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CHAPTER 7

Incremental Analysis
ASSIGNMENT CLASSIFICATION TABLE
Study Objectives

Questions

Brief
Exercises

Exercises

A
Problems

B
Problems

1.

Identify the steps in


managements decisionmaking process.

1, 2

2.

Describe the concept


of incremental analysis.

3, 4

3.

Identify the relevant


costs in accepting an
order at a special price.

2, 3, 4, 14

1A

1B

4.

Identify the relevant


costs in a make-or-buy
decision.

6, 7

5, 6, 14

2A

2B

5.

Identify the relevant costs


in determining whether to
sell or process materials
further.

8, 9, 10

5, 6

7, 8, 9, 14

3A

3B

6.

Identify the relevant costs


to be considered in
retaining or replacing
equipment.

11

10, 11, 14

4A

4B

7.

Identify the relevant costs


in deciding whether to
eliminate an unprofitable
segment.

12

12, 13, 14

5A

5B

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ASSIGNMENT CHARACTERISTICS TABLE


Problem
Number

Description

Difficulty
Level

Time
Allotted (min.)

Simple

2030

1A

Make incremental analysis for special order and identify


nonfinancial factors in the decision.

2A

Make incremental analysis related to make or buy,


consider opportunity cost, and identify nonfinancial
factors.

Moderate

3040

3A

Determine if product should be sold or processed further.

Moderate

3040

4A

Compute gain or loss, and determine if equipment should


be replaced.

Moderate

3040

5A

Compute contribution margin and prepare incremental


analysis concerning elimination of divisions.

Moderate

3040

1B

Make incremental analysis for special order and identify


nonfinancial factors in the decision.

Simple

2030

2B

Make incremental analysis related to make or buy,


consider opportunity cost, and identify nonfinancial
factors.

Moderate

3040

3B

Determine if product should be sold or processed further.

Moderate

3040

4B

Compute gain or loss, and determine if equipment should


be replaced.

Moderate

3040

5B

Compute contribution margin and prepare incremental


analysis concerning elimination of divisions.

Moderate

2030

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7-3

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 materials further.

Identify the relevant costs to


be considered in retaining or
replacing equipment.

Identify the relevant costs in


deciding whether to eliminate
an unprofitable segment.

*3.

*4.

*5.

*6.

*7.

Broadening Your Perspective

Describe the concept of


incremental analysis.

*2.

Q7-8
Q7-9
Q7-10

Identify the steps in managements BE7-1


decision-making process.

Real-World Focus Decision Making All About


Across the
You
Exploring the Web
Decision Making
Organization
Activity
Across the
Organization

BE7-8

Q7-12

E7-7
E7-8
E7-9

BE7-5
BE7-6

P7-5A
P7-5B

P7-4A
P7-4B

E7-14
P7-3A
P7-3B

P7-2A
P7-2B

Managerial Analysis
Decision Making
Across the
Organization
Ethics Case
Communication

E7-12
E7-13
E7-14

E7-10
E7-11
E7-14

E7-5
E7-6
E7-14

BE7-4

E7-14
P7-1A
P7-1B

Evaluation

E7-2
E7-3
E7-4

Synthesis

BE7-3

BE7-2

Analysis

BE7-7

E7-1

E7-1

Application

Q7-11

Q7-6
Q7-7

Q7-5

Q7-3
Q7-4

Q7-1
Q7-2

Knowledge Comprehension

*1.

Study Objective

Correlation Chart between Blooms Taxonomy, Study Objectives and End-of-Chapter Exercises and Problems

BLOOMS TAXONOMY TABLE

STUDY OBJECTIVES
1. IDENTIFY THE STEPS IN MANAGEMENTS DECISIONMAKING PROCESS.
2. DESCRIBE THE CONCEPT OF INCREMENTAL ANALYSIS.
3. IDENTIFY THE RELEVANT COSTS IN ACCEPTING AN
ORDER AT A SPECIAL PRICE.
4. IDENTIFY THE RELEVANT COSTS IN A MAKE OR BUY
DECISION.
5. IDENTIFY THE RELEVANT COSTS IN DETERMINING
WHETHER TO SELL OR PROCESS MATERIALS
FURTHER.
6. IDENTIFY THE RELEVANT COSTS TO BE CONSIDERED IN RETAINING OR REPLACING EQUIPMENT.
7. IDENTIFY THE RELEVANT COSTS IN DECIDING
WHETHER TO ELIMINATE AN UNPROFITABLE
SEGMENT.

7-4

CHAPTER REVIEW

Incremental Analysis
1.

(S.O. 1) Managements decision-making process frequently involves the following steps:


a. Identify the problem and assign responsibility.
b. Determine and evaluate possible courses of action.
c. Make a decision.
d. Review the results of the decision.
Accountings contribution to the decision-making process occurs primarily in steps (b) and (d).

2.

(S.O. 2) Business decisions involve a choice among alternative courses of action. In making such
decisions, management ordinarily considers both financial and nonfinancial information. The
process used to identify the financial data that change under alternative courses of action is called
incremental analysis.
a. Incremental analysis involves not only identifying relevant revenues and costs, but also
determining the probable effects of the decision on future earnings.
b. Data for incremental analysis involves estimates and uncertainty.
c. Gathering data may involve market analysts, engineers, and accountants.

3.

In incremental analysis, both costs and revenues may change. However, in some cases
(1) variable costs may not change under the alternative courses of action, and (2) fixed costs may
change.

Accept an Order at a Special Price


4.

(S.O. 3) An order at a special price should be accepted when the incremental revenue from the
order exceeds the incremental costs.
a. It is assumed that sales in other markets will not be affected by the special order.
b. If the units can be produced within existing plant capacity, generally only variable costs will
be affected.

Make or Buy
5.

(S.O. 4) In a make or buy decision, management must determine the costs which are different
under the two alternatives. If there is an opportunity to use the productive capacity for another
purpose, opportunity cost should be considered. Opportunity cost is the potential benefit that
may be obtained by following an alternative course of action. This cost is an additional cost of
making the component.

Sell or Process Further


6.

(S.O. 5) The basic decision rule in a sell or process further decision is: Process further as long
as the incremental revenue from such processing exceeds the incremental processing costs.
Incremental revenue is the increase in sales which results from processing the product further.

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Retain or Replace Equipment


7.

(S.O. 6) In a decision to retain or replace equipment, management compares the costs which
are affected by the two alternatives. Generally, these are variable manufacturing costs and the
cost of the new equipment.
a. The book value of the old machine is a sunk cost which does not affect the decision. A sunk
cost is a cost that cannot be changed by any present or future decision.
b. However, any trade-in allowance or cash disposal value of the existing asset must be
considered.

Eliminate an Unprofitable Segment


8.

(S.O. 7) In deciding whether to eliminate an unprofitable segment, management should


choose the alternative which results in the highest net income. Often fixed costs allocated to the
unprofitable segment must be absorbed by the other segments. It is possible, therefore, for net
income to decrease when what appears to be an unprofitable segment is eliminated.

9.

Many of the decisions involving incremental analysis also have important qualitative features.

7-6

LECTURE OUTLINE
A.

Managements Decision-Making Process.

TEACHING TIP

Use ILLUSTRATION 7-1 to discuss the management decision-making process.


Emphasize that accountants are mainly involved in developing quantitative data
that is relevant for alternative courses of action and preparing reports that
review the results of decisions.
1. The steps are:
a.

Identify the problem and assign responsibility.

b.

Determine and evaluate possible courses of action.

c.

Make a decision.

d.

Review the results of the decision.

2. Accountings contribution to the decision-making process occurs primarily


in steps (b) and (d)evaluating possible courses of action, and reviewing
results.

B.

Incremental Analysis.
1. The process used to identify the financial data that change under
alternative courses of action is called incremental analysis.
TEACHING TIP

ILLUSTRATION 7-2 presents a list of the most common types of decision


situations that utilize incremental analysis.

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2. These data are relevant to the decision because they will vary in the
future among the possible alternatives.
3. Incremental analysis sometimes involves changes that might seem
contrary to your intuition. For example, sometimes:
a.

Variable costs do not change under the alternative courses of


action.

b.

Fixed costs do change.

