#1 - 19th Edition - Modified Chapter 21

Chapter 21
Incremental
Analysis
Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
The Challenge of Changing Markets
 Short-run business decisions are inherently different
from future-oriented, long-run strategic plans.
◦ Short-run decisions are made with a fixed set of
resources and must meet the demands of the
current marketplace.
◦ There is no time to create demand or acquire a
significantly different resource base.
 Costs identified as important for a particular
business decision are called relevant costs.
21-2
Specific Decisions
 Good judgment about relevant information occurs
by looking through the lens of the particular
decision under consideration.
 Specific decisions to be examined in this chapter
include:
1. Special Order decisions
2. Product Mix decisions
3. Make or Buy decisions
4. Production Constraints
5. Sell, Scrap, or Rebuild
6. Dropping Segments
21-3
Relevant Financial Information
21-4
Concept of Relevant Cost Information
 Kevin Anderson is a sophomore at the University of Minnesota in
Minneapolis.
 Following the most brutal winter ever recorded in the state’s
history, Anderson is faced with an extremely important decision:
Should he drive to Miami for spring break, or should he fly?
◦ If he drives, he will leave on Saturday, stay in a roadside motel
Saturday night, and arrive in Miami late Sunday evening,
allowing him to enjoy five full days in Miami (Monday through
Friday).
◦ However, he would have to leave the following Saturday, and
spend another Saturday night in a motel, to arrive back in
Minneapolis late Sunday evening.
◦ If he flies, he will simply leave on Saturday morning and arrive
in Miami late that night, allowing him to relax on the beach for
seven full days before having to fly back to Minnesota Sunday.
21-5
Identifying Relevant Information
21-6
Analyze the Information and Make a
Decision
Let’s help Kevin analyze this information and make a
decision regarding his vacation plans.
 If he decides to drive to Florida, he must stay a total of
eight nights in a motel (two nights on the interstate and
six nights in Miami).
 If he decides to fly, he must also stay eight nights in a
motel (from Saturday through Saturday in Miami).
 Thus, if we assume that the cost of a room in Miami
does not differ significantly from the cost of a room
along the interstate, motel charges are not relevant in
deciding between driving or flying.
21-7
Decision (cont. 1)
 The same logic applies to the dog sitting cost and
the cost of Kevin’s meals. Regardless of how Kevin
gets to Miami, he will be away from Minneapolis a
total of nine days and eight nights. Thus the dog
will require the same amount of care, and Kevin’s
total food costs will be about the same, whether he
drives or flies.
 Therefore, the costs associated with dog sitting and
meals are not relevant in deciding between driving
or flying.
21-8
Decision (cont. 2)
How about the $800 Kevin spent for car
insurