Cost and management accounting-I

CHAPTER FIVE

INCREMENTAL ANALYSIS

Cost classification for Decision making:

Business decisions involve choosing between alternative courses of actions. Each alternative will
have certain costs and benefits that must be compared to the costs and benefits of other available
alternatives. Managerial accountant often classify costs that are useful in decision making what
cost information is relevant to the decisions. Hence, we see such cost classification for decision
making, here under.

1. Differential cost:
2. Incremental cost
3. Opportunity cost
4. Relevant and Irrelevant costs
5. Avoidable and Un-avoidable costs

Differential cost:

Differential cost may be defined as the increase or decrease in total cost that result from any
variations in operations. In simple words it is the difference between total costs of two
alternatives.

Differential cost is determined for the purpose of:

a) Choosing between two methods of production or distribution

b) Choosing between make or buy decisions etc.

Incremental cost:

Differential cost in often called as Incremental cost. However, from conceptual point of view,
differential cost refers to both incremental cost as well as decrement cost.

Incremental cost refers to increase in costs and benefits of any two alternatives.

Opportunity costs:

An opportunity cost is the benefit that could have been obtained by pursuing an alternative
course of action. In other words, it is the benefit that is given up or forgone when one alternative
is selected over the alternative. Managers must take opportunity costs into account while taking
decisions, although these are not recorded in accounting records.

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Relevant and Irrelevant costs:

To be relevant, costs and benefits must differ between the alternatives under consideration. That
is, relevant costs and benefits make a difference between alternatives. Conversely, costs and
benefits that are the same across all the available alternatives are irrelevant and have no bearing
on a decision.

To sum up, it can be said, “Only those predicted future costs and benefits that differ in total
among the alternatives under evaluation are relevant in a decision making”. If costs and benefits
will be the same regardless of the alternative selected, then the decision has no effect on such
costs or benefits and, therefore, they can be safely ignored or eliminated from the analysis, as
they are irrelevant.

Avoidable and Un-avoidable costs:

Avoidable costs:

Avoidable costs are those costs that can be eliminated in whole or in part by choosing one
alternative over another. Avoidable costs are frequently called relevant costs as they represent
future costs that differ among alternatives.

Unavoidable costs:

Costs that do not differ between alternatives are not avoidable and, therefore, are not relevant in
making decisions. These are costs that would continue to be incurred no matter which alternative
is selected and, therefore, are irrelevant in decision-making situation. The committed fixed costs
and allocated common costs are examples of unavoidable costs. In brief, costs that would be
incurred whether or not a decision is made are unavoidable costs.

Note: Avoidable costs, relevant costs, incremental costs and differential costs are often used
interchangeably.

Analysis of special decisions:

The following special decisions will covered in this unit.

1. Choosing between two alternatives

2. Make or Buy decisions
3. Special order decisions
4. Product Mix decisions

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I. Choosing between two alternatives:

1. Alex Trading Enterprises is thinking about changing its marketing method from its present
distribution through retailers to a proposed distribution by door-to-door direct sale.

Present distribution and proposed distribution costs and benefits are as follows:

Retailer Distribution Direct sale

(Present) (Proposed)
Sales Revenue 1,100,000 1,350,000
Costs:
Cost of goods sold (v) 605,000 742,500
Sales commissions (v) - 67,500
Advertising (f) 126,000 76,000
Warehouse expenses (f) 79,000 135,000
Other fixed expenses (f) 95,000 95,000
Total cost 905,000 1,116,000

Should Alex Trading Enterprises change its marketing method from present distribution method
to proposed distribution method?

Solution:

Present Proposed Differential costs and

Revenues
Sales Revenue 1,100,000 1,350,000 250,000
Less: Costs:
Cost of goods sold (v) 605,000 742,500 137,500
Sales commissions (v) 67,500 67,500
Advertising (f) 126,000 76,000 (50,000)
Warehouse exp. (f) 79,000 135,000 56,000
Other fixed exp. 95,000 95,000
Total costs 905,000 1,116,000 211,000
Net Income 195,000 234,000 39,000

Decision:

 Since proposed distribution method is having more Net Income than present distribution
method, proposed method in preferred.
OR
 Under the proposed marketing plan, differential revenue is 250,000 and differential cost
total is 211,000 resulting in differential net income of 39,000. Hence proposed
distribution method is preferred to present method.
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2. Ethiopian Airlines presently is running a Non-stop flight between Addis to Nigeria route. The
manager of Ethiopian Airlines is considering a stop in Gambia, so that the route would attract
additional passengers if the stop is made. However, there would be some additional costs and
benefits are associated with proposed plan.

The following are the costs to benefits details of two alternatives.

Non-stop Route With stop in Gambia

Revenues: Passenger Revenue $ 300,000 $ 360,000
Cargo Revenue 100,000 110,000
Costs:
Landing fees in Gambia - 12,000
Use of airport gate facilities - 7,000
Flight crew cost 4,500 4,500
Fuel cost 18.000 25,000
Meals and services 8,000 9,000
Aircraft maintenance 2,500 2,500

Should the Ethiopian Airlines make a stop in Gambia? Advise the manager using differential
costing?

Solution:

Differential cost statement or Incremental Analysis:

Revenues: Amount in $ Amount in $

Increase in passenger revenue 60,000
Increase in Cargo revenue 10,000
Increase in Total revenue 70,000
Less: Increase in costs:
Landing fees in Gambia 12,000
Use of airport gate facilities 7,000
Fuel 7,000
Meals and services 1,000 27,000
Net benefit of stopping at Gambia 43,000

Hence, the manager is advised to a make decision of stopping flight at Gambia.

 Differential costs are interchangeably used with incremental costs, avoidable costs and
relevant costs.
 Non-relevant costs are unavoidable costs or that do not differ between two alternatives.
In the above illustration Flight crew cost and aircraft maintenance cost are irrelevant
costs since they are same ( not differing) under both the alternatives.
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II. Make or buy decisions:

 Avoidable costs < outside purchase price = Make internally

 Avoidable costs > outside purchase price = Buy from outside

1. A Television Manufacturing Company is currently producing a spare part called X007.

The cost structure to manufacture the spare part is as under.
Direct material 32 per unit
Direct wages 12 per unit
Variable overheads 5 per unit
Fixed cost 7 per unit
_________
Total cost 56 per unit
__________
The same spare part is offered by an outside seller for Br. 45 per unit with assured
supply. Should the company make or buy the spare part.

Answer:

Production cost per unit Per unit differential cost

Make Buy
Direct material 32 32 -
Direct wages 12 12 -
Variable 5 5 -
overheads
Fixed cost 7 - -
Outside supply 45
price
49 45

The company should buy the component since avoidable costs (Birr 49 per unit) are
more than outside supply price (Birr 45 per unit).

2. Tata Motors Company is an automobile manufacturing company. The company is

currently producing tyres used for its automobiles. The cost of manufacturing 60,000
tyres per annum is as follows:
Direct material 480,000
Direct labor 360,000
Variable overheads 180,000
Fixed overheads 360,000
________
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1,380,000
An outside supplier specialized in manufacturing tyres has offered to sell the same tyres
to Tata motors company for $ 25 per tyre. The entire fixed overheads will continue
unchanged if Tata motors company purchases the tyres from supplier, except $ 120,000
pertaining to supervisory and other personnel salaries which can be avoided.
a) Assuming that the capacity (space & Manufacturing facilities) currently used to make
the tyres internally will become idle if they purchase, should the company continue to
make or buy the tyres?
b) Assuming that the capacity now used to make the tyres if used to make another
product that will contribute $ 250,000 per annum, should the company continue to
make or buy the tyres?

Answer to situation “a”:

Item Productio Per unit Differential cost Total Differential costs for
n cost per 60,000 units
unit Make tyres Buy tyres Make tyres Buy tyres
Direct material 8 8 - 480,000 -
Direct labor 6 6 - 360,000 -
Variable overheads 3 3 - 180,000 -
Fixed over heads 6 2 - 120,000 -
Outside purchase price 21 1,260,000
23 19 21 1,140,000 1,260,000

Decision: Tata Motors Company should reject the outside supplier’s offer and continue to make
the tyres because it costs (21-19) $ 2 less and $ 120,000 in total (1,260,000 – 1,140,000) if tyres
are produced.

Answer to situation “b”:

Make tyres Buy tyres and

use idle capacity for another
product
Cost to make and buy tyres 1,140,000 1,260,000
Opportunity cost or
Profit contribution from another product
(250,000)
1,140,000 1,010,000

Differential cost $130,000(1,140,000 – 1,010,000) favoring purchase of tyres.

Decision: The Company should buy the tyres from outside supplier and use idle space for
producing another product. By doing so the company gets benefit of $ 130,000 per annum.
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III. Special order decisions:

A special order is a one-time order that is not considered as part of the company’s normal
ongoing business. Occasionally, a company may receive these orders but not from a company’s
customers.

When special orders are received by a company, the management must assess whether the
special order should be accepted or rejected by considering the additional benefits (revenues) and
additional costs that will be incurred by a company. Special order decisions are made by
comparing the incremental revenue and incremental costs. If

 Incremental revenue > Incremental cost = accept the order

 Incremental revenue < Incremental cost = Reject the order.

In special order decisions, consideration of plant capacity is vital. If the company is having
excess (idle) capacity, then only special orders can be accepted.

For example: A company’s manufacturing capacity per month is 15,000 units due to market
demand, the company presently producing and selling only 12,000 units per month (80%
capacity only), it means company is having 20% idle capacity.

Illustration1: Paramount Company manufactures Tennis Balls that it distributes exclusively

through professional shops in U.S.A. Although the company has the capacity to manufacture 1.5
million balls per month, its current sales require that only 800,000 units be produced. At this
level of output, the manufacturing costs are as follows:

Manufacturing costs: Amount in $

Variable costs ($0.20 per ball x 800,000) 160,000
Fixed costs 320,000
Total manufacturing cost 480,000
Selling price per ball 1.25

The company received an export order from Japan Company for 500,000 balls at $ 0.50 per ball.

Whether Paramount Company should accept or reject this order?

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Solution:

Without special With special order Incremental

Order (800,000 (800,000+500,000 Analysis
balls) )
1,300,000 balls
Sales:
Regular sales @ 1.25 per ball 1,000,000 1,000,000
Special order @ 0.50 per ball 250,000 250,000
Less: Manufacturing costs:
Variable @ 0.20 per ball (160,000) (260,000) (100,000)
Fixed manufacturing cost (320,000) (320,000)
Profit 520,000 670,000 150,000

Decision: Paramount Company should accept the special order since incremental revenue is i.e.
250,000 is more than incremental cost i.e. 100,000. By accepting the order the company gets
additional profit of $ 150,000.

Illustration 2: National Textiles is producing 50,000 units per month with a monthly production
capacity of 75,000 units per month. The cost of production per unit in Birr is as under:

Direct material 7.00

Direct wages 10.00

Variable overheads 5.00

Fixed overheads 150,000

Selling price per unit 30.00

The company received an export order for 20,000 units at price of Br. 20.00 per unit.

Advice the company whether to accept the order or not?

Solution:

Incremental revenue = 20,000 X 20 = 400,000

Incremental costs (7+10+5) = 20,000 X 22 = 440,000

_________

Loss (40,000)

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Decision: Since incremental costs are more than incremental revenue, the export order should be
rejected.

IV. Product mix decisions:

A business unit may engage in producing multiple products. A change in the product mix derives
change in profits. Product mix means the ratio in which various products are produced and sold.

The management has to take wise decisions regarding appropriate product mix by using variable
costing technique. The most profitable mix is the one which yields highest contribution.

Illustration1: Technical director of a company has submitted the following three proposals of
sales mix.

a) 100 units of product ‘X’ and 300 units of product ‘Y’

b) 300 units of product ‘X’ and 100 units of product ‘Y’
c) 200 units of product ‘X’ and 200 units of product ‘Y’

The cost structure of two products as under:

Product X Product Y

Direct material 25 22

Direct wages 7 5

Variable cost 7 5

Selling price 50 40

Fixed expenses Br. 1,000

Advice the company which sales mix is more profitable?

Solution:

1. Calculation of variable cost per unit

Product X = 25 + 7 + 7= 39
Product X = 22 + 5 + 5 = 32
2. Calculation of sales revenue of three proposals:
Proposal A = (100 x 50) + (300 x 40)
= 5,000 + 12,000 = 17,000
Proposal B = (300 x 50) + (100 x 40)
= 15,000 + 4,000 = 19,000
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Proposal C = (200 x 50) + (200 x 40)

= 10,000 + 8,000 = 18,000

3. Calculation of variable cost of three proposals:

Proposal A = (100 x 39) + (300 x 32)
= 3,900 + 9,600 = 13,500
Proposal B = (300 x 39) + (100 x 32)
= 11,700 + 3,200 = 14,900
Proposal C = (200 x 39) + (200 x 32)
= 7,800 + 6,400 = 14,200

Proposal A Proposal B Proposal C

Sales 17,000 19,000 18,000
Less: Variable cost 13,500 14,900 14,200
Contribution 3,500 4,100 3,800
Less: Fixed expenses 1,000 1,000 1,000
Profit 2,500 3,100 2,800

Decision: Since Proposal “B”( i.e. product mix of 300units of Product X and 100 units of
Product Y) is yielding more contribution or profit that product mix is preferable.

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