Professional Documents
Culture Documents
Prepared by
Karleen Nordquist..
The College of St. Benedict...
and St. Johns University...
with contributions by
Marianne Bradford..
The University of Tennessee...
Gregory K. Lowry.
Macon Technical Institute..
Chapter 9
Incremental Analysis
Chapter 9
Incremental Analysis
After studying this chapter, you should be able to:
1 Identify the steps in managements decision-making
process.
2 Describe the concept of incremental analysis.
3 Identify the relevant costs in accepting an order at a
special price.
4 Indicate the relevant costs in a make-or-buy decision.
5 Give the decision rule in deciding whether to sell or
process materials further.
Chapter 9
Incremental Analysis
After studying this chapter, you should be able to:
6 Identify the factors to be considered in retaining or
replacing equipment.
7 Explain the factors that are relevant in deciding
whether to eliminate an unprofitable segment.
8 Explain the term sales mix and its effects in
determining break-even sales.
9 Determine sales mix when a company has limited
resources.
Preview of Chapter 9
Decision-Making Process
Incremental Analysis Approach
How Incremental Analysis
Works
INCREMENTAL
ANALYSIS
Preview of Chapter 9
Sales Mix
Break-even Sales
Limited Resources
INCREMENTAL
ANALYSIS
Other Considerations
Qualitative Factors
Incremental Analysis and ABC
Study Objective 1
Study Objective 2
Incremental Analysis
Business decisions involve a choice among alternative courses of
action.
The process used to identify the financial data that change under
alternative courses of action is called incremental analysis.
In some cases, both costs and revenues will change under
alternative choices. In other cases only costs or revenues will
vary.
It is important to recognize that
variable costs may not change under the alternatives, and
fixed costs may change.
Incremental Analysis
Incremental analysis involves not only
identifying relevant revenues and costs, but
also determining the probable effects of
decisions on future earnings.
Data for incremental analysis often involves
estimates and uncertainty.
Gathering data may involve market analysts,
engineers, and accountants.
Alternative
A
$125,000
100,000
$ 25,000
Alternative
B
$110,000
80,000
$ 30,000
Net Income
Increase (Decrease)
$(15,000)
20,000
$ 5,000
Illustration 9-2
Types of Incremental
Analysis
A number of different types of decisions involve
incremental analysis. The more common types of
decisions are whether to:
Accept an order at a special price.
Make or buy component parts or finished
products.
Sell products or process them further.
Retain or replace equipment.
Eliminate an unprofitable business segment.
Study Objective 3
Accept an Order at a
Special Price
Sometimes a company may have an opportunity to obtain
additional business if it is willing to make major price
concessions to a specific customer.
An order at a special price should be accepted when the
incremental revenue from the order exceeds the incremental
costs.
It is assumed that sales in other markets will not be affected
by the special order. If other sales were affected, the lost
sales would have to be considered in making the decision.
If the units can be produced within existing plant capacity,
generally only variable costs will be affected.
Accept an Order at a
Special Price
To
Toillustrate,
illustrate,assume
assumethat
thatSunbelt
SunbeltCompany
Company
produces
produces100,000
100,000automatic
automaticblenders
blendersper
per
month,
month,which
whichis
is80%
80%of
ofplant
plantcapacity.
capacity.
Variable
Variablemanufacturing
manufacturingcosts
costsare
are$8
$8per
per
unit,
unit,and
andfixed
fixedmanufacturing
manufacturingcosts
costsare
are
$400,000,
$400,000,or
or$4
$4per
perunit.
unit. The
Theblenders
blendersare
are
normally
normallysold
soldto
toretailers
retailersat
at$20
$20each.
each.
Question:
Question:
Sunbelt
Sunbelthas
hasan
anoffer
offerfrom
fromMexico
MexicoCo.
Co.
to
topurchase
purchasean
anadditional
additional2,000
2,000
blenders
blendersat
at$11
$11per
perunit.
unit.Acceptance
Acceptance
of
ofthis
thisoffer
offerwould
wouldnot
notaffect
affectnormal
normal
sales
salesof
ofthe
theproduct,
product,and
andthe
the
additional
additionalunits
unitscan
canbe
bemanufactured
manufactured
without
withoutincreasing
increasingplant
plantcapacity.
capacity.
Accept an Order at a
Special Price: Incremental Analysis
If management makes its decision on the basis of total cost per unit of $12
($8 + $4), the order would be rejected, because costs ($12) would exceed
revenues ($11) by $1 per unit. However, since the units can be produced
within existing plant capacity, the special order will not increase fixed
costs. The relevant data for the decision, therefore, are the variable
manufacturing costs per unit of $8 and the expected revenue of $11 per unit.
Revenues
Costs
Net income
Reject
Order
$ -0-0$ -0-
Accept
Order
$22,000
16,000
$ 6,000
Net Income
Increase (Decrease)
$ 22,000
(16,000)
$ 6,000
Illustration 9-4
Decision:
Decision:
Sunbelt
Sunbeltwill
willincrease
increaseits
itsnet
netincome
incomeby
by$6,000
$6,000when
whenaccepting
acceptingthis
this
special
specialorder.
order.
Study Objective 4
Make or Buy
When a manufacturer assembles component parts in
producing a finished product, management must
decide whether to make or buy the components.
This is often referred to as an outsourcing decision.
If there is an opportunity to use the productive
capacity for another purpose, opportunity costs
should be considered.
The decision to make or buy components should be
made on the basis of incremental analysis.
Make or Buy
Assume
Assumethat
thatBaron
BaronCo.
Co.incurs
incursthe
thefollowing
following
annual
annualcosts
costsin
inproducing
producing25,000
25,000ignition
ignition
switches
switchesfor
formotor
motorscooters.
scooters.
Direct materials
Direct labor
Variable manufacturing overhead
Fixed manufacturing overhead
Total manufacturing costs
Total cost per unit ($225,000 25,000)
$ 50,000
75,000
40,000
60,000
$225,000
$9.00
Alternatively,
Alternatively,Baron
Baronmay
maypurchase
purchasethe
the
ignition
ignitionswitches
switchesfrom
fromIgnition,
Ignition,Inc.,
Inc.,at
at
aaprice
priceof
of$8
$8per
perunit.
unit.
Question:
Question:
Should
ShouldBaron
Baronmake
makeor
orbuy
buythe
the
ignition
ignitionswitches?
switches?
Make or Buy:
Incremental Analysis
At first glance, it appears that management should buy the switches for
$8 instead of make for $9. However, a review of operations indicates that
if the switches are purchased all of Barons variable costs, but only
$10,000 of its fixed manufacturing costs, will be eliminated. Thus,
$50,000 of fixed costs will remain. The incremental costs are:
Illustration 9-6
Direct materials
Direct labor
Variable manufacturing costs
Fixed manufacturing costs
Purchase price
Total annual cost
Make
Buy
$ 50,000 $ - 0 75,000
-040,000
-060,000
50,000
-0200,000
$225,000 $250,000
Net Income
Increase (Decrease)
$ 50,000
75,000
40,000
10,000
(200,000)
$ (25,000)
Decision:
Decision:
Barton
BartonCompany
Companywill
willincur
incur$25,000
$25,000of
ofadditional
additionalcosts
costsby
bybuying
buyingthe
the
switches.
switches. Therefore,
Therefore,Barton
Bartonshould
shouldcontinue
continueto
tomake
makethe
theswitches.
switches.
Illustration 9-7
Make
Buy
$225,000 $250,000
28,000
-0$225,000 $250,000
Net Income
Increase (Decrease)
$(25,000)
28,000
$ 3,000
Decision:
Decision:
ItItis
isnow
nowadvantageous
advantageousto
tobuy
buythe
theswitches.
switches. Barton
Bartonwill
willsave
save$3,000
$3,000
worth
worthof
ofcosts
costswith
withthis
thisalternative.
alternative.
Study Objective 5
$ 15
10
6
4
$35
The
Theselling
sellingprice
priceper
perunfinished
unfinishedunit
unitis
is$50.
$50.
Woodmasters
Woodmasterscurrently
currentlyhas
hasunused
unusedproductive
productive
capacity
capacitythat
thatis
isexpected
expectedto
tocontinue
continueindefinitely
indefinitelyand
and
can
canbe
beused
usedto
tofinish
finishthe
thetables
tablesand
andsell
sellthem
themfor
for$60
$60
each.
each.For
Foraafinished
finishedtable
tabledirect
directmaterials
materialsand
anddirect
direct
labor
laborcosts
costswill
willincrease
increase$2
$2and
and$4,
$4,respectively.
respectively.
