

 INCREMENTAL ANALYSIS
Make or Buy
Study Objective 4

 Outsourcing: The decision to buy parts or services ra

ther than making them
Example:
Baron Co. incurs the following costs to make 25,000 switches:

 Switches can be purchased for $8 per switch ($200,000)

 Eliminates all variable costs and $10,000 of fixed costs; ho
wever, $50,000 of fixed costs remain
 INCREMENTAL ANALYSIS
Make or Buy
Example (Continued)

Net Income
Make Buy Increase (Decrease)
Direct materials $ 50,000 $ -0- $ 50,000
Direct labor 75,000 -0- 75,000
Variable manufacturing costs 40,000 -0- 40,000
Fixed manufacturing costs 60,000 50,000 10,000
Purchase price -0- 200,000 (200,000)
Total annual cost $225,000 $250,000 $ (25,000)

 Based on analysis of costs under both alternatives:

 Purchasing adds $25,000 to cost of switches

Decision: Continue to make switches.

 INCREMENTAL ANALYSIS
Opportunity Costs

The potential benefit

that may be obtained
from following an alt
ernative course of ac
tion
 INCREMENTAL ANALYSIS
Opportunity Costs
Example – Baron Company Continued
 Assume that buying the switches allows Baron to use the relea
sed capacity to generate $28,000 additional income.
 Thus, the $28,000 lost income is an additional cost of making t
he switches

Net Income
Make Buy Increase (Decrease)
Total annual cost $225,000 $250,000 $(25,000)
Opportunity cost 28,000 -0- 28,000
Total cost $253,000 $250,000 $ 3,000

Decision: Based on the analysis,

Baron should buy the switches
as the company will be $3,000 better off.
 INCREMENTAL ANALYSIS
Sell or Process Further
Study Objective 5

 Manufacturers may have to decide, at a given point in

production, whether to sell now or to process further a
nd sell at a higher price later.

 Decision Rule:
Process further as long as
the incremental revenue from
such processing exceeds the
incremental processing costs
 INCREMENTAL ANALYSIS
Sell or Process Further
Single-Product Case
 Cost to manufacture one unfinished table:
Direct materials $15
Direct labor 10
Variable manufacturing overhead 6
Fixed manufacturing overhead 4
Manufacturing cost per unit $35
 Selling price of unfinished unit is $50
 Unused capacity used to finish the tables to sell for $6
0 per table.
 Relevant unit costs of finishing tables:
 Direct materials increase $2
 Direct labor increase $4
 Variable manufacturing overhead costs increase by $2.4
0 (60 percent of direct labor increase)
 Fixed manufacturing costs will not increase
 INCREMENTAL ANALYSIS
Sell or Process Further
Single-Product Case (Continued)

Process Net Income

Sell Further Increase (Decrease)
Sales per unit $50.00 $60.00 $10.00
Cost per unit
Direct materials 15.00 17.00 (2.00)
Direct labor 10.00 14.00 (4.00)
Variable manufacturing overhead 6.00 8.40 (2.40)
Fixed manufacturing overhead 4.00 4.00 - 0 -
Total $35.00 $43.40 $(8.40)

Net income per unit $15.00 $16.60 $1.60

Decision: Process further.

Incremental revenue ($10) exceeds incremental processing c
osts ($8.40); income increases $1.60 per unit
 INCREMENTAL ANALYSIS
Sell or Process Further
Multiple-Product Case

 Especially appropriate when multiple products are produced s

imultaneously
 Many end-products are produced from a single raw material
and a common production process
 Joint products - multiple end products
 Petroleum – gasoline, lubricating oil, kerosene
 Meat Packing – meat, hides, bones
 INCREMENTAL ANALYSIS
Sell or Process Further
Multiple-Product Case

 Joint costs
 all costs incurred prior to split-off point
 allocate to individual products based on relative sales value

 Sunk costs
 already incurred and cannot be changed
 irrelevant for sell or process
further decisions

