Chapter

20 Incremental Analysis

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc.

 The
The Challenge
Challenge of
of
Changing
Changing Markets
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

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc.

 The
The Concept
Concept of
of
Relevant
Relevant Cost
Cost Information
Information
Will
Will you
you drive
drive oror fly
fly to
to Florida
Florida for
for spring
spring break?
break?
You
You have
have gathered
gathered the the following
following information
information to
to
help
help you
you with
with the
the decision.
decision.
Motel

Motelcost
costisis$80
$80per
pernight.
night.
Meal

Mealcost
costisis$20
$20per
perday.
day.
Your

Yourcar
carinsurance
insuranceisis$100
$100per
permonth.
month.
Kennel

Kennelcost
costfor
foryour
yourdog
dogisis$5
$5per
perday.
day.
Round-trip

Round-tripcost
costof
ofgasoline
gasolinefor
foryour
yourcar
carisis$200.
$200.
Round-trip

Round-tripairfare
airfareand
andrental
rentalcar
carfor
foraaweek
weekisis$500.
$500.
Driving
Driving requires
requires two
two days,
days, with
with an
an overnight
overnight stay,
stay,
cutting
cutting your
your time
time in
in Florida
Florida by
by two
two days.
days.
McGraw-Hill/Irwin The McGraw-Hill Companies, Inc.
 The
The Concept
Concept of
of
Relevant
Relevant Cost
Cost Information
Information

Florida Spring Break

Drive/Fly Analysis
8 days @ $80
Cost Drive Fly
Motel $ 640 $ 640 8 days @ $20
Eating out costs 160 160
Kennel cost 40 40 8 days @ $5
Car insurance 100 100
Gasoline 200 -
Airfare/rental car - 500

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc.

 The
The Concept
Concept of
of
Relevant
Relevant Cost
Cost Information
Information

Florida Spring Break

Drive/Fly Analysis
Cost Drive Fly
Motel $ 640 $ 640
Eating out costs 160 160 Costs do not differ,
so they are not
Kennel cost 40 40
relevant to decision.
Car insurance 100 100
Gasoline 200 - Also, car insurance
Airfare/rental car - 500 is not relevant to
the decision as it
is a past cost.
McGraw-Hill/Irwin The McGraw-Hill Companies, Inc.
 The
The Concept
Concept of
of
Relevant
Relevant Cost
Cost Information
Information

Florida Spring Break Are

Arethe
theextra
extratwo
two
Drive/Fly Analysis days
days in
inFlorida
Florida
worth
worththe
the$300
$300
Cost Drive Fly extra
extracost
cost to
tofly?
fly?
Motel $ 640 $ 640
Eating out costs 160 160
Kennel cost 40 40 Transportation
Car insurance 100 100 costs differ between
Gasoline 200 - the two alternatives,
Airfare/rental car - 500 so they are relevant
to your decision
McGraw-Hill/Irwin The McGraw-Hill Companies, Inc.
 Decision
Decision Making
Making
Decision making involves five steps:

Define the problem.

Identify the alternatives.
Collect information on alternatives.
Eliminate irrelevant information.
Make a decision with the
remaining relevant information.

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc.

 Relevant
Relevant Information
Information
in
in Business
Business Decisions
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.

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc.

 Opportunity
Opportunity Cost
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.
McGraw-Hill/Irwin The McGraw-Hill Companies, Inc.
 Sunk
Sunk Costs
Costs Versus
Versus
Out-of-Pocket
Out-of-Pocket Costs
Costs
All costs incurred in the past that cannot be changed by any decision made now or in the
future.

Sunk costs should not be considered in decisions.

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

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc.

 Sunk
Sunk Costs
Costs Versus
Versus
Out-of-Pocket
Out-of-Pocket Costs
Costs

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

Trade ?
two years ago today

The
Thedealer
dealerwill
will trade
tradeforfor$20,000
$20,000plus
plusyour
yourcar.
car.
What
What amount
amountis isrelevant
relevanttotoyour
yourdecision,
decision,
the
the$10,000
$10,000 sunk
sunkcost
cost of
ofyour
your car
car or
or the
the
$20,000
$20,000 out-of-pocket
out-of-pocket cash cashdifferential?
differential?

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc.

 Incremental
Incremental Analysis
Analysis in
in
Common
Common Business
Business Decisions
Decisions

We will now
examine
several
different types
of managerial
decisions.

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc.