Variable
Variableoverhead
overheadwill
willincrease
increaseby
by$2.40
$2.40(60%
(60%of
ofdirect
direct
labor).
labor).There
Therewill
willbe
beno
noincrease
increasein
infixed
fixedoverhead.
overhead.
Question:
Question: Should
ShouldWoodmasters
Woodmasterssell
sellthe
the
unfinished
unfinishedtables
tablesor
orprocess
processthem
themfurther?
further?
Sell
$50.00
Process
Further
$60.00
15.00
10.00
6.00
4.00
$35.00
$15.00
17.00
14.00
8.40
4.00
$43.40
$16.60
Net Income
Increase (Decrease)
$10.00
(2.00)
(4.00)
(2.40)
-0$(8.40)
$ 1.60
Decision:
Decision:
ItItwould
wouldbe
beadvantageous
advantageousfor
forWoodmasters
Woodmastersto
toprocess
processthe
thetables
tables
further.
further. In
Inthis
thiscase,
case,the
theper
perunit
unitincremental
incrementalrevenue
revenueof
of$10.00
$10.00from
from
the
theadditional
additionalprocessing
processingis
is$1.60
$1.60higher
higherthan
thanthe
theper
perunit
unitincremental
incremental
processing
processingcosts
costsof
of$8.40.
$8.40.
Study Objective 6
Retain or Replace
Equipment
Management often has to decide whether to continue
using an asset or replace it.
In a decision to retain or replace equipment,
management compares the costs which are affected
by the two alternatives. Generally, these are variable
manufacturing costs and the cost of the new
equipment.
The book value of the old machine is a sunk cost
which is a cost that cannot be changed by any present
or future decision. Sunk costs are not relevant in
incremental analysis.
Any trade-in allowance or cash disposal value of the
existing asset is relevant, however.
Retain or Replace
Equipment
Assume
Assumethat
thatJeffcoat
JeffcoatCompany
Companyhas
hasaa
factory
factorymachine
machinewith
withaabook
bookvalue
valueof
of
$40,000
$40,000and
andaaremaining
remaininguseful
usefullife
lifeof
offour
four
years.
years. AAnew
newmachine
machineis
isavailable
availablethat
thatcosts
costs
$120,000
$120,000and
andis
isexpected
expectedto
tohave
havezero
zero
salvage
salvagevalue
valueat
atthe
theend
endof
ofits
its4-year
4-yearuseful
useful
life.
life.IfIfthe
thenew
newmachine
machineis
isacquired,
acquired,variable
variable
manufacturing
manufacturingcosts
costsare
areexpected
expectedto
to
decrease
decreasefrom
from$160,000
$160,000to
to$125,000
$125,000annually
annually
and
andthe
theold
oldunit
unitwill
willbe
bescrapped.
scrapped.
Question:
Question:
Should
ShouldJeffcoat
JeffcoatCompany
Company
retain
retainor
orreplace
replacethe
themachine?
machine?
Retain or Replace:
Incremental Analysis
The incremental analysis for the 4-year period is as follows:
Variable manufacturing costs
New machine cost
Total
(4 years x $160,000)
b
(4 years x $125,000)
Retain
$640,000a
$640,000
Replace
$500,000b
120,000
$620,000
Net Income
Increase (Decrease)
$140,000
(120,000)
$ 20,000
Illustration 9-10
Decision:
Decision:
In
Inthis
thiscase,
case,ititwould
wouldbe
beto
tothe
thecompanys
companysadvantage
advantageto
toreplace
replacethe
the
equipment.
equipment. The
Thelower
lowervariable
variablemanufacturing
manufacturingcosts
costsdue
dueto
to
replacement
replacementmore
morethan
thanoffset
offsetthe
thecost
costof
ofthe
thenew
newequipment.
equipment.
Study Objective 7
Eliminate an Unprofitable
Segment
Management sometimes needs to decide whether to eliminate
an unprofitable business segment.
Again, the key is to focus on the data that change under the
alternative courses of action.
Often fixed costs allocated to the unprofitable segment must
be absorbed by the other segments. It is possible, therefore,
for net income to decrease when an unprofitable segment is
eliminated.
In deciding whether to eliminate an unprofitable segment,
management should choose the alternative which results in
the highest net income for the company as a whole.
Eliminate an Unprofitable
Segment
Assume
Assumethat
thatMartina
MartinaCompany
Companymanufactures
manufactures
tennis
tennisracquets
racquetsin
inthree
threemodels:
models: Pro,
Pro,Master,
Master,
and
andChamp.
Champ. Pro
Proand
andMaster
Masterare
areprofitable
profitable
lines,
lines,whereas
whereasChamp
Champoperates
operatesat
ataaloss.
loss.
Condensed
Condensedincome
incomestatement
statementdata
dataare:
are:
Sales
Variable expenses
Contribution margin
Fixed expenses
Net income
Pro
$800,000
520,000
280,000
80,000
$200,000
Master
$300,000
210,000
90,000
50,000
$ 40,000
Champ
$100,000
90,000
10,000
30,000
$(20,000)
Total
$1,200,000
820,000
380,000
160,000
$ 220,000
Question:
Question:
Should
Shouldthe
theChamp
Champsegment
segmentbe
beeliminated?
eliminated?
Eliminate an Unprofitable
Segment
Although
Althoughititappears
appearsthat
thatincome
incomewould
wouldincrease
increaseififthe
the
Champ
Champline
linewas
wasdiscontinued,
discontinued,ititis
ispossible
possiblefor
forincome
income
to
todecrease
decreaseififChamp
Champwas
wasdiscontinued.
discontinued. The
Thereason
reasonis
is
that
thatthe
thefixed
fixedexpense
expenseallocated
allocatedto
toChamp
Champwill
willhave
haveto
tobe
be
absorbed
absorbedby
bythe
theother
otherproducts.
products.To
Toillustrate,
illustrate,assume
assume
that
thatthe
the$30,000
$30,000of
offixed
fixedcosts
costsare
areallocated
allocated2/3
2/3to
toPro
Pro
and
and1/3
1/3to
toMaster.
Master.The
Therevised
revisedincome
incomestatement
statementdata
datais:
is:
Sales
Variable expenses
Contribution margin
Fixed expenses
Net income
Pro
$800,000
520,000
280,000
100,000
$200,000
Master
Total
$300,000 $1,100,000
210,000
730,000
90,000
370,000
60,000
160,000
$ 40,000 $ 210,000
Decision:
Decision: Total
Totalnet
netincome
incomehas
hasdecreased
decreased$10,000
$10,000($220,000
($220,000$210,000).
$210,000).
Unprofitable Segment:
Incremental Analysis
This result is also obtained in the following incremental
analysis:
Illustration 9-13
Sales
Variable expenses
Contribution margin
Fixed expenses
Net income
Continue
$100,000
90,000
10,000
30,000
$(20,000)
Eliminate
$ -0-0-030,000
$ 30,000)
Net Income
Increase (Decrease
$(100,000)
90,000
(10,000)
-0$ (10,000)
Decision:
Decision:
Once
Onceagain,
again,total
totalnet
netincome
incomehas
hasdecreased
decreased$10,000
$10,000($220,000
($220,000
$210,000).
$210,000).This
Thiscorresponds
correspondsto
tothe
theChamp
Champsegments
segmentscontribution
contribution
margin.
margin. Thus,
Thus,management
managementshould
shouldnot
notdiscontinue
discontinuethe
theChamp
Champ
segment
segmentunless
unlessother
otherlines
linescan
canrecover
recoversome
someor
orall
allof
ofthe
the
sales/contribution
sales/contributionmargin
marginlost
lostby
bythe
thediscontinued
discontinuedsegment.
segment.
Study Objective 8
Sales Mix
One of the assumptions of CVP analysis
(discussed in Chapter 5) is that if more than one
product is involved, the sales mix of the
products remains constant.
Sales mix is the relative combination in which a
companys products are sold.
For example, if 4 chairs are sold with each table,
the sales mix of chairs to tables is 4:1.
Break-Even Sales
Break-even sales can be computed for a mix of two or
more products by determining the weighted average
unit contribution margin of all the products.
VCRs
$500
300
$200
TVs
$800
400
$400
Illustration 9-14
Break-Even Sales
The total contribution margin for the sales mix of
3 VCRs to 1 TV is $1,000, computed as follows:
[($200 x 3) + ($400 x 1)] = $1,000
The weighted average unit contribution margin, which is total CM divided by the number of units in the sales mix is $250, computed as follows:
$1,000/4 units = $250
Break-Even Formula:
Sales Mix
Then use the weighted average unit contribution margin to compute
break-even sales as follows:
Assume Vargo Video has $200,000 of fixed costs.