Joint costs are sunk costs for sell or process further decisions.
INCREMENTAL ANALYSIS
Sell or Process Further
Multiple-Product Case

Example - Marais Creamery decision:

Sell cream and skim milk
or
Process them further before selling
 INCREMENTAL ANALYSIS
Sell or Process Further
Multiple-Product Case – Example (Continued)
 Sell cream or process further into cottage cheese?
 Joint cost allocated to cream $ 9,000
 Processing cream into cottage cheese $10,000
 Expected revenue per day:
Cream $19,000 Cottage cheese $27,000

Process Net Income

Sell Further Increase (Decrease)
Sales per day $19,000 $27,000 $ 8,000
Cost per day
Processing cream into
cottage cheese -0- 10,000 (10,000)
$19,000 $17,000 $ (2,000)

Decision: Do not process the cream further.

Incremental revenue ($8,000) is less than incremental costs ($10,000); inco
me decreases $2,000.
 INCREMENTAL ANALYSIS
Sell or Process Further
Multiple-Product Case – Example (Continued)
 Sell skim milk or process further into condensed milk?
 Joint cost allocated to skim milk $ 5,000
 Processing skim milk into condensed milk $ 8,000
 Expected revenue per day:
Skim milk $11,000 Condensed milk $26,000

Process Net Income

Sell Further Increase (Decrease)
Sales per day $11,000 $26,000 $ 15,000
Cost per day
Processing skim milk into
condensed milk -0- 8,000 ( 8,000)
$11,000 $18,000 $ 7,000

Decision: Process the skim milk further.

Incremental revenue ($15,000) exceeds incremental costs ($8,000);
income increases $7,000.
 INCREMENTAL ANALYSIS
Retain or Replace Equipment
Study Objective 6

Example
 Assessment of replacement of a factory machine:
Old Machine New Machine
Book value $40,000
Cost $120,000
Remaining useful life four years four years
Scrap value -0- -0-

 Variable costs:
Decrease from $160,000
to $125,000 annually
 INCREMENTAL ANALYSIS
Retain or Replace Equipment
Example (Continued)
Net Income
Retain Replace Increase (Decrease)
Variable manufacturing costs $640,000a $500,000b $140,000
New machine cost 120,000 (120,000)
Total $640,000 $620,000 $ 20,000

a(4 years x $160,000) b(4 years x $125,000)

Decision: replace equipment.

Lower variable manufacturing costs more than
offset cost of new equipment.
The book value of the old machine does not affect
the decision.
 INCREMENTAL ANALYSIS
Eliminate an Unprofitable Segment
Study Objective 7

 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 s
egment is eliminated
 Decision Rule:
 Retain the segment unless fixed costs eliminated ex
ceed the contribution margin lost
 INCREMENTAL ANALYSIS
Eliminate an Unprofitable Segment
Study Objective 7

Example – Martina Company

 Manufactures three models of tennis racquets:
 Profitable lines: Pro and Master
 Unprofitable line: Champ
 Condensed Income Statement data:

Pro Master Champ Total

Sales $800,000 $300,000 $100,000 $1,200,000
Variable expenses 520,000 210,000 90,000 820,000
Contribution margin 280,000 90,000 10,000 380,000
Fixed expenses 80,000 50,000 30,000 160,000
Net income $200,000 $ 40,000 $(20,000) $ 220,000

Should Champ be eliminated?

 INCREMENTAL ANALYSIS
Eliminate an Unprofitable Segment
Example (Continued)

 If Champ is eliminated, allocate its $30,000 fixed costs:

2/3 to Pro and 1/3 to Master
 Revised Income Statement data:
ELIMINATE CHAMP?
Pro Master Total
Sales $800,000 $300,000 $1,100,000
Variable expenses 520,000 210,000 730,000
Contribution margin 280,000 90,000 370,000
Fixed expenses 100,000 60,000 160,000
Net income $180,000 $ 30,000 $ 210,000

 Total income has decreased by $10,000 ($220,000 - $210,000)

 INCREMENTAL ANALYSIS
Eliminate an Unprofitable Segment
Example (Continued)
 Incremental analysis of Champ provides the same results

ELIMINATE CHAMP? Net Income

Continue Eliminate Increase (Decrease)
Sales $100,000 $ -0- $(100,000)
Variable expenses 90,000 -0- 90,000
Contribution margin 10,000 -0- (10,000)
Fixed expenses 30,000 30,000 -0-
Net income $(20,000) $ 30,000) $ (10,000)

 Decrease in net income is due to Champ’s contribution margin ($10,000) th

at will not be realized if the segment is discontinued

Decision: Do not eliminate Champ.

