Prepared by Diane Tanner University of North Florida Chapter 11 1 Incremental Analysis

Incremental Analysis Components Incremental Revenue The additional revenue as a result of selecting one decision over another Incremental Revenue The additional revenue as a result of selecting one decision 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/netted with incremental costs 2

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 3

Why Do We Use Relevant Costs?  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 4

Steps in 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 Step 3: List and clearly label each incremental line item as an 1) incremental revenue, 2) incremental cost, or 3) incremental cost savings  Include a ‘+’ sign if the incremental amount increases profit (i.e., a benefit)  Show the amount in ( ) parentheses if the amount causes profit to decline 5 5

6 Qualitative Issues  Should be considered regardless if the outcome points to accepting or rejecting the decision  Includes:  Morale  Control over design, quality, timeliness, & reliability  Environmental effects and safety  Prestige  Future price increases  Contractual issues

Types of Incremental Decisions  Special order  Outsourcing / Make-or-buy  Keep or Drop  A customer, product, segment, or subdivision  Capacity constraints 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 8

9 The End