Financial and Managerial

Accounting (MBA 521)

Chapter Five
Incremental Analysis
Instructor: Habtamu B. Abera [PhD]
The Concept of Relevant
Information
Some cost concepts
 Common costs:
 Are costs which will be identical for all alternatives.
e.g. rent or rates on a factory.
 Sunk costs:
 Also called past costs. e.g. dedicated fixed assets,
development costs already incurred.
 Committed costs:
 Is a future cash outflow that will be incurred anyway,
whatever decision is taken now. e.g. contracts already
entered into which cannot be altered.
 Which of these costs are relevant costs?
What makes information relevant to
a decision problem?
 Two/three criteria are important:
 Bearing on the future:
 The consequence of the decisions are born
in the future, not in the past.
 Different under competing alternatives
 Must involve costs or benefits that differ
among the alternatives
 Cash Flow
 Must be a cash expense/revenue.
Incremental Analysis to Common
Business Decisions
 Special Orders Decisions:
• XYZ Co. has received a one-time offer for 500 prints
at a special price of Br. 0.40 per print (Br.200).

• The regular price is Br. 0.50. should the offer be accepted

or rejected.

Sales for the week (5,000 prints at Br. 0.50) Br.2,500

Less: Variable costs, including paper, maintenance,
and etc (5,000 copies at Br. 0.20) 1,000
Total contribution margin Br. 1,500
Less: Fixed costs (supplies, plus allocated costs
of the print shop) 1,200
Operating profit for the week Br. 300
 Special Orders Decisions
Condition I: Analysis of Special Order: Idle capacity
Status
Quo: Alternative:
(Without (with
Special Special Difference
Offer) Offer) (Af – Bf)
Comparison of Totals
Sales revenue Br.2,500 Br.2,700 Br.200
Variable costs (1,000) (1,100) (100)
Total contribution Br.1,500 Br.1,600 Br.100
Fixed costs (1,200) (1,200) -0-
Operating profit Br. 300 Br. 400 Br.100

Alternative Presentation: Differential Analysis

Differential sales, 500 at Br. 0.40 Br. 200
Less: Differential costs, 500 at Br. 0.20 100
Differential operating profit (before taxes) Br. 100

The special order should be accepted

 Special Orders Decisions
Condition II: Analysis of Special Order: No Idle capacity
Status
Quo: Alternative:
(Without (with
Special Special
Offer) Offer) Difference
Comparison of Totals
Sales revenue Br.2,500 Br.2,450 Br.(50)
Less: Variable costs 1,000 1,000 -0-
Total contribution Br.1,500 Br.1,450 Br.(50)
Less: Fixed costs 1,200 1,200 -0-
Operating profit Br. 300 Br. 250 Br.(50)

Alternative Presentation: Differential Analysis

Differential sales, 500 at Br. (0.10) Br. (50)
Less: Differential costs, -0-
Differential operating profit (before taxes) Br. (50)

The special order should be rejected

 Use of Differential Analysis for Production
Decision

Understand how to apply differential analysis to production

decisions.

Decision to make goods or services

Make or buy
internally or purchase them externally

Add or drop Decision to add or drop a product

a segment line or close a business unit

Product Decision on what products or

choice services to offer (product mix)
 Make-or-Buy Decisions
XYZ company’s current costs of developing prints:

100,000
Per unit prints
Costs directly traceable:
Direct materials Br.0.05 Br. 5,000
Direct labor 0.12 12,000
Variable manufacturing overhead 0.03 3,000
Fixed manufacturing overhead 4,000
Common costs allocated to this product line 10,000
Total costs Br.34,000

This year’s expected volume is 100,000 prints, so the full cost of

processing a print is:
Br. 34,000 ÷ 100,000 = Br. 0.34
Make-or-Buy Decisions
The Co. has received an offer from an outside
developer to process any number of prints for Br. 0.25
each.

Should XYZ Co. accept this offer?

The accounting department

prepared cost analyses at volume
levels of 50,000 and 100,000 prints
per year.
Add or Drop a product/service
 Add or Drop Decisions Should the prints
segment be
dropped?
XYZ Co.
Product Line Income Statement

Total Prints Cameras Frames

Sales revenue Br.80,000 Br.10,000 Br.50,000 Br.20,000

Cost of sales (all variable) 53,000 8,000 30,000 15,000
Contribution margin Br.27,000 Br. 2,000 Br.20,000 Br. 5,000
Less fixed costs:
Rent 4,000 1,000 2,000 1,000
Salaries 5,000 1,000 2,500 1,500
Marketing and administrative* 3,000 500 1,500 1,000
Operating profit (loss) Br.15,000 Br. (500) Br.14,000 Br. 1,500

*Half of the Marketing and Administrative cost is fixed.

Product Choice Decisions
Product Choice Decisions
Constraints
Activities, resources, or policies that limit the
attainment of an objective are called constraints.

Contribution Margin per Unit of Scarce

Resource
Contribution margin per unit of a particular input
with limited availability.
Product Choice Decisions
XYZ Co
Revenue and Cost Information
Metal Wood
frames frames
Price
Less: Variable costs per unit Br.50 Br.80
Material 8 22
Labor 8 24
Overhead 4 4
Contribution margin per unit Br.30 Br.30
Fixed costs
Manufacturing Br.3,000
Marketing and administrative 1,500
Total Br.4,500
Product Choice Decisions
XYZ Co.
Revenue and Cost Information
Metal Wood
frames frames

Per unit:
Contribution margin Br. 30 Br. 30
Machine hours required ÷ 0.5 ÷ 1.0
Contribution margin per machine hour Br. 60 Br. 30

Metal Frames have a higher contribution margin

per machine hour.
Product Choice Decisions
Suppose XYZ Co. has 200 machine hours per
month available.
Metal Wood
frames frames
Capacity 400 200
Contribution margin per unit × Br.30 × Br.30
Total contribution margin Br.12,000 Br.6,000
Less: Fixed manufacturing costs 3,000 3,000
Less: Fixed marketing and admin. costs 1,500 1,500
Operating profit Br. 7,500 Br.1,500

Selling metal frames will result in higher profits than

selling wooden frames.
Joint Product Decisions
 Joint Product Decisions
Two or more products produced from a
common input are called joint products.

Product A
Joint costs are
the costs of
Joint Costs Product B processing prior to
the split-off point.

Product C
The split-off point is the point in a process where
joint products can be recognized as separate products.
Joint Product Decisions
Firms 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
 Joint Product Decisions
Addis Mfg Co. produces two products, X and Y, from this process.

Further Final
OIL X Revenue
Revenue
Br.
Br.80,000
80,000 Processing Sale
Br. 50,000 Br.120,000

Joint Common
Cost Joint
Production
Br. 120,000 Product
Process

CHEMICALS Y Revenue Further Final

Br. 70,000 Processing Sale
Br. 40,000 Br.115,000
Split-Off
Point

Should the products be sold at split-off or processed further?

 Joint Product Decisions
Incremental Incremental
Product Revenue Cost Difference
X Br. 40,000 Br. 50,000 Br.(10,000)
Y 45,000 40,000 5,000

Product X incremental revenue = Br. 120,000 - 80,000

Product Y incremental revenue = Br. 115,000 - 70,000

Decision:
Process product Y, but sell product X at the split-off point.
Note that the Br.120,000 joint cost is irrelevant to the
processing decision.
Joint Product Decisions
Joint costs are not relevant
• ainproduct
decisions regarding
after the split-off what
point. to do with
• 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.
End of Chapter VII

• Wish You Good

Work and Luck!!
Financial and Managerial
Accounting (MBA 521)

End of Chapter Five