Incremental Analysis

Chapter 21

McGraw-Hill/Irwin

Copyright © 2010 by The McGraw-Hill Companies, Inc. All

The Challenge of Changing 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 order decisions

Product mix decisions

Make or buy decisions

Joint product decisions
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Decision Making
Decision making involves these five steps:

 Define the problem.  Identify the alternatives.  Collect information on alternatives.  Eliminate irrelevant information.  Make a decision with the
remaining relevant information.

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Relevant Information in Business Decisions
Information that varies among the possible courses of action being considered. ― Incremental costs and revenues ―
Important cost concepts for business decisions
 Opportunity  Sunk

2

1

costs

costs  Out-of-pocket costs

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Opportunity 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.
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Sunk Costs Versus Out-of-Pocket Costs
All costs incurred in the past that cannot be changed All costs incurred in the past that cannot be changed by any decision made now or in the future. by any decision made now or in the future. Sunk costs should not be considered in decisions. Sunk costs should not be considered in decisions. Example: You bought an automobile that cost $10,000 Example: You bought an automobile that cost $10,000 two years ago. The $10,000 cost is sunk because two years ago. The $10,000 cost is sunk because whether you drive it, park it, trade it, or sell it, you whether you drive it, park it, trade it, or sell it, you cannot change the $10,000 cost. cannot change the $10,000 cost.

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Sunk Costs Versus Out-of-Pocket Costs

Cost = $10,000 two years ago

Trade ?

Cost = $25,000 today

The dealer will trade for $20,000 plus your car. The dealer will trade for $20,000 plus your car. What amount is relevant to your decision, What amount is relevant to your decision, the $10,000 sunk cost of your car or the the $10,000 sunk cost of your car or the $20,000 out-of-pocket cash differential? $20,000 out-of-pocket cash differential?
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Special Order 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.
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Make or Buy Decisions
Should I continue to make the part, or should I buy it? I suppose I should compare the outside purchase price with the additional costs to manufacture the part. What will I do with my idle facilities if I buy the part?

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Make or Buy 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.

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Sell, Scrap, or Rebuild 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.

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

Product 1
Joint costs are the costs of processing prior to the split-off point.

Joint Costs

Product 2 Product 3

The split-off point is the point in a process where The split-off point is the point in a process where joint products can be recognized as separate products. joint products can be recognized as separate products.
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Joint Product 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.

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Joint Product 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. 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.
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Nonfinancial Considerations
Leg al issu es Reputa tion Environm ental impacts

Distinguishing fact from opinion Ethical implicat ions

It would be irresponsible for me to base my decision entirely on revenue and cost figures.
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End of Chapter 21

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