Fixed Costs
$200,000
Weighted
Average Unit
Contribution
Margin
Break-even Point
in Units
$250
800 units
Break-Even Sales
Note that with a sales mix of 3:1, of the units sold will be
VCRs and will be TVs. Therefore, in order to break even,
Vargo Video must sell 600 VCRs ( x 800) and 200 TVs (
x 800). This can be verified by the following:
Product
VCRs
TVs
Unit Sales
600
200
800
x
x
x
Unit CM
$200
400
=
=
=
Total CM
$120,000
80,000
$200,000
Illustration 9-16
Study Objective 9
Limited Resources
When a company has limited resources (floor space, raw
materials, or machine hours), management must decide which
products to make and sell in order to maximize net income.
In an allocation of limited resources decision, it is necessary to
find the contribution margin per unit of limited resource.
This is obtained by dividing the contribution margin per unit of
each product by the number of units of the limited resource
required for each product.
Production should be geared to the product with the highest
contribution margin per unit of limited resource.
Limited Resources
Assume
Assumethat
thatCollins
CollinsCo.
Co.manufactures
manufacturesdeluxe
deluxe
and
andstandard
standardpen
penand
andpencil
pencilsets.
sets. The
Thelimited
limited
resource
resourceis
ismachine
machinecapacity,
capacity,which
whichis
is3,600
3,600
hours
hoursper
permonth.
month. Relevant
Relevantdata
dataconsists
consistsof:
of:
Contribution margin per unit
Machine hours required per unit
Deluxe
$8
.4
Standard
$6
.2
Question:
Question:
Should
ShouldCollins
CollinsCo.
Co.shift
shiftits
itssales
salesmix
mix
toward
towarddeluxe
deluxeor
orstandard
standardsets?
sets?
Limited Resources
Based
Basedon
onthe
theprevious
previousdata,
data,ititmight
mightappear
appearthat
thatdeluxe
deluxe
is
ismore
moreprofitable
profitablesince
sincethey
theyhave
haveaahigher
highercontribution
contribution
margin.
margin. However,
However,standard
standardsets
setstake
takefewer
fewermachine
machine
hours.
hours. Therefore,
Therefore,ititis
isnecessary
necessaryto
tofind
findthe
thecontribution
contribution
margin
marginper
perunit
unitof
oflimited
limitedresource,
resource,as
asshown
shownbelow:
below:
Contribution margin per unit (a)
Machine hours required per unit (b)
Contribution margin per unit of
limited resource (a b)
Deluxe
$8
.4
Standard
$6
.2
$20
$30
Decision:
Decision: Since
Sincethe
thestandard
standardset
sethas
has
the
thehigher
highercontribution
contributionmargin
marginper
per
unit
unitof
oflimited
limitedresource,
resource,sales
salesmix
mix
should
shouldshift
shifttowards
towardsthat
thatproduct.
product.
Limited Resources:
Incremental Analysis
This result is confirmed by the following incremental analysis:
Illustration 9-19
If Produce
Deluxe Sets
600
$20
$12,000
If Produce
Standard Sets
600
$30
$18,000
Decision:
Decision:
Once
Onceagain,
again,ititis
isclear
clearthat
thatstandard
standardsets
setsproduce
producemore
morecontribution
contribution
margin.
margin. Thus,
Thus,given
givenadequate
adequatedemand
demandfor
forstandard
standardsets,
sets,the
thesales
sales
mix
mixshould
shouldshift
shiftto
tothat
thatproduct
productin
inorder
orderto
tomaximize
maximizeCollins
Collins
Companys
Companysincome.
income.
Other Considerations in
Decision Making
In this chapter, the focus was primarily
on the quantitative (those attributes that
can be easily expressed in terms of
numbers) factors that affect a decision.
Many of the decisions involving
incremental analysis have important
qualitative features that, while not easily
measured, should not be ignored.
Other Considerations in
Decision Making
It was noted in Chapter 4 that many
companies have shifted to activitybased costing (ABC) to allocate
overhead costs to products.
The concepts presented in this chapter
are completely consistent with the use of
ABC. In fact, ABC will result in better
identification of relevant costs, and
therefore, better incremental analysis.
Copyright
Copyright 1999 John Wiley & Sons, Inc. All rights
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contained herein.
Chapter 9
Incremental Analysis