Incremental Analysis

Chapter 21

McGraw-Hill/Irwin Copyright © 2010 by The McGraw-Hill Companies, Inc. All

The Challenge of Changing
Markets
 Product markets can change quickly due to competitor
price cuts, changing customer preferences, and
introduction of new products by competitors.
 Managers must make short-run decisions, with a fixed
set of resources, to react to the changing market place.

Special Product Make Joint

order mix or buy product
decisions decisions decisions decisions

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Decision Making
Decision making involves these five steps:

 Define the problem.

 Identify the alternatives.
 Collect information on alternatives.
 Eliminate irrelevant information.
 Make a decision with the
remaining relevant information.

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Relevant Information
in Business Decisions
Information that varies among the possible
courses of action being considered.

― Incremental costs and revenues ―

Important cost concepts for 2

1
business decisions
 Opportunity costs
 Sunk costs
 Out-of-pocket costs

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Opportunity Cost
The benefit that could have been attained
by pursuing an alternative course of action.

Example: If you were not

attending college, you could be
earning $20,000 per year. Your
opportunity cost of attending
college for one year includes the
$20,000.

Opportunity costs are not recorded in the

accounting records, but are relevant to
decisions because they are a real sacrifice.
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Sunk Costs Versus
Out-of-Pocket Costs
All
All costs
costs incurred
incurred in
in the
the past
past that
that cannot
cannot be be changed
changed
by
by any
any decision
decision made
made now
now or
or in
in the
the future.
future.

Sunk
Sunk costs
costs should
should not
not be
be considered
considered in
in decisions.
decisions.

Example:
Example: You
You bought
bought an an automobile
automobile that that cost
cost $10,000
$10,000
two
two years
years ago.
ago. The
The $10,000
$10,000 costcost is
is sunk
sunk because
because
whether
whether you
you drive
drive it,
it, park
park it,
it, trade
trade it,
it, or
or sell
sell it,
it, you
you
cannot
cannot change
change the
the $10,000
$10,000 cost.cost.

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Sunk Costs Versus
Out-of-Pocket Costs

Cost = $10,000 Cost = $25,000

Trade ?
two years ago today

The
The dealer
dealer will
will trade
trade for
for $20,000
$20,000 plus
plus your
your car.
car.
What
What amount
amount is is relevant
relevant to
to your
your decision,
decision,
the
the $10,000
$10,000 sunk
sunk cost
cost of
of your
your car
car or
or the
the
$20,000
$20,000 out-of-pocket
out-of-pocket cashcash differential?
differential?

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Special Order Decisions
The decision to accept
additional business
should be based on
incremental costs and
incremental revenues.

Incremental amounts are

those that occur only if
the company decides to
accept the new business.

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Make or Buy Decisions
Should I
continue to make
the part, or should
I buy it?
I suppose I
should compare What will I
the outside purchase do with my
price with the additional idle facilities if
costs to manufacture I buy the part?
the part.

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Make or Buy Decisions
 Incremental costs also are important in the
decision to make a product or buy it from a
supplier.
 The cost to produce an item must include
(1) direct materials, (2) direct labor and
(3) incremental overhead.
 We should not use the predetermined
overhead rate to determine product cost.

21-10
Sell, Scrap, or Rebuild
Decisions
Costs incurred in manufacturing units of
product that do not meet quality standards
are sunk costs and cannot be recovered.

As long as rebuild costs are recovered

through sale of the product, and
rebuilding does not interfere with normal
production, we should rebuild.

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Joint Product Decisions
Two
Two or
or more
more products
products produced
produced from
from aa
common
common input
input are
are called
called joint
joint products.
products.

Product 1
Joint costs are
the costs of
processing prior to
Joint Costs Product 2
the split-off point.

Product 3
The
The split-off
split-off point
point is
is the
the point
point in
in aa process
process where
where
joint
joint products
products can
can be
be recognized
recognized as as separate
separate products.
products.

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Joint Product Decisions
Businesses are often faced with the
decision to sell partially completed
products at the split-off point or to
process them to completion.

General rule:
Process further only if
incremental revenues > incremental costs.

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Joint Product Decisions
Joint costs are really common costs incurred to
simultaneously produce a variety of end products.

Joint costs are commonly allocated to end products on

the basis of the relative sales value of each product or
on some other basis.

Joint costs are not relevant in decisions regarding what

to do with a product after the split-off point.
As a general rule . . .
It is always profitable to continue processing a joint
product after the split-off point so long as the
incremental revenue exceeds the incremental
processing costs.
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Nonfinancial
Considerations
Leg
al Reputa
issu tion
es
Environm
ental
impacts

Distinguishing
fact from opinion It would be irresponsible
for me to base my
Ethical decision entirely on revenue
implicat and cost figures.
ions
21-15
End of Chapter 21

21-16