 Special
Special Order
Order Decisions
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.
McGraw-Hill/Irwin The McGraw-Hill Companies, Inc.
 Special
Special Order
Order Decisions
Decisions
JamCo currently sells 100,000 units of its
product. The company has revenue and costs
as shown below:
Per Unit Total
Sales $ 10.00 $ 1,000,000
Direct materials 3.50 350,000
Direct labor 2.20 220,000
Factory overhead 1.10 110,000
Selling expenses 1.40 140,000
Administrative expenses 0.80 80,000
Total expenses $ 9.00 $ 900,000
Operating income $ 1.00 $ 100,000

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc.

 Special
Special Order
Order Decisions
Decisions
JamCo is approached by an overseas
company that offers to purchase
10,000 units at $8.50 per unit.
If JamCo accepts the offer, total factory
overhead will increase by $5,000; total selling
expenses will increase by $2,000; and total
administrative expenses will increase
by $1,000.
Should JamCo
accept the offer?

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc.

 Special
Special Order
Order Decisions
Decisions
First
First lets
lets look
look at
at incorrect
incorrect reasoning
reasoning
that
that leads
leads toto an
an incorrect
incorrect decision.
decision.

Our cost is $9.00

per unit. I cant sell
for $8.50 per unit.

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc.

 Special
Special Order
Order Decisions
Decisions
Current Additional
Business Business Combined
Sales $ 1,000,000 $ 85,000 $ 1,085,000
Direct materials $ 350,000 $ 35,000 $ 385,000
Direct labor 220,000 22,000 242,000
Factory overhead 110,000 5,000 115,000
Selling expenses 140,000 2,000 142,000
Admin. expenses 80,000 1,000 81,000
Total expenses $ 900,000 $ 65,000 $ 965,000
Operating income $ 100,000 $ 20,000 $ 120,000

This analysis leads to the correct decision.

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc.
 Special
Special Order
Order Decisions
Decisions
Current Additional
Business Business Combined
Sales $ 1,000,000 $ 85,000 $ 1,085,000
Direct materials $ 350,000 $ 35,000 $ 385,000
Direct labor 220,000 22,000 242,000
Factory overhead 110,000 5,000 115,000
Selling expenses 140,000 2,000 142,000
Admin. expenses 80,000 1,000 81,000
Total expenses $ 900,000 $ 65,000 $ 965,000
Operating income $ 100,000 $ 20,000 $ 120,000

10,000 new units $8.50 selling price = $85,000

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc.
 Special
Special Order
Order Decisions
Decisions
Current Additional
Business Business Combined
Sales $ 1,000,000 $ 85,000 $ 1,085,000
Direct materials $ 350,000 $ 35,000 $ 385,000
Direct labor 220,000 22,000 242,000
Factory overhead 110,000 5,000 115,000
Selling expenses 140,000 2,000 142,000
Admin. expenses 80,000 1,000 81,000
Total expenses $ 900,000 $ 65,000 $ 965,000
Operating income $ 100,000 $ 20,000 $ 120,000

10,000 new units $3.50 = $35,000

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc.
 Special
Special Order
Order Decisions
Decisions
Current Additional
Business Business Combined
Sales $ 1,000,000 $ 85,000 $ 1,085,000
Direct materials $ 350,000 $ 35,000 $ 385,000
Direct labor 220,000 22,000 242,000
Factory overhead 110,000 5,000 115,000
Selling expenses 140,000 2,000 142,000
Admin. expenses 80,000 1,000 81,000
Total expenses $ 900,000 $ 65,000 $ 965,000
Operating income $ 100,000 $ 20,000 $ 120,000

10,000 new units $2.20 = $22,000

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc.
 Special
Special Order
Order Decisions
Decisions
Current Additional
Business Business Combined
Sales $ 1,000,000 $ 85,000 $ 1,085,000
Even
Direct though the$$8.50
materials selling price
350,000 $ is less than
35,000 $ the
385,000
normal
Direct labor $10 selling price, JamCo should
220,000 22,000accept the
242,000
offer
Factory because net income
overhead 110,000will increase by $20,000.
5,000 115,000
Selling expenses 140,000 2,000 142,000
Admin. expenses 80,000 1,000 81,000
Total expenses $ 900,000 $ 65,000 $ 965,000
Operating income $ 100,000 $ 20,000 $ 120,000

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc.

 Special
Special Order
Order Decisions
Decisions
We can also look at this decision
using contribution margin.
Per Unit Total
Special order revenue $ 8.50 $ 85,000
Direct materials 3.50 35,000
Direct labor 2.20 22,000
Contribution margin $ 2.80 $ 28,000
Increase in fixed costs:
Factory overhead $ 5,000
Selling expenses 2,000
Administrative expenses 1,000
Special order profit $ 20,000

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc.

 Production
Production Constraint
Constraint Decisions
Decisions
Managers often face the problem of deciding
how scarce resources are going to be utilized.
Usually, fixed costs are not affected by this
particular decision, so management can focus
on maximizing total contribution margin.