4. Accept an order at a special price.

TEACHING TIP

ILLUSTRATION 7-3 provides an in-class example of a decision situation involving


an order at a special price. Emphasize that if fixed costs do not change, the
special price must be greater than the unit variable cost of the product in order
for the proposal to be profitable.
Also available as teaching transparency.
a.

The relevant information is the difference between the variable


manufacturing costs to produce the special order and expected
revenues.

b.

If other sales are affected, then the company would have to consider
the lost sales in making the decision.

c.

If the company is operating at full capacity, it is likely that the special


order would be rejected.

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5. Make or buy.

TEACHING TIP

ILLUSTRATION 7-4 provides an in-class example of a make or buy decision.


Point out that if resources have alternative uses, there is an opportunity cost that
must be included in the analysis.
Also available as teaching transparencies.
a.

In a make or buy decision, the relevant costs are:


(1) The variable manufacturing costs that will be saved.
(2) The fixed manufacturing costs that can be eliminated.
(3) The purchase price.
(4) Opportunity costs: The potential benefit that may be obtained
by following an alternative course of action.

6. Sell or process further.


a.

Many manufacturers have the option of selling products at a given


point in the production cycle or continuing to process with the
expectation of selling them at a later point at a higher price.

b.

The basic decision rule is: Process further as long as the incremental revenue from such processing exceeds the incremental
processing costs.

c.

In many industries, a number of end-products are produced from a


single raw material and a common production process. These multiple
end-products are referred to as joint products.

d.

All costs incurred prior to the point at which the two products are
separately identifiable (the split-off point) are called joint costs.

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e.

Joint product costs must be allocated to individual products,


frequently done based on the relative sales value of the joint
products.

f.

The allocation of joint product costs is important for the determination


of product cost but is irrelevant for any sell-or-process-further
decisions since these joint costs are sunk costs. They have already
been incurred and cannot be avoided by any subsequent decision.

7. Retain or replace equipment.


a.

Management often has to decide whether to continue using an asset


or replace it.

b.

The relevant items to be considered are:


(1) The effects on variable costs.
(2) The cost of the new equipment.

c.

Any disposal value of the existing asset must also be considered.

d.

The book value of the old asset does not affect the decision. Book
value is a sunk cost, which is a cost that cannot be changed by any
present or future decision.

8. Eliminate an unprofitable segment.


a.

In deciding whether to eliminate an unprofitable segment, the relevant


information is the contribution margin produced by the segment and
the disposition of the segments fixed expenses.

b.

In deciding on the future status of an unprofitable segment, management should consider the effect of elimination on related segments.

c.

Management should also consider the effect of eliminating the segment on employees who may have to be discharged or retrained.

7-10

20 MINUTE QUIZ
Circle the correct answer.
True/False
1.

Determining and evaluating possible courses of action is a step in managements


decision-making process.
True

2.

In incremental analysis fixed costs may not change under alternative courses of action,
while variable costs may change.
True

3.

False

Joint product costs are relevant for any sell-or-process further decisions.
True

10.

False

In deciding on the future status of an unprofitable segment, management should consider


the effect of elimination on related product lines.
True

9.

False

Opportunity costs are costs that have already been incurred and will not be avoided by
any future decision.
True

8.

False

Fixed manufacturing costs will never be relevant in a make or buy decision.


True

7.

False

Book value is a sunk cost and is therefore relevant in incremental analysis of retain or
replace equipment.
True

6.

False

The basic decision rule to sell or process further is: process further as long as the
incremental revenue from such processing exceeds the incremental processing costs.
True

5.

False

The relevant information to consider in accepting an order at a special price are the
additional manufacturing costs incurred and expected revenues.
True

4.

False

False

Any trade-in allowance or cash disposal value of the old asset is relevant in a retain or
replace equipment decision.
True

False
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Multiple Choice
1.

Which of the following is not a step in managements decision-making process?


a. Identify the problem and assign responsibility.
b. Determine and evaluate possible courses of action.
c. Make a decision.
d. Prepare financial statements.

2.

If revenues are $315,000 under alternative A and $324,000 under alternative B, and
costs are $285,000 for A and $306,000 for B, then using the basic approach in
incremental analysis, incremental revenues, costs, and net income, in comparing B to A
are respectively
a. $9,000, $(21,000), $(12,000).
b. $(9,000), $21,000, $12,000.
c. $9,000, $21,000, $12,000.
d. $(9,000), $(21,000), $(12,000).

