Prepared by Diane Tanner University of North Florida ACG Incremental Analysis 3-1

What is Incremental Analysis?  An approach to simplifying complex business decisions  Allows us to focus on only the few things that matter  Much quicker decision making  Mingling irrelevant costs with relevant costs may cause confusion and distract attention from critical matters  Incremental amounts are often called differential or relevant 2

Incremental Analysis Components Incremental Revenue The additional revenue as a result of selecting one alternative over another Incremental Revenue The additional revenue as a result of selecting one alternative over another Incremental Cost The additional cost as a result of selecting one alternative over another Incremental Cost The additional cost as a result of selecting one alternative over another Incremental Savings The reduction of cost as a result of selecting one alternative over another Incremental Savings The reduction of cost as a result of selecting one alternative over another Usually combined with incremental costs 3

Terminology Avoidable Cost Can be avoided if a certain decision is made Sunk Cost A cost that has already been incurred and irreversible Opportunity Cost Represents the benefit forgone by selecting one alternative over another 4

Preparing a Single Column Incremental Analysis Step 1: Compare revenues under both alternatives ‘Change’ in revenues = relevant revenues Step 2: Compare costs under both alternatives ‘Change’ in costs = relevant costs and cost savings Step 3: List and clearly label each incremental line item Display as a positive amount if the incremental amount increases profit (i.e., a benefit) Display as a (negative) amount in ( ) parentheses if the amount causes profit to decline Step 4: Label the bottom line as ‘Incremental increase(or decrease) in profit if ………………..’ (replacing …. with the nature of the analysis) 5

6 Qualitative Issues Nonfinancial issues should always be considered, regardless if the financial incremental increase or decrease in profit is positive or negative Should be considered regardless if the outcome points to accepting or rejecting the decision Includes: – Employee morale – Control over design, quality, timeliness of delivery, & reliability – Environmental effects and safety – Future expectations of customers/suppliers – Contractual issues

Types of Incremental Decisions  Capacity constraints – limited resources  Outsourcing / make-or-buy  Keep or drop  A customer, product, segment, or subdivision  Special order decisions 7

Capacity Constraints Often called product mix decisions Exists when demand exceeds production that is limited by a particular resource –Labor hours –Machine hours –Space –Materials Goal is to maximize the contribution margin per unit of the constrained resource, such as –CM per labor hour –CM per square foot –CM per yard of fabric 8 No particular incremental analysis format required

Outsourcing Decisions Also known as a make or buy decision Relates to whether an item should be made internally (or service performed internally) or purchased from an external supplier/provider Only incremental costs and cost savings are relevant No incremental revenue exists because the selling price of the cost object will not be changed A single column incremental analysis is prepared.

Keep or Drop Products or Segments  Relates to whether a company should drop a product or segment that appears to have an operating loss, or keep it Incremental cost savings and incremental revenues are relevant –Incremental costs will result if demand changes occur in other products/segments  Caution  Allocated fixed costs are not usually eliminated and must be absorbed by other products A single column incremental analysis is prepared. Cost Allocation Death Spiral

Special Orders  Two types  One-time-only orders  Goal is to recover all incremental and opportunity costs  Long-run orders  Goal is to recover the full cost of products and opportunity costs  Companies cannot operate successfully in the long- run without recovering ‘all’ costs  Incremental revenues, incremental costs, and opportunity costs are relevant  Capacity considerations are relevant A single column incremental analysis is prepared.

One-Time-Only Special Orders  If idle capacity exists  Minimum selling price of the special order is the incremental cost  Opportunity cost is zero  If idle capacity does not exist  Minimum selling price of the special order is the incremental cost plus the opportunity cost  Opportunity cost  Contribution margin of the sales to regular customers that must be given up in order to accept the special order

Special Order Minimum Price Example Variable cost of washing$4.60 Allocated fixed manufacturing overhead1.80 AutoWash is an automatic car wash with a capacity of 2,000 cars per month. Its current demand is 1,800 washes per month. The unit cost of washing one car follows: Bug Patrol has offered to purchase 500 washes per month at $6.00 per wash even though regular customers pay $7.00 each. What is the least price per car wash that AutoWash should accept from Bug Patrol? Incremental cost + Opportunity cost = Minimum price Incremental cost: 500 × $4.60 = $2,300 Opportunity cost of 300 washes: 720 Minimum price of the order$3,020 Number of washes over capacity: Capacity2,000 Special order (500) Regular customers (1,800) Over capacity (300) Opportunity cost: CM per wash ($ $4.60) $2.40 # of washes over capacity 300 Total opportunity cost $720 Minimum price for each wash: $3,020 ÷ 500 = $6.04 Minimum price for each wash: $3,020 ÷ 500 = $6.04

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