1. CHAPTER 6 INCREMENTAL ANALYSIS Study Objectives
Identify 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.

2. 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.

3. 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:

4. 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

5. 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

6. 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 , , ,000
Net income $ 25, $ 30, $ 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

7. MANAGEMENT’S DECISION MAKING How Incremental Analysis Works
Uses three important cost concepts

8. 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

9. INCREMENTAL ANALYSIS Accept 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

10. INCREMENTAL ANALYSIS Accept an Order at a Special Price
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

11. Decision: Accept the offer – Income will increase by $6,000.
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
Revenue increases $22,000; variable costs increase $16,000;
Thus, net income increases $6,000
Net Income
Reject Order Accept Order Increase (Decrease)
Revenues $ $22, $22,000
Costs , (16,000)
Net income $ $ 6, $ 6,000
Decision: Accept the offer – Income will increase by $6,000.

12. INCREMENTAL ANALYSIS Make 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

13. INCREMENTAL ANALYSIS Make or Buy Example (Continued)
Net Income Make Buy Increase (Decrease)
Direct materials $ 50, $ $ 50,000
Direct labor 75, ,000
Variable manufacturing costs 40, ,000
Fixed manufacturing costs 60, , ,000
Purchase price , (200,000)
Total annual cost $225, $250, $ (25,000)
Based on analysis of costs under both alternatives:
Purchasing adds $25,000 to cost of switches
Decision: Continue to make switches.

14. INCREMENTAL ANALYSIS Opportunity Costs
The potential benefit that may be obtained from following an alternative course of action

15. Decision: Based on the analysis, Baron should buy the switches
INCREMENTAL ANALYSIS Opportunity Costs Example – 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, $250, $(25,000)
Opportunity cost , ,000
Total cost $253, $250, $ 3,000
Decision: Based on the analysis,
Baron should buy the switches
as the company will be $3,000 better off.

16. 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 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

17. INCREMENTAL ANALYSIS Sell or Process Further Single-Product Case
Cost to manufacture one unfinished table:
Direct materials $15
Direct labor
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 $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

18. Decision: Process further.
INCREMENTAL ANALYSIS Sell or Process Further Single-Product Case (Continued)
Process Net Income Sell Further Increase (Decrease)
Sales per unit $ $ $10.00
Cost per unit
Direct materials (2.00)
Direct labor (4.00)
Variable manufacturing overhead (2.40)
Fixed manufacturing overhead
Total $ $ $(8.40)
Net income per unit $ $ $1.60
Decision: Process further.
Incremental revenue ($10) exceeds incremental processing costs ($8.40); income increases $1.60 per unit

19. INCREMENTAL ANALYSIS Sell or Process Further Multiple-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

20. 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.

21. INCREMENTAL ANALYSIS Sell or Process Further Multiple-Product Case
Example - Maris Creamery decision:
Sell cream and skim milk or
Process them further before selling

22. Decision: Do not process the cream further.
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, $27, $ 8,000
Cost per day
Processing cream into
cottage cheese , (10,000)
$19, $17, $ (2,000)
Decision: Do not process the cream further.
Incremental revenue ($8,000) is less than incremental costs ($10,000); income decreases $2,000.

23. 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, $26, $ 15,000
Cost per day
Processing skim milk into
condensed milk , ( 8,000)
$11, $18, $ 7,000
Decision: Process the skim milk further.
Incremental revenue ($15,000) exceeds incremental costs ($8,000);
income increases $7,000.

24. 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

25. 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)
Total $640, $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.

26. 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

27. Example – Martina Company Should Champ be eliminated?
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:
Should Champ be eliminated?
Pro Master Champ Total
Sales $800,000 $300,000 $100,000 $1,200,000
Variable expenses , , , ,000
Contribution margin 280,000 90,000 10, ,000
Fixed expenses , , , ,000
Net income $200,000 $ 40,000 $(20,000) $ 220,000

28. 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:
Total income has decreased by $10,000 ($220,000 - $210,000)
Pro Master Total
Sales $800,000 $300,000 $1,100,000
Variable expenses , , ,000
Contribution margin 280,000 90, ,000
Fixed expenses , , ,000
Net income $180, $ 30,000 $ 210,000
ELIMINATE CHAMP?

29. Decision: Do not eliminate Champ.
INCREMENTAL ANALYSIS Eliminate an Unprofitable Segment 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 $ $(100,000)
Variable expenses , ,000
Contribution margin 10, (10,000)
Fixed expenses , ,
Net income $(20,000) $(30,000) $ (10,000)
Decision: Do not eliminate Champ.

30. 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

31. 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 has higher contribution margin: $8
Standard set takes fewer machine hours per unit
Deluxe set Standard set
Contribution margin per unit $ $6
Machine hours required per unit per unit

32. 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 increase machine capacity

33. 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.