1. John Wiley & Sons, Inc. © 2005 Prepared by Dan R. Ward Suzanne P. Ward University of Louisiana at Lafayette Managerial Accounting Weygandt Kieso Kimmel CHAPTER 6 INCREMENTAL ANALYSIS

2. 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.

3. 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.

4. 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:

5. 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

6. 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

7. MANAGEMENT’S DECISION MAKING How Incremental Analysis Works Example 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 AlternativeAlternativeNet Income A B Increase (Decrease) Revenues$125,000 $110,000 $(15,000) Costs 100,000 80,000 20,000 Net income$ 25,000 $ 30,000 $ 5,000

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

9. Let’s Review Incremental analysis is the process of identifying the financial data that: a.Do not change under alternative courses of action b.Change under alternative courses of action c.Are mixed under alternative courses of action d.None of the above

10. Let’s Review Incremental analysis is the process of identifying the financial data that: a.Do not change under alternative courses of action b.Change under alternative courses of action c.Are mixed under alternative courses of action d.None of the above

11. 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

12. 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

13. 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

14. 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; v ariable costs increase $16,000;  Thus, net income increases $6,000 Net Income Reject Order Accept Order Increase (Decrease) Revenues$ -0- $22,000 $22,000 Costs -0- 16,000 (16,000) Net income$ -0- $ 6,000 $ 6,000 Decision: Accept the offer – Income will increase by $6,000.

15. 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

16. INCREMENTAL ANALYSIS Make or Buy Example (Continued)  Based on analysis of costs under both alternatives:  Purchasing adds $25,000 to cost of switches Net Income Make Buy Increase (Decrease) Direct materials$ 50,000 $ - 0 - $ 50,000 Direct labor75,000 - 0 - 75,000 Variable manufacturing costs40,000 - 0 - 40,000 Fixed manufacturing costs60,000 50,000 10,000 Purchase price -0- 200,000 (200,000) Total annual cost$225,000 $250,000 $ (25,000) Decision: Continue to make switches.

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

18. 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$225,000 $250,000 $(25,000) Opportunity cost 28,000 - 0 - 28,000 Total cost$253,000 $250,000 $ 3,000 Decision: Based on the analysis, Baron should buy the switches as the company will be $3,000 better off.

19. 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

20. INCREMENTAL ANALYSIS Sell or Process Further Single-Product Case  Cost to manufacture one unfinished table: Direct materials $15 Direct labor 10 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

21. INCREMENTAL ANALYSIS Sell or Process Further Single-Product Case (Continued) Process Net Income Sell Further Increase (Decrease) Sales per unit $50.00 $60.00 $10.00 Cost per unit Direct materials15.00 17.00 (2.00) Direct labor 10.00 14.00 (4.00) Variable manufacturing overhead 6.00 8.40 (2.40) Fixed manufacturing overhead 4.00 4.00 - 0 - Total $35.00 $43.40 $(8.40) Net income per unit$15.00 $16.60 $1.60 Decision: Process further. Incremental revenue ($10) exceeds incremental processing costs ($8.40); income increases $1.60 per unit

22. 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

23. 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.

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

25. INCREMENTAL ANALYSIS Sell or Process Further Multiple-Product Case – Example (Continued) Process Net Income Sell Further Increase (Decrease) Sales per day $19,000 $27,000 $ 8,000 Cost per day Processing cream into cottage cheese - 0 - 10,000 (10,000) $19,000 $17,000 $ (2,000)  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 $19,000Cottage cheese$27,000 Decision: Do not process the cream further. Incremental revenue ($8,000) is less than incremental costs ($10,000); income decreases $2,000.

26. INCREMENTAL ANALYSIS Sell or Process Further Multiple-Product Case – Example (Continued) Process Net Income Sell Further Increase (Decrease) Sales per day $11,000 $26,000 $ 15,000 Cost per day Processing skim milk into condensed milk - 0 - 8,000 ( 8,000) $11,000 $18,000 $ 7,000  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 $11,000Condensed milk $26,000 Decision: Process the skim milk further. Incremental revenue ($15,000) exceeds incremental costs ($8,000); income increases $7,000.

27. 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 - 0 - - 0 -

28. INCREMENTAL ANALYSIS Retain or Replace Equipment Example (Continued) Net Income Retain Replace Increase (Decrease) Variable manufacturing costs$640,000 a $500,000 b $140,000 New machine cost 120,000 (120,000) Total $640,000 $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. 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.

29. 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

30. 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 520,000 210,000 90,000 820,000 Contribution margin280,00090,00010,000 380,000 Fixed expenses 80,000 50,000 30,000 160,000 Net income$200,000$ 40,000 $(20,000)$ 220,000

31. 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 520,000 210,000 730,000 Contribution margin280,00090,000370,000 Fixed expenses 100,000 60,000 160,000 Net income $180,000 $ 30,000 $ 210,000 ELIMINATE CHAMP?

32. 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 $ - 0 - $(100,000) Variable expenses 90,000 - 0 - 90,000 Contribution margin10,000 - 0 - (10,000) Fixed expenses 30,000 30,000 - 0 - Net income$(20,000) $ 30,000) $ (10,000) Decision: Do not eliminate Champ.

33. 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

34. 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 setStandard set Contribution margin per unit $8 $6 Machine hours required 0.4 per unit 0.2 per unit

35. 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

36. 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.

37. INCREMENTAL ANALYSIS Theory of Constraints  Approach used to identify and manage constraints so as to achieve company goals  Requires identification of constraints  Continual attempts to reduce or eliminate constraints

38. MANAGEMENT’S DECISION MAKING Other Considerations  Qualitative factors  Potential effects of decision on employees and community  Low morale  Employee turnover  Incremental Analysis and Activity-Based Costing  Completely consistent with each other  ABC better identifies relevant costs resulting in better incremental analysis

39. Let’s Review In a decision to retain or replace equipment, the book value of the old equipment is a (an): a.Opportunity costs b.Incremental cost c.Sunk cost d.Marginal cost

40. Let’s Review In a decision to retain or replace equipment, the book value of the old equipment is a (an): a.Opportunity costs b.Incremental cost c.Sunk cost d.Marginal cost

41. Summary of Study Objectives  Identify the steps in management’s decision-making process.  Identify the problem and assign responsibility  Determine and evaluate courses of action  Make the decision  Review results  Describe the concept of incremental analysis. Process of identifying data that change under alternative courses of action

42. Summary of Study Objectives  Identify the relevant costs in accepting an order at a special price. Generally the relevant costs will be the variable manufacturing costs; total fixed costs will not change.  Identify the relevant costs in a make-or-buy decision.  Variable manufacturing costs that will be saved  Purchase price  Opportunity costs

43. Summary of Study Objectives  Identify the relevant costs in determining whether to sell or process materials further. Process further as long as incremental revenue exceeds incremental costs  Identify the relevant costs to be considered in retaining or replacing equipment.  Effect on variable costs  Cost of new equipment  Any disposal value of old equipment

44. Summary of Study Objectives  Identify the relevant costs in deciding whether to eliminate an unprofitable segment. Retain segment unless fixed costs eliminated exceed the contribution margin lost  Determine sales mix when a company has limited resources.  Find contribution margin per unit of limited resource  Multiply this amount by the units of limited resource to determine which product maximizes net income

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