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Incremental

Analysis
Ismu Kusumanto

Pengertian
Incremental analysis is used to find the impact
of changes in costs or revenues, given a
specific potential scenario. Decisions involving
incremental analysis include the following:
Sell

or process further: Sell or process further issues


often arise in industries which refine raw materials. The key
question is whether the incremental revenues from a more
highly refined product will at least offset the increased costs
associated with additional processing

Pengertian

Make or buy: Should we make a component ourselves


or farm out the work to someone else? Qualitative
considerations may or may not override quantitative
issues. For example, we may be able to subcontract
work more economically than we can do it ourselves, but
if the contractor is unable to maintain the necessary level
of quality or meet delivery schedules, subcontracting
may not be worthwhile. The impact of quality and/or
delivery problems may not be quantifiable, thus making
the whole business a judgment call.

Pengertian

Changes in production and/or technology:


Modifications in production processes or
acquisition of new machinery typically entail
adjustments in costs. New machinery or a
revised process may enhance efficiency in the
use of labor and/or material. It is clearly
important to know whether the improvements
offset whatever incremental costs may be
associated with the changes.

Types of Incremental Analysis


A number of different types of decisions involve
incremental analysis. The more common types of
decisions are whether to:
1) Accept an order at a special price.
2) Make or buy.
3) Sell or process further.
4) Retain or replace equipment.
5) Eliminate an unprofitable business segment.
6) Allocate limited resources.

MANAGEMENTS
DECISION MAKING PROCESS

Considers both financial and


nonfinancial information

Financial information
Revenues and costs
Overall profitability

Nonfinancial information
Effect of decision on
employee turnover
Environment
Overall image of company

Comparing Mutually Exclusive


Alternatives Based on IRR
Issue: Can we rank the mutually exclusive
projects by the magnitude of its IRR?
n

A1

A2

-$1,000

-$5,000

$2,000

$7,000

IRR

100%

>

40%

$818

<

$1,364

PW (10%)

Who Got More Pay Raise?

Bill

Hillary

10%
Contemporary
Engineering Economics,

5%

Cant Compare without


Knowing Their Base Salaries
Bill

Hillary

Base Salary

$50,000

$200,000

Pay Raise (%)

10%

5%

Pay Raise ($)

$5,000

$10,000

For the same reason, we cant compare mutually exclusive projects based on
the magnitude of its IRR. We need to know the size of investment and its timing
of when to occur.

Incremental Investment
n
0
1
ROR
PW(10%)

Project A1
-$1,000
$2,000
100%
$818

Project A2
-$5,000
$7,000
40%
$1,364

Incremental
Investment
(A2 A1)
-$4,000
$5,000
25%
$546

Assuming a MARR of 10%, you can always earn that rate from other
investment source, i.e., $4,400 at the end of one year for $4,000
investment.
By investing the additional $4,000 in A2, you would make additional
$5,000, which is equivalent to earning at the rate of 25%. Therefore,
the incremental investment in A2 is justified.

Incremental Analysis
(Procedure)
Step 1:
Compute the cash flow for the difference

Step 2:
Step 3:

between the projects (A,B) by subtracting


the cash flow of the lower investment
cost project (A) from that of the higher
investment cost project (B).
Compute the IRR on this incremental
investment (IRRB-A ).
Accept the investment B if and only if
IRR B-A > MARR

NOTE: Make sure that both IRRA and IRRB are greater than MARR.

Example 7.10 - Incremental Rate of


Return
n
0
1
2
3
IRR

B1

B2

-$3,000 -$12,000
1,350
4,200
1,800
6,225
1,500
6,330
25%

17.43%

B2 - B1
-$9,000
2,850
4,425
4,830
15%

Given MARR = 10%, which project is a better choice?


Since IRRB2-B1=15% > 10%, and also IRRB2 > 10%, select B2.

IRR on Increment Investment:


Three Alternatives
n
0

D1

D2

D3

-$2,000 -$1,000 -$3,000

1,500

800

1,500

1,000

500

2,000

800

500

1,000

IRR

34.37% 40.76% 24.81%

Step 1: Examine the IRR for each


project to eliminate any project
that fails to meet the MARR.
Step 2: Compare D1 and D2 in pairs.
IRRD1-D2=27.61% > 15%,
so select D1. D1 becomes the
current best.
Step 3: Compare D1 and D3.
IRRD3-D1= 8.8% < 15%,
so select D1 again.
Here, we conclude that D1 is the best
alternative.

For example, assume the ABC Company is


planning to expand its productive capacity. The plan
consists of purchasing a new machine for $50,000
and disposing of the old machine without receiving
anything for it. The new machine has a five-year
life. The old machine has a five-year remaining life
and a book value of $12,500. The new machine will
reduce variable operating costs from $35,000 per
year to $20,000 per year. Annual sales and other
operating costs are shown below:

At first glance, it appears that the new machine


provides an increase in net income of $7500 per
year. The book value of the present machine,
however, is a sunk cost and is irrelevant in this
decision. Furthermore, sales and fixed costs such
as insurance and taxes are also irrelevant since
they do not differ between the two alternatives
being considered. Eliminating all the irrelevant
costs leaves us with only the incremental costs, as
follows:

Savings in variable costs $15,000


Less: Increase in fixed costs 7,500
Net annual cash savings arising from the new
machine $ 7,500

Practice Problem
You are considering
four types of
engineering designs.
The project lasts 10
years with the following
estimated cash flows.
The interest rate
(MARR) is 15%. Which
of the four is more
attractive?

Project
A

Initial cost

$150

$220

$300

$340

Revenues/
Year

$115

$125

$160

$185

Expenses/
Year

$70

$65

$60

$80

27.32

24.13

31.11

28.33

IRR (%)

Example 7.13 Incremental Analysis for


Cost-Only Projects
Items

CMS Option

FMS Option

Annual O&M costs:


Annual labor cost

$1,169,600

$707,200

832,320

598,400

3,150,000

1,950,000

470,000

300,000

141,000

31,500

1,650,000

1,917,000

Total annual costs

$7,412,920

$5,504,100

Investment

$4,500,000

$12,500,000

$500,000

$1,000,000

Annual material cost


Annual overhead
cost
Annual tooling cost
Annual inventory
cost
Annual income taxes

Net salvage value

Incremental Cash Flow (FMS


CMS)
n

CMS Option

FMS Option

Incremental
(FMS-CMS)

-$4,500,000

-$12,500,000

-$8,000,000

-7,412,920

-5,504,100

1,908,820

-7,412,920

-5,504,100

1,908,820

-7,412,920

-5,504,100

1,908,820

-7,412,920

-5,504,100

1,908,820

-7,412,920

-5,504,100

1,908,820

-7,412,920

-5,504,100

Salvage

+ $500,000

+ $1,000,000

$2,408,820

Solution:
PW (i) FMS CMS $8,000,000
$1,908,820( P / A, i,5)
$2,408,820( P / F, i,6)
0
IRRFMS CMS 12.43% 15%,
select CMS.

Example 7.14 IRR Analysis


for Projects with Different
Lives
MARR = 15%
The incremental cash flows
(Model B Model A) result
in a nonsimple and mixed
investment.
RICBA = 50.68% > 15%
Select Model B

Summary

Rate of return (ROR) is the interest rate earned on


unrecovered project balances such that an investments cash
receipts make the terminal project balance equal to zero.
Rate of return is an intuitively familiar and understandable
measure of project profitability that many managers prefer to
NPW or other equivalence measures.
Mathematically we can determine the rate of return for a
given project cash flow series by locating an interest rate that
equates the net present worth of its cash flows to zero. This
break-even interest rate is denoted by the symbol i*.

Internal rate of return (IRR) is another term for ROR that


stresses the fact that we are concerned with the interest
earned on the portion of the project that is internally invested,
not those portions that are released by (borrowed from) the
project.
To apply rate of return analysis correctly, we need to classify
an investment into either a simple or a nonsimple investment.
A simple investment is defined as one in which the initial
cash flows are negative and only one sign change occurs in
the net cash flow, whereas a nonsimple investment is one for
which more than one sign change occurs in the net cash flow
series.
Multiple i*s occur only in nonsimple investments. However,
not all nonsimple investments will have multiple i*s either.

For a pure investment, the solving rate of return (i*) is the


rate of return internal to the project; so the decision rule is:
If IRR > MARR, accept the project.
If IRR = MARR, remain indifferent.
If IRR < MARR, reject the project.
IRR analysis yields results consistent with NPW and other
equivalence methods.
For a mixed investment, we need to calculate the true IRR,
or known as the return on invested capital. However, if your
objective is simply to make an accept or reject decision, it is
recommended that either the NPW or AE analysis be used to
make an accept/reject decision.
To compare mutually exclusive alternatives by the IRR
analysis, the incremental analysis must be adopted.

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