 INCREMENTAL ANALYSIS
Allocate Limited Resources
Study Objective 8

 Resources are always limited

 floor space for a retail firm
 raw material, direct labor hours, or m
achine capacity for a manufacturing fi
rm
 Management must decide whic
h products to make and sell to
maximize net income
 INCREMENTAL ANALYSIS
Allocate Limited Resources
Study Objective 8

Example – Collins Company

 Produces standard and deluxe
pen and pencil sets
 Limiting resource – 3,600 machine
hours per month

Deluxe set Standard set

Contribution margin per unit $8 $6
Machine hours required 0.4 per unit 0.2 per unit
 Deluxe set has higher contribution margin: $8
 Standard set takes fewer machine hours per unit
 INCREMENTAL ANALYSIS
Allocate Limited Resources
Example (Continued)

 Must compute contribution margin per unit of limited resource

 Standard sets have higher contribution margin per unit of

limited resources

Decision:
Shift sales mix to standard sets or increa
se machine capacity
 INCREMENTAL ANALYSIS
Allocate Limited Resources
Example (Continued)

Alternative: Increase machine capacity from 3,600 to 4,200 hours

To maximize net income, all 600 hours should be used to produce
standard sets.
 INCREMENTAL ANALYSIS
Theory of Constraints

 Approach used to identi

fy and manage constrai
nts so as to achieve com
pany goals
 Requires identification
of constraints
 Continual attempts to r
educe or eliminate const
raints
MANAGEMENT’S DECISION MAKING
Other Considerations
 Qualitative factors
 Potential effects of decision on em
ployees and community
 Low morale
 Employee turnover
 Incremental Analysis and Activi
ty-Based Costing
 Completely consistent with each o
ther
 ABC better identifies relevant cost
s resulting in better incremental a
nalysis
 Let’s Review
In a decision to retain or replace equipm
ent, the book value of the old equipment
is a (an):

– Opportunity costs
– Incremental cost
– Sunk cost
– Marginal cost
 Let’s Review
In a decision to retain or replace equipm
ent, the book value of the old equipment
is a (an):

– Opportunity costs
– Incremental cost
– Sunk cost
– Marginal cost
 Summary of Study Objectives
 Identify the steps in management’s decision-making process
.
 Identify the problem and assign responsibility
 Determine and evaluate courses of action
 Make the decision
 Review results

 Describe the concept of incremental analysis.

Process of identifying data that change under
alternative courses of action
 Summary of Study Objectives
 Identify the relevant costs in accepting an order at a spe
cial price.
Generally the relevant costs will be the variable manufacturing
costs; total fixed costs will not change.

 Identify the relevant costs in a make-or-buy decision.

 Variable manufacturing costs that will be saved
 Purchase price
 Opportunity costs
 Summary of Study Objectives

 Identify the relevant costs in determining

whether to sell or process materials furth
er.
Process further as long as incremental
revenue exceeds incremental costs

 Identify the relevant costs to be considere

d in retaining or replacing equipment.
 Effect on variable costs
 Cost of new equipment
 Any disposal value of old equipment
 Summary of Study Objectives
 Identify the relevant costs in deciding whether to elim
inate an unprofitable segment.
Retain segment unless fixed costs eliminated exceed the
contribution margin lost

 Determine sales mix when a company has limited res

ources.
 Find contribution margin per unit of limited resource
 Multiply this amount
by the units of limited resource
to determine which product
maximizes net income
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