INCREMENTAL ANALYSIS

Stark Ltd. prepares complete party kits for various types of celebrations. It is currently
operating at 75% of its capacity. Operating income of Stark Ltd. Is $4.50 to make a packet that
it sells for $25.00. It currently makes and sells 84,000 packets per year. Detailed information
follows:

Particulars Per Unit Annual Total

Sales $ 25.00 $ 21,00,000
Direct Material $ 12.00 $ 10,08,000
Direct Labour $ 6.00 $ 5,04,000
Overhead $ 0.50 $ 42,000
Selling Expenses $ 1.75 $ 1,47,000
Administrative Expenses $ 0.25 $ 21,000
Total Costs and Expenses $ 20.50 $ 17,22,000
Operating Income $ 4.50 $ 3,78,000

The Stark Ltd. has received a special order request for 15,000 packets at a price of $20 per
packet to be shipped overseas. This transaction would not affect the company's current
business. If 84,000 packets is 75% of capacity, 112,000 packets would be 100% of capacity.
The Stark Ltd. has the capacity to prepare the 15,000 packets requested without changing its
existing operations. Should the Stark Ltd. accept this special order? The answer would be no
using its current cost information because accepting the order would generate a $7,500 loss.

Particulars Per Unit Annual Total

Sales $ 20.00 $ 3,00,000
Direct Material $ 12.00 $ 1,80,000
Direct Labour $ 6.00 $ 90,000
Overhead $ 0.50 $ 7,500
Selling Expenses $ 1.75 $ 26,250
Administrative Expenses $ 0.25 $ 3,750
Total Costs and Expenses $ 20.50 $ 3,07,500
Operating Income $ -0.50 $ -7,500.00

However, this is not the proper way to analyze the alternative. Incremental analysis, which
identifies only those revenues and costs that change if the order were accepted, should be used
to analyze the alternative. This requires a review of the costs. Suppose the following
information is discovered with further analysis:

• Accepting this order would not impact current sales.

• To manufacture 15,000 packets would require $12.00 of direct materials and $6.00 of
direct labour.
• The per unit overhead cost of $0.50 is 50% variable ($0.25) and 50% fixed ($0.25).
 • Selling costs {includes commissions($1/packet) and delivery
costs($0.75/packet)} for the 15,000 packets, since it did not require and
selling effort by any employee only the delivery cost would be incurred.
• Administrative expenses would not change.

Particulars Per Unit Annual Total

Sales $ 20.00 $ 3,00,000
Direct Material $ 12.00 $ 1,80,000
Direct Labour $ 6.00 $ 90,000
Overhead $ 0.25 $ 3,750
Selling Expenses $ 0.75 $ 11,250
Administrative Expenses - -
Total Costs and Expenses $ 19.00 $ 2,85,000
Operating Income $ 1.00 $ 15,000

Under this scenario, $300,000 of additional revenues would be created with additional costs of
$285,000, so operating income would increase by $15,000 if the order were accepted. Given
the available capacity, this opportunity would not result in additional costs to expand capacity.
If the current capacity were unable to handle the special request, any new costs for expanding
capacity would be included in the analysis. Also, if current sales were impacted by this order,
then the lost contribution margin would be considered an opportunity cost for this alternative.
With an additional operating income of $15,000, this order could be accepted.
 MULTI PRODUCT ANALYSIS
ABC Ltd for an example of a multi-product break-even analysis. West Brothers manufactures
and sells 3 types of house siding: restoration vinyl, architectural vinyl, and builder grade vinyl,
each with its own sales price, variable cost, and contribution margin.

The sales mix for ABC Ltd is 5 ft2 of builder grade to 3 ft2 of architectural grade to 2 ft2 of
restoration grade vinyl (a ratio of 5:3:2).

ABC Ltd fixed costs are $145,000 per year.

Calculate what will be the contribution margin?

Calculate what will be the break-even point?
 CONTRIBUTION MARGIN
The selling price and the variable cost per composite unit is given as follows: -
Selling price

Variable Cost

Contribution Margin is obtained by:

• Selling Price – Variable Cost

• $73 - $42.25 = $30.75

 • This measure determines how much of each sale contributes to covering fixed costs and
ultimately to profit of the business

• It gives business owners a way of assessing how various sales levels will affect
profitability.

BEAK EVEN POINT

In multi-product analysis, breakeven is the point where the total revenue from selling all the
products is equal to the total cost of producing and selling all the products. In other words, it is
the point where a company is not making a profit or a loss.
To calculate the breakeven point in multi-product analysis, you need to consider the sales mix,
which is the proportion of each product sold. Here are the steps to calculate the breakeven
point:

• Determine the contribution margin for each product, which is the difference between
the selling price and the variable cost per unit.
• Calculate the weighted average contribution margin by multiplying the contribution
margin of each product by its sales mix and adding up the results.
• Calculate the fixed costs, which are the costs that do not vary with the level of
production.
• Divide the fixed costs by the weighted average contribution margin to get the breakeven
point in units.
• Multiply the breakeven point in units by the selling price to get the breakeven point in
dollars.

Once we have calculated the breakeven point, we can use it as a reference to make decisions
about pricing, production, and sales strategies. If the actual sales volume is below the breakeven
point, the company is operating at a loss, and it may need to adjust its prices or reduce its costs.
If the actual sales volume is above the breakeven point, the company is making a profit, and it
may consider expanding its production or increasing its marketing efforts.
In the case of ABC Ltd., we have already calculated the contribution margin which is $ 30.75
and we have the Total fixed costs at $ 145,000 and SP of $73
To get the break-even point we’ll divide the Total Fixed costs by the contribution margin per
unit, i.e., Break Even Point = Total Fixed costs/ Contribution Margin per unit
Break-Even Point = 45,000 ÷ $30.75
= 4,715.45 ≈ 4,715.45 units
The break-even point is the point at which no profit or loss occurs because Total Cost = Total
Revenue.
In this case, ABC Ltd. will break even when it sells 4,715 composite units.
Using the Break Even point we can calculate how many of each product ABC Ltd. should sell
by applying the sales mix ratio of 5:3:2 to the break-even quantity. Th break-even point would
change if the sales mix ratio were to change so it is directly proportional to the sales mix ratio.