chapter 7-1 chapter 7 incremental analysis incremental analysis managerial accounting, fifth edition

Chapter 7-1

CHAPTER CHAPTER 77

INCREMENTAL INCREMENTAL ANALYSISANALYSIS

Managerial Accounting, Fifth Edition

Chapter 7-2

Management’s Decision-Making Management’s Decision-Making ProcessProcess

Management’s Decision-Making Management’s Decision-Making ProcessProcess

Decision-making is an important management function that does not always follow a set pattern.Steps in management’s decision-making process:Steps in management’s decision-making process:

Accounting helps management in making decisions by evaluating possible courses of action (step 2) and reviewing results (step 4).

SO 1: Identify the steps in management’s decision-making process.SO 1: Identify the steps in management’s decision-making process.

Illustration 7-1

Chapter 7-3

Management’s Decision-making ProcessManagement’s Decision-making ProcessManagement’s Decision-making ProcessManagement’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.

SO 1: Identify the steps in management’s decision-making process.SO 1: Identify the steps in management’s decision-making process.

Chapter 7-4

Incremental Analysis ApproachIncremental Analysis ApproachIncremental Analysis ApproachIncremental 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,orOnly revenues may vary,

orOnly costs may vary.

SO 2: Describe the concept of incremental analysis.SO 2: Describe the concept of incremental analysis.

Chapter 7-5

Incremental Analysis Incremental Analysis 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 7-6

GATHERING DATA MAY INVOLVE:

MARKET ANALYSTSENGINEERSACCOUNTANTS

NEED TO PRODUCE THE MOST RELIABLE INFORMATION AVAILABLE AT THE TIME THE DECISION MUST BE MADE.

Incremental Analysis Incremental Analysis Incremental Analysis Incremental Analysis

Chapter 7-7

How Incremental Analysis WorksHow Incremental Analysis WorksHow Incremental Analysis WorksHow Incremental Analysis Works


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...

BE 7-2 Marlowe Company is considering two alternatives.

Revenues Costs Net IncomeAlternative A $150,000 $100,000. $50,000Alternative B $185,000 $125,000. $60,000

$35,000 ($25,000) $10,000Compare Alternative A to Alternative B showing incremental revenues, cost and net income.

Chapter 7-8

How Incremental Analysis WorksHow Incremental Analysis WorksHow Incremental Analysis WorksHow Incremental Analysis Works

Uses Three Important Cost Concepts:

Relevant Cost:Opportunity Cost:

Sunk Cost:


Illustration 7-3

Chapter 7-9

Types of Incremental AnalysisTypes of Incremental AnalysisTypes of Incremental AnalysisTypes of Incremental Analysis

Accept an order at a special price.Accept an order at a special price.

Make or buy components or Make or buy components or finished products.finished products.

Sell products or process further.Sell products or process further.

Retain or replace equipment.Retain or replace equipment.

Eliminate an unprofitable Eliminate an unprofitable business segment.business segment.

Allocate limited resources.Allocate limited resources.


Chapter 7-10

Obtain additional business Obtain additional business by making price concessions by making price concessions to a specific customer.to a specific customer.

Assumes sales of the Assumes sales of the product in other markets product in other markets would not be affected by this would not be affected by this special order.special order.

Assumes company is Assumes company is notnot operating at full capacity.operating at full capacity.

SO 3: Identify the relevant costs in accepting an order at a special price.SO 3: Identify the relevant costs in accepting an order at a special price.

Accept an Order at a Special PriceAccept an Order at a Special PriceAccept an Order at a Special PriceAccept an Order at a Special Price

Chapter 7-11

Accept an Order at a Special Price E7-3Accept an Order at a Special Price E7-3Shandling Company manufactures toasters. For the first 8 Shandling Company manufactures toasters. For the first 8 months of 2011, the company reported the following months of 2011, the company reported the following operating results while operating a 75% of plant capacityoperating results while operating a 75% of plant capacity

Sales (350,000 units) $4,375,000

Cost of goods sold 2,500,000

Gross Profit 1,875,000

Operating Expenses 875,000

Net Income 1,000,000

Cost of goods sold was 70% variable and 30% fixed; operating expenses were also 70% variable and 30% fixed

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.

a) Prepare an incremental analysis for the special order

b) Should Shandling Company accept the special order? Why or why not?

Chapter 7-12

Accept an Order at a Special Price E Accept an Order at a Special Price E 7-37-3

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**

a)a) Reject OrderReject Order Accept OrderAccept Order Net IncomeNet Income

Revenues Revenues

(15,000 X $7.50)(15,000 X $7.50) $0 $0 $112,500 $112,500 $112,500 $112,500

Cost of goods soldCost of goods sold 0 0 75,000* (75,000) 75,000* (75,000)

Operating Expenses Operating Expenses 00 29,250** 29,250** (29,250 (29,250))

Net IncomeNet Income 0 0 $ 8,250 $ 8,250 $ 8,250 $ 8,250

b) Shandling should accept

the special order.

Chapter 7-13

It costs a company $14 of variable costs and $6 of It costs a company $14 of variable costs and $6 of fixed costs to produce product Z200 that sells for fixed costs to produce product Z200 that sells for $30. A foreign buyer offers to purchase 3,000 units $30. A foreign buyer offers to purchase 3,000 units at $18 each. If the special offer is accepted and at $18 each. If the special offer is accepted and produced with unused capacity, net income will:produced with unused capacity, net income will:

a.a. decrease $6,000decrease $6,000.

b. increase $6,000.

c. increase $12,000.

d. increase $9,000.

Let’s ReviewLet’s ReviewLet’s ReviewLet’s Review

SO 3: Identify the relevant costs in accepting an order at a special SO 3: Identify the relevant costs in accepting an order at a special price.price.

$18 - $14= $4$4 × 3,000 units = $12,000

Chapter 7-14

Make or BuyMake or BuyMake or BuyMake or Buy

Management must decide whether to make or buy components.

SO 4: Identify the relevant costs in a make-or-buy decision.SO 4: Identify the relevant costs in a make-or-buy decision.

Chapter 7-15

Make or Buy – Continued BE 7-4Make or Buy – Continued BE 7-4Make or Buy – Continued BE 7-4Make or Buy – Continued BE 7-4

Lafleur Manufacturing incurs unit costs of $7.50 ($4.50 variable cost and 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 $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 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. 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 Prepare an analysis showing the total cost saving, if any, Lafleur will realize by buying parts.realize by buying parts.

Make BuyNet Income

Increase(Decrease)

Variable manufacturing costs

Fixed manufacturing costs

Purchase price

Total annual cost

$45,000

30,000

–0–

$75,000

$ –0–

30,000

50,000

$80,000

$ 45,000

0

(50,000)

($ (5,000)

The decision should be to make the part.

Chapter 7-16

Make or BuyMake or BuyMake or BuyMake or Buy

Opportunity CostsOpportunity 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 7-17

Make or Buy – Opportunity Cost Make or Buy – Opportunity Cost ExampleExample

Make or Buy – Opportunity Cost Make or Buy – Opportunity Cost ExampleExample


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 Buy Net Income Increase (Decrease)

Total Annual Cost 75,000 80,000(5,000)

Opportunity Cost 20,000 020,000

Total Cost 95,000 80,00015,000

Chapter 7-18

Sell or Process FurtherSell or Process FurtherSell or Process FurtherSell 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 fromsuch processing exceeds theincremental processing costs.

SO 5: Identify the relevant costs in determining whetherSO 5: Identify the relevant costs in determining whetherto sell or process materials further.to sell or process materials further.

Chapter 7-19

Sell or Process further? BE 7-5 Sell or Process further? BE 7-5 EXAMPLEEXAMPLE

Bolus Inc, makes unfinished bookcases that it Bolus Inc, makes unfinished bookcases that it sells for $60. Production costs are $35 sells for $60. Production costs are $35 variable and $10 fixed. Because it has variable and $10 fixed. Because it has unused capacity, Bolus is considering unused capacity, Bolus is considering finishing the book cases and selling them for finishing the book cases and selling them for $70. Variable finishing costs are expected to $70. Variable finishing costs are expected to be $8 per unit with no increase in fixed costs. be $8 per unit with no increase in fixed costs.

Instructions:Instructions:

Prepare an analysis on a per unit basis Prepare an analysis on a per unit basis showing whether Bolus should sell unfinished showing whether Bolus should sell unfinished or finished bookcasesor finished bookcases. .

Chapter 7-20

Sell or Process further? BE 7-5 Sell or Process further? BE 7-5 EXAMPLEEXAMPLE

Sell ProcessFurther

Net IncomeIncrease

(Decrease)Sales price per unitCost per unit

VariableFixed

TotalNet income per unit

$60.00

35.00 10.00 45.00

$15.00

$70.00

43.00 10.00 53.00

$17.00

$10.00(

(8.00) 0

( (8.00)

$ 2.00

The bookcases should be processed further because the incremental revenues exceed incremental costs by $2.00 per unit.

Chapter 7-21

Sell or Process Further - ExampleSell or Process Further - ExampleSell or Process Further - ExampleSell or Process Further - Example

Single-Product Case

Cost to manufacture one unfinished table:

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.SO 5: Identify the relevant costs in determining whetherSO 5: Identify the relevant costs in determining whether

to sell or process materials further.to sell or process materials further.

Illustration 7-8

Chapter 7-22


Incremental revenues ($10) exceed incremental costs ($8.40); Income increases $1.60 per unit.

Process further.Process further.

SO 5: Identify the relevant costs in determining whetherSO 5: Identify the relevant costs in determining whetherto sell or process materials further .to sell or process materials further .

Illustration 7-9

Chapter 7-23


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 7-24



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 7-25

Sell or Process Further - ExampleSell or Process Further - ExampleSell or Process Further - ExampleSell or Process Further - Example


Marais Creamery must decide whether to:

Sell cream and skim milk now,or

Process each further before selling.


Illustration 7-10

Chapter 7-26

Sell or Process Further – Example Sell or Process Further – Example ContinuedContinued


The daily cost and revenue data for Marais Creamery are:


Illustration 7-11

Chapter 7-27



Sell cream or process further into cottage cheese?

Do not process cream further:To do so will incur an incremental loss of $2,000.


Illustration 7-12

Chapter 7-28


Sell skim milk or process further into condensed milk?

Marais should process the skim milk:To do so will increase net income by $7,000.


Illustration 7-13

Chapter 7-29

Retain or Replace Equipment BE 7-7Retain or Replace Equipment BE 7-7Retain or Replace Equipment BE 7-7Retain 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.

SO 6: Identify the relevant costs to be considered inSO 6: Identify the relevant costs to be considered inretaining or replacing equipment.retaining or replacing equipment.

Chapter 7-30

Retain or Replace Equipment – BE7-7Retain or Replace Equipment – BE7-7Retain or Replace Equipment – BE7-7Retain or Replace Equipment – BE7-7

RetainRetain ReplaceReplace Net 4-yearNet 4-year

EquipmentEquipment EquipmentEquipment Incr/Incr/(Decr)(Decr)

Variable ManufacturingVariable Manufacturing

cost for 4 yearscost for 4 years $2,400,000$2,400,000 $2,000,000$2,000,000 $400,000$400,000

Ne w Machine Cost 00,000,00000,000,000 250,000 250,000 (250,000(250,000))

Total $2,400,000$2,400,000 $$2,250,0002,250,000 $ 150,000$ 150,000

The old factory machine should be replaced.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.

SO 6: Identify the relevant costs to be considered inSO 6: Identify the relevant costs to be considered inretaining or replacing equipment.retaining or replacing equipment.

Chapter 7-31

Eliminate an Unprofitable SegmentEliminate an Unprofitable SegmentEliminate an Unprofitable SegmentEliminate 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.SO 7: Identify the relevant costs in deciding whetherSO 7: Identify the relevant costs in deciding whether

to eliminate an unprofitable segment.to eliminate an unprofitable segment.

Chapter 7-32

Other Considerations in Decision MakingOther Considerations in Decision MakingOther Considerations in Decision MakingOther 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 7-33

Chapter Review - Exercise 7-1 Chapter Review - Exercise 7-1 Chapter Review - Exercise 7-1 Chapter Review - Exercise 7-1

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 decision-making 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.

Identify each of the following statements as true or false.

Chapter 7-34

Chapter Review - Exercise 7-1 Chapter Review - Exercise 7-1 ContinuedContinued

Chapter Review - Exercise 7-1 Chapter Review - Exercise 7-1 ContinuedContinued

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.

Identify each of the following statements as true or false.

Chapter 7-35

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Chapter 7-36

ANY QUESTIONSANY QUESTIONS

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