John Wiley & Sons, Inc. © 2005 Prepared by Dan R. Ward Suzanne P. Ward University of Louisiana at Lafayette Managerial Accounting Weygandt Kieso Kimmel

John Wiley & Sons, Inc. © 2005

Prepared byPrepared byDan R. WardDan R. Ward

Suzanne P. WardSuzanne P. WardUniversity of Louisiana at LafayetteUniversity of Louisiana at Lafayette

Managerial AccountingManagerial Accounting

Weygandt Weygandt •• Kieso • Kimmel Kieso • Kimmel

CHAPTER 6 INCREMENTAL ANALYSIS

CHAPTER 6

INCREMENTAL ANALYSIS

Study ObjectivesIdentify the steps in management’s decision-

making 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 decision.

Identify the relevant costs in determining whether to sell or process further.

Study Objectives: Continued

Identify the relevant costs to be considered in retaining or replacing equipment.

Identify the relevant costs in deciding whether to eliminate an unprofitable segment.

Determine sales mix when a company has limited resources.

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 information

Financial information

• Revenues and costs

• Overall profitability

Nonfinancial information

• Effect of decision on employee turnover

• Environment

• Overall image of company

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 data that change under alternative actions

Identifies probable effects of decisions on future earnings

MANAGEMENT’S DECISION MAKING How Incremental Analysis Works

Example

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

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

MANAGEMENT’S DECISION MAKING How Incremental Analysis Works

Uses three important cost concepts

Let’s ReviewLet’s Review

Incremental analysis is the process of identifying the financial data that:

a. Do not change under alternative courses of action

b. Change under alternative courses of action

c. Are mixed under alternative courses of action

d. None of the above


Incremental analysis is the process of identifying the financial data that:

a. Do not change under alternative courses of action

b. Change under alternative courses of action

c. Are mixed under alternative courses of action

d. None of the above

MANAGEMENT’S DECISION MAKING Types of Incremental Analysis

Accept an order at a special price

Make or buy component parts or finished products

Sell products or process further

Retain or replace equipment

Eliminate an unprofitable business segment

INCREMENTAL ANALYSISAccept an Order at a Special Price

Study Objective 3

Obtain additional business by making price concessions

Assumes sales of the products in other markets would not be affected by special order

Assumes company is not operating at full capacity


Example Customer offers to buy a special order of 2,000

blenders 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), reject offer as cost exceeds selling price of $11


Example (Continued)

No change in fixed costs since within existing capacity – thus fixed costs are not relevantOnly total variable costs change – thus they are relevant

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

Thus, net income increases $6,000

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

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

INCREMENTAL ANALYSISMake or Buy

Study Objective 4

Outsourcing: The decision to buy parts or services rather 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;

however, $50,000 of fixed costs remain

INCREMENTAL ANALYSISMake or Buy

Example (Continued)

Based on analysis of costs under both alternatives: Purchasing adds $25,000 to cost of switches

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)

Decision: Continue to make switches.


Opportunity Costs

The potential benefit that may be obtained from following an alternative course of action


Opportunity CostsExample – Baron Company Continued

Assume that buying the switches allows Baron to use the released capacity to generate $28,000 additional income.

Thus, the $28,000 lost income is an additional cost of making the 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.


Sell or Process FurtherStudy Objective 5

Manufacturers may have to decide, at a given point in production, whether to sell now or to process further and sell at a higher price later.

Decision Rule: Process further as long as the incremental revenue from such processing exceeds the incremental processing costs


Sell or Process FurtherSingle-Product Case

Cost to manufacture one unfinished table:Direct materials $15Direct labor 10Variable manufacturing overhead 6Fixed manufacturing overhead 4Manufacturing cost per unit $35

Selling price of unfinished unit is $50 Unused capacity used to finish the tables to sell for

$60 per table. Relevant unit costs of finishing tables:

Direct materials increase $2 Direct labor increase $4 Variable manufacturing overhead costs increase by

$2.40 (60 percent of direct labor increase) Fixed manufacturing costs will not increase


Sell or Process FurtherSingle-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 costs ($8.40); income increases $1.60 per unit


Sell or Process FurtherMultiple-Product Case

Especially appropriate when multiple products are produced simultaneously

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.


Sell or Process FurtherMultiple-Product Case

Example - Marais Creamery decision:

Sell cream and skim milk

or

Process them further before selling


Multiple-Product Case – Example (Continued)

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)

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

Decision: Do not process the cream further.Incremental revenue ($8,000) is less than incremental costs ($10,000);

income decreases $2,000.


Multiple-Product Case – Example (Continued)

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

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

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:

Variable costs: Decrease from $160,000

to $125,000 annually

Old Machine New Machine

Book value $40,000

Cost $120,000

Remaining useful life four years four years

Scrap value - 0 - - 0 -

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.

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 segment is eliminated

Decision Rule:

Retain the segment unless fixed costs eliminated exceed the contribution margin lost


Study Objective 7

Example – Martina Company Manufactures three models of tennis racquets:

Profitable lines: Pro and Master Unprofitable line: Champ

Condensed Income Statement data:

Should Champ be eliminated?

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


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:

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

Pro Master Total Sales $800,000 $300,000$1,100,000Variable expenses 520,000 210,000 730,000Contribution margin 280,000 90,000 370,000Fixed expenses 100,000 60,000 160,000Net income $180,000 $ 30,000 $ 210,000

ELIMINATE CHAMP?


Example (Continued)

Incremental analysis of Champ provides the same results

Decrease in net income is due to Champ’s contribution margin ($10,000) that will not be realized if the segment is discontinued

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)

Decision: Do not eliminate Champ. 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

machine capacity for a manufacturing firm

Management must decide which products to make and sell to maximize net income


Study Objective 8

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

Deluxe set has higher contribution margin: $8 Standard set takes fewer machine hours per unit

Deluxe set Standard setContribution margin per unit $8 $6Machine hours required 0.4 per unit 0.2 per unit


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

increase machine capacity


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 identify and manage constraints so as to achieve company goals

Requires identification of constraints

Continual attempts to reduce or eliminate constraints

MANAGEMENT’S DECISION MAKING Other Considerations

Qualitative factors Potential effects of decision on

employees and community Low morale Employee turnover

Incremental Analysis and Activity-Based Costing Completely consistent with each

other ABC better identifies relevant

costs resulting in better incremental analysis


In a decision to retain or replace equipment, the book value of the old equipment is a (an):

a. Opportunity costs

b. Incremental cost

c. Sunk cost

d. Marginal cost


In a decision to retain or replace equipment, the book value of the old equipment is a (an):

a. Opportunity costs

b. Incremental cost

c. Sunk cost

d. 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 underalternative courses of action


Identify the relevant costs in accepting an order at a special 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


Identify the relevant costs in determining whether to sell or process materials further.

Process further as long as incremental revenue exceeds incremental costs

Identify the relevant costs to be considered in retaining or replacing equipment.

Effect on variable costs Cost of new equipment Any disposal value of old equipment


Identify the relevant costs in deciding whether to eliminate an unprofitable segment.

Retain segment unless fixed costs eliminated exceed the

contribution margin lost

Determine sales mix when a company has limited resources.

Find contribution margin per unit of limited resource

Multiply this amount by the units of limited resourceto determine which product maximizes net income

COPYRIGHT

Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written consent of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.

Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written consent of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.

Documents

John Wiley & Sons, Inc. © 2005 Prepared by Dan R. Ward Suzanne P. Ward University of Louisiana at Lafayette Managerial Accounting Weygandt Kieso Kimmel