3.

The cost to manufacture an unfinished unit is $120 ($90 variable, $30 fixed). The selling
price per unit is $150. The company has unused productive capacity and has determined
that units could be finished and sold for $195 with an increase in variable costs of 40%.
What is the additional net income per unit to be gained by finishing the unit?
a. $9.
b. $30.
c. $45.
d. $36.

4.

The potential benefit that may be obtained from following an alternative course of action
is called
a. opportunity benefit.
b. opportunity cost.
c. relevant cost.
d. sunk cost.

5.

In a make or buy decision, the relevant costs include each of the following except the
a. variable manufacturing costs that will be saved.
b. fixed manufacturing costs that can be eliminated.
c. opportunity costs.
d. each of the above is a relevant cost.

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ANSWERS TO QUIZ
True/False
1.
2.
3.
4.
5.

True
True
True
True
False

6.
7.
8.
9.
10.

False
False
True
False
True

Multiple Choice
1.
2.
3.
4.
5.

d.
a.
a.
b.
d.

7-13

ILLUSTRATION 7-1
MANAGEMENTS DECISION-MAKING PROCESS

Identify the problem and


assign responsibility

Determine and evaluate


possible courses of action

Review the results


of the decision

Make the decision

7-14

ILLUSTRATION 7-2
TYPES OF INCREMENTAL ANALYSIS

1.
2.
3.
4.
5.

Accept an order at a special price.


Make or buy.
Sell or process further.
Retain or replace equipment.
Eliminate an unprofitable segment.

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ILLUSTRATION 7-3
INCREMENTAL ANALYSISSPECIAL ORDER PROPOSAL
Your company produces 10,000 units which is 80% of capacity and its normal
selling price is $25/unit.
The following cost data are provided at 10,000 units:
Variable cost per unit
$16
Fixed cost per unit
4
Will you accept a special order from a foreign company for an additional
Yes
2,000 units at a price of $22/unit?
No
Those of you who said "yes," would you
Yes
accept the order at $19/unit?
No
Those of you who said "yes," would you
Yes
accept the order at $15/unit?
No

With Special Order


Without Special Order

$22
$294,000
(192,000 )
(40,000 )
$ 62,000

$19

$15

$288,000
(192,000 )
(40,000 )
$ 56,000

$280,000
(192,000 )
(40,000 )
$ 48,000

Change in revenue
Change in costs

$44,000
32,000

$38,000
32,000

$30,000
32,000

Change in net income

$12,000

$ 6,000

$ (2,000 )

Sales
Variable costs
Fixed costs
Net income

$250,000
(160,000 )
(40,000 )
$ 50,000

7-16

ILLUSTRATION 7-4
INCREMENTAL ANALYSISMAKE OR BUY

Your company manufactures a certain part. Another company will


provide this part to your company for $50.
Provide the incremental analysis given the following cost data:
Current Production
of 5,000 Units
Direct materials
Direct labor
Manufacturing overhead
Variable
Fixed

Unit Cost

$ 60,000
85,000

$12
17

40,000
90,000
$275,000

8
18
$55

Fixed costs of $55,000 will continue if the parts are purchased.


a. Would you make or buy this part?
b. The productive capacity not used if the parts are purchased may
be rented for $36,000/year. Make or buy?

7-17

ILLUSTRATION 7-4 (Continued)


INCREMENTAL ANALYSISMAKE OR BUY

Make
Direct materials

Buy

Net Income
Increase
(Decrease)

$ 60,000

$ 0

$ 60,000

Direct labor

85,000

85,000

Variable manufacturing overhead

40,000

40,000

Fixed manufacturing overhead

90,000

55,000

35,000

250,000

(250,000 )

$275,000

$305,000

$ (30,000 )

Make

Buy

Increase
(Decrease)

Total annual costs

$275,000

$305,000

$ (30,000 )

Opportunity cost

36,000

36,000

$311,000

$305,000

$ 6,000

Buy units (5,000 at $50/unit)


Total annual costs
a. "Make" and save $30,000.

Opportunity costs are additional costs added to "make" or reduction of costs


subtracted from "buy."
b. "Buy" and save $6,000.

7-18