Presentation on theme: "CHAPTER 6 INCREMENTAL ANALYSIS Study Objectives"— Presentation transcript:
1CHAPTER 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.
2Study 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.
3MANAGEMENT’S DECISION-MAKING PROCESS Study Objective 1 Does not always follow a set pattern or processDecisions vary in scopeDecisions vary in urgency and importanceHowever some steps can be identified:
4MANAGEMENT’S DECISION MAKING PROCESS Considers both financial and nonfinancial informationFinancial informationRevenues and costsOverall profitabilityNonfinancial informationEffect of decision on employee turnoverEnvironmentOverall image of company
5MANAGEMENT’S DECISION-MAKING Incremental Analysis Approach Study Objective 2 Decisions involve a choice among alternative actionsFinancial data relevant to a decision are the data that vary in the future among alternativesBoth costs and revenues may vary orOnly revenues may vary orOnly costs may varyIncremental Analysis: Process to identify financial data that change under alternative actionsIdentifies probable effects of decisions on future earnings
6MANAGEMENT’S DECISION MAKING How Incremental Analysis Works Example Alternative Alternative Net IncomeA B Increase (Decrease)Revenues $125,000 $110,000 $(15,000)Costs , , ,000Net income $ 25, $ 30, $ 5,000Alternative B is being compared to Alternative AIncremental revenue is $15,000 less under Alternative BIncremental cost savings of $20,000 is realizedAlternative B produces $5,000 more net income
7MANAGEMENT’S DECISION MAKING How Incremental Analysis Works Uses three important cost concepts
8MANAGEMENT’S DECISION MAKING Types of Incremental Analysis Accept an order at a special priceMake or buy component parts or finished productsSell products or process furtherRetain or replace equipmentEliminate an unprofitable business segment
9INCREMENTAL ANALYSIS Accept an Order at a Special Price Study Objective 3 Obtain additional business by making price concessionsAssumes sales of the products in other markets would not be affected by special orderAssumes company is not operating at full capacity
10INCREMENTAL ANALYSIS Accept an Order at a Special Price ExampleCustomer offers to buy a special order of 2,000 blenders at $11 per unit from Sunbelt.No effect on normal sales; sufficient plant capacityOperating at 80 percent capacity = 100,000 unitsCurrent fixed manufacturing costs = $400,000 or $4 per unitVariable manufacturing cost = $8 per unitNormal selling prince = $20 per unitBased strictly on total cost of $12 per unit ($8 + $4), reject offer as cost exceeds selling price of $11
11Decision: 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 relevantOnly total variable costs change – thus they are relevantRevenue increases $22,000; variable costs increase $16,000;Thus, net income increases $6,000Net IncomeReject Order Accept Order Increase (Decrease)Revenues $ $22, $22,000Costs , (16,000)Net income $ $ 6, $ 6,000Decision: Accept the offer – Income will increase by $6,000.
12INCREMENTAL ANALYSIS Make or Buy Study Objective 4 Outsourcing: The decision to buy parts or services rather than making themExample: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
13INCREMENTAL ANALYSIS Make or Buy Example (Continued) Net Income Make Buy Increase (Decrease)Direct materials $ 50, $ $ 50,000Direct labor 75, ,000Variable manufacturing costs 40, ,000Fixed manufacturing costs 60, , ,000Purchase 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 switchesDecision: Continue to make switches.
14INCREMENTAL ANALYSIS Opportunity Costs The potential benefit that may be obtained from following an alternative course of action
15Decision: Based on the analysis, Baron should buy the switches INCREMENTAL ANALYSIS Opportunity Costs Example – Baron Company ContinuedAssume 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 switchesNet Income Make Buy Increase (Decrease)Total annual cost $225, $250, $(25,000)Opportunity cost , ,000Total cost $253, $250, $ 3,000Decision: Based on the analysis,Baron should buy the switchesas the company will be $3,000 better off.
16INCREMENTAL 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 asthe incremental revenue fromsuch processing exceeds theincremental processing costs
17INCREMENTAL ANALYSIS Sell or Process Further Single-Product Case Cost to manufacture one unfinished table:Direct materials $15Direct laborVariable manufacturing overhead 6Fixed manufacturing overhead 4Manufacturing cost per unit $35Selling price of unfinished unit is $50Unused capacity used to finish the tables to sell for $60 per table.Relevant unit costs of finishing tables:Direct materials increase $2Direct labor increase $4Variable manufacturing overhead costs increase by $2.40 (60 percent of direct labor increase)Fixed manufacturing costs will not increase
18Decision: Process further. INCREMENTAL ANALYSIS Sell or Process Further Single-Product Case (Continued)Process Net Income Sell Further Increase (Decrease)Sales per unit $ $ $10.00Cost per unitDirect materials (2.00)Direct labor (4.00)Variable manufacturing overhead (2.40)Fixed manufacturing overheadTotal $ $ $(8.40)Net income per unit $ $ $1.60Decision: Process further.Incremental revenue ($10) exceeds incremental processing costs ($8.40); income increases $1.60 per unit
19INCREMENTAL ANALYSIS Sell or Process Further Multiple-Product Case Especially appropriate when multiple products are produced simultaneouslyMany end-products are produced from a single raw material and a common production processJoint products - multiple end productsPetroleum – gasoline, lubricating oil, keroseneMeat Packing – meat, hides, bones
20INCREMENTAL ANALYSIS Sell or Process Further Multiple-Product Case Joint costsall costs incurred prior to split-off pointallocate to individual products based on relative sales valueSunk costsalready incurred and cannot be changedirrelevant for sell or processfurther decisionsJoint costs are sunk costs for sell or process further decisions.
21INCREMENTAL ANALYSIS Sell or Process Further Multiple-Product Case Example - Maris Creamery decision:Sell cream and skim milkorProcess them further before selling
22Decision: 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 $ 9,000Processing cream into cottage cheese $10,000Expected revenue per day:Cream $19,000 Cottage cheese $27,000Process Net Income Sell Further Increase (Decrease)Sales per day $19, $27, $ 8,000Cost per dayProcessing cream intocottage 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.
23INCREMENTAL 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 $ 5,000Processing skim milk into condensed milk $ 8,000Expected revenue per day:Skim milk $11,000 Condensed milk $26,000Process Net Income Sell Further Increase (Decrease)Sales per day $11, $26, $ 15,000Cost per dayProcessing skim milk intocondensed milk , ( 8,000)$11, $18, $ 7,000Decision: Process the skim milk further.Incremental revenue ($15,000) exceeds incremental costs ($8,000);income increases $7,000.
24INCREMENTAL ANALYSIS Retain or Replace Equipment Study Objective 6 ExampleAssessment of replacement of a factory machine:Variable costs:Decrease from $160,000to $125,000 annuallyOld Machine New MachineBook value $40,000Cost $120,000Remaining useful life four years four yearsScrap value
25INCREMENTAL ANALYSIS Retain or Replace Equipment Example (Continued) Net Income Retain Replace Increase (Decrease)Variable manufacturing costs $640,000a $500,000b $140,000New machine cost , (120,000)Total $640, $620,000 $ 20,000a(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.
26INCREMENTAL ANALYSIS Eliminate an Unprofitable Segment Study Objective 7 Key: Focus on relevant costsConsider effect on related product linesFixed costs allocated to the unprofitable segment must be absorbed by the other segmentsNet income may decrease when an unprofitable segment is eliminatedDecision Rule:Retain the segment unless fixed costs eliminated exceed the contribution margin lost
27Example – Martina Company Should Champ be eliminated? INCREMENTAL ANALYSIS Eliminate an Unprofitable Segment Study Objective 7Example – Martina CompanyManufactures three models of tennis racquets:Profitable lines: Pro and MasterUnprofitable line: ChampCondensed Income Statement data:Should Champ be eliminated?Pro Master Champ TotalSales $800,000 $300,000 $100,000 $1,200,000Variable expenses , , , ,000Contribution margin 280,000 90,000 10, ,000Fixed expenses , , , ,000Net income $200,000 $ 40,000 $(20,000) $ 220,000
28INCREMENTAL 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 MasterRevised Income Statement data:Total income has decreased by $10,000 ($220,000 - $210,000)Pro Master TotalSales $800,000 $300,000 $1,100,000Variable expenses , , ,000Contribution margin 280,000 90, ,000Fixed expenses , , ,000Net income $180, $ 30,000 $ 210,000ELIMINATE CHAMP?
29Decision: Do not eliminate Champ. INCREMENTAL ANALYSIS Eliminate an Unprofitable Segment Example (Continued)Incremental analysis of Champ provides the same resultsDecrease in net income is due to Champ’s contribution margin ($10,000) that will not be realized if the segment is discontinuedELIMINATE CHAMP? Net IncomeContinue Eliminate Increase (Decrease)Sales $100,000 $ $(100,000)Variable expenses , ,000Contribution margin 10, (10,000)Fixed expenses , ,Net income $(20,000) $(30,000) $ (10,000)Decision: Do not eliminate Champ.
30INCREMENTAL ANALYSIS Allocate Limited Resources Study Objective 8 Resources are always limitedfloor space for a retail firmraw material, direct labor hours, or machine capacity for a manufacturing firmManagement must decide which products to make and sell to maximize net income
31INCREMENTAL ANALYSIS Allocate Limited Resources Study Objective 8 Example – Collins CompanyProduces standard and deluxepen and pencil setsLimiting resource – 3,600 machinehours per monthDeluxe set has higher contribution margin: $8Standard set takes fewer machine hours per unitDeluxe set Standard setContribution margin per unit $ $6Machine hours required per unit per unit
32INCREMENTAL ANALYSIS Allocate Limited Resources Example (Continued) Must compute contribution margin per unit of limited resourceStandard sets have higher contribution margin per unit oflimited resourcesDecision:Shift sales mix to standard sets or increase machine capacity
33INCREMENTAL ANALYSIS Allocate Limited Resources Example (Continued) Alternative: Increase machine capacity from 3,600 to 4,200 hoursTo maximize net income, all 600 hours should be used to producestandard sets.