Lets look at the Kaser Company example.

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc.

 Production
Production Constraint
Constraint Decisions
Decisions
Kaser Company produces two products and
selected data is shown below:
Products
1 2
Selling price per unit $ 60 $ 50
Less: variable expenses per unit 36 35
Contribution margin per unit $ 24 $ 15
Current demand per week (units) 2,000 2,200
Contribution margin ratio 40% 30%
Processing time required
on machine A1 per unit 1.00 min. 0.50 min.

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc.

 Production
Production Constraint
Constraint Decisions
Decisions
Machine A1 is the scarce resource because
there is excess capacity on other machines.
Machine A1 is being used at 100% of its
capacity.
Machine A1 capacity is 2,400 minutes per week.

Should Kaser focus its efforts on Product

1 or 2?

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc.

 Production
Production Constraint
Constraint Decisions
Decisions
Lets calculate the contribution margin per unit of
the scarce resource, machine A1.
Products
1 2
Contribution margin per unit $ 24 $ 15
Time required to produce one unit 1.00 min. ? min.
Contribution margin per minute $ 24 ?

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc.

 Production
Production Constraint
Constraint Decisions
Decisions
Lets calculate the contribution margin per unit of
the scarce resource, machine A1.
Products
1 2
Contribution margin per unit $ 24 $ 15
Time required to produce one unit 1.00 min. 0.50 min.
Contribution margin per minute $ 24 $ 30

Product 2 should be emphasized. It is the more

valuable use of the scarce resource, machine A1,
yielding a contribution margin of $30 per minute as
opposed to $24 for Product 1.
McGraw-Hill/Irwin The McGraw-Hill Companies, Inc.
 Production
Production Constraint
Constraint Decisions
Decisions
Lets calculate the contribution margin per unit of
the scarce resource, machine A1.
Products
1 2
Contribution margin per unit $ 24 $ 15
Time required to produce one unit 1.00 min. 0.50 min.
Contribution margin per minute $ 24 $ 30

If there are no other considerations, the best plan would

be to produce to meet current demand for Product 2 and
then use any capacity that remains to make Product 1.

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc.

 Production
Production Constraint
Constraint Decisions
Decisions
Lets see how this plan would work.
Allotting Our Scarce Resource (Machine A1)

Weekly demand for Product 2 2,200 units

Time required per unit 0.50 min.
Total time required to make
Product 2 1,100 min.

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc.

 Production
Production Constraint
Constraint Decisions
Decisions
Lets see how this plan would work.
Allotting Our Scarce Resource (Machine A1)

Weekly demand for Product 2 2,200 units

Time required per unit 0.50 min.
Total time required to make
Product 2 1,100 min.

Total time available 2,400 min.

Time used to make Product 2 1,100 min.
1,300

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc.

 Production
Production Constraint
Constraint Decisions
Decisions
Lets see how this plan would work.
Allotting Our Scarce Resource (Machine A1)

Weekly demand for Product 2 2,200 units

Time required per unit 0.50 min.
Total time required to make
Product 2 1,100 min.

Total time available 2,400 min.

Time used to make Product 2 1,100 min.
Time available for Product 1 1,300 min.
Time required per unit 1.00 min.
Production of Product 1 1,300 units

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc.

 Production
Production Constraint
Constraint Decisions
Decisions
According to the plan, we will produce 2,200 units
of Product 2 and 1,300 of Product 1. Our
contribution margin looks like this.
Product 1 Product 2
Production and sales (units) 1,300 2,200
Contribution margin per unit $ 24 $ 15.00
Total contribution margin $ 31,200 $ 33,000

The total contribution margin for Kaser is $64,200.

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc.

 Make
Make or
or Buy
Buy Decisions
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.

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc.

 Make
Make or
or Buy
Buy Decisions
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.

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc.

 Make
Make or
or Buy
Buy Decisions
Decisions
Exitel
Exitel makes
makes computer
computer chips
chips used
used inin
one
one of
of its
its products.
products. Unit
Unit costs,
costs, based
based onon
production
production ofof 20,000
20,000 chips
chips per
per year,
year, are:
are:

Unit Costs
Direct Material $ 9.00
Direct Labor 5.00
Variable Overhead 1.00
Fixed Overhead 13.00
Total $ 28.00

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc.

 Make
Make or
or Buy
Buy Decisions
Decisions
An outside supplier has offered to provide
the 20,000 chips at a cost of $25 per chip.
Fixed overhead costs will not be avoided if
the chips are purchased. Exitel has no
alternative use for the facilities.

Should Exitel accept the offer?

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc.

 Make
Make or
or Buy
Buy Decisions
Decisions
Differential costs of making (costs avoided
if bought from outside supplier)
Unit Cost
Direct Material $ 9.00
Direct Labor 5.00
Variable Overhead 1.00
Total $ 15.00

Exitel should not pay $25 per unit to an outside

supplier to avoid the $15 per unit differential cost of
making the part. Fixed costs are irrelevant to decision.
McGraw-Hill/Irwin The McGraw-Hill Companies, Inc.
 Make
Make or
or Buy
Buy Decisions
Decisions
If Exitel buys the chips from the outside
supplier, the idle facilities could be leased
to another company for $250,000 per year.

Should Exitel buy the chips and

lease the facilities?

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc.

 Make
Make or
or Buy
Buy Decisions
Decisions
Disadvantage of buying
20,000 units ($25 - $15) $ 200,000
Opportunity cost of facilities:
The lease revenue 250,000
Advantage of buying part
and leasing facilities $ 50,000

The opportunity cost of facilities changes the decision.

The real question to answer is,

What is the best use of Exitels facilities?
McGraw-Hill/Irwin The McGraw-Hill Companies, Inc.
 Sell,
Sell, Scrap,
Scrap, or
or Rebuild
Rebuild Decisions
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.

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc.

 Sell,
Sell, Scrap,
Scrap, or
or Rebuild
Rebuild Decisions
Decisions
OserCo has 10,000 defective units that
cost $1.00 each to make. The units can be
scrapped now for $.40 each or rebuilt at an
additional cost of $.80 per unit.
If rebuilt, the units can be sold for the normal
selling price of $1.50 each. Rebuilding the 10,000
defective units will prevent the production of
10,000 new units that would also sell for $1.50.
Should OserCo scrap or rebuild?

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc.

 Sell,
Sell, Scrap,
Scrap, or
or Rebuild
Rebuild Decisions
Decisions

Scrap
Now Rebuild
Sale of defects $ 4,000 $ 15,000
Less rebuild costs -
Less opportunity cost -
Net return $ 4,000

10,000 units $0.40 per unit

10,000 units $1.50 per unit

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc.
 Sell,
Sell, Scrap,
Scrap, or
or Rebuild
Rebuild Decisions
Decisions
10,000 units $0.80 per unit
Scrap
Now Rebuild
Sale of defects $ 4,000 $ 15,000
Less rebuild costs - (8,000)
Less opportunity cost - (5,000)
Net return $ 4,000 2,000

10,000 units ($1.50 - $1.00) per unit

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc.

 Sell,
Sell, Scrap,
Scrap, or
or Rebuild
Rebuild Decisions
Decisions
OserCo should scrap the units now.

Scrap
Now Rebuild
Sale of defects $ 4,000 $ 15,000
Less rebuild costs - (8,000)
Less opportunity cost - (5,000)
Net return $ 4,000 2,000

If OserCo fails to include the opportunity cost,

the rework option would show a return of $7,000,
mistakenly making rebuild appear more favorable.

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc.

 Joint
Joint Product
Product Decisions
Decisions
Two
Twoor
ormore
moreproducts
productsproduced
producedfromfromaa
common
commoninput
inputare
arecalled
called joint
joint products.
products.

Product 1
Joint
Joint costs
costs are
are
the
thecosts
costsof of
Joint Costs Product 2 processing
processingprior
priortoto
the
thesplit-off
split-off point.
point.
Product 3
The
The split-off
split-off point
point is
isthe
the point
point in
inaaprocess
processwhere
where
joint
jointproducts
productscan canbe
berecognized
recognizedas asseparate
separateproducts.
products.
McGraw-Hill/Irwin The McGraw-Hill Companies, Inc.
 Joint
Joint Product
Product Decisions
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.

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc.

 Joint
Joint Product
Product Decisions
Decisions
Ames Co. produces two products, A and B, from this process.
Should the products be
sold at split-off or Additional Final
Revenue Processing Sale
processed further? $70,000 $40,000 $120,000

Joint Common A
Cost Production
$100,000 Process

Additional Final
Revenue
Processing Sale
$50,000
$20,000 $65,000
Split-Off
Point B The McGraw-Hill Companies, Inc.
McGraw-Hill/Irwin
 Joint
Joint Product
Product Decisions
Decisions
Incremental Incremental
Product Revenue Cost Difference
A $ 50,000 $ 40,000 $ 10,000
B 15,000 20,000 (5,000)

Product A incremental revenue = $120,000 - $70,000

Product B incremental revenue = $65,000 - $50,000

Decision: Process product A, but sell product B at the

split-off point. Note that the $100,000 joint cost is
irrelevant to the processing decision.

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc.

 Joint
Joint Product
Product Decisions
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.

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc.

 Joint
Joint Product
Product Decisions
Decisions
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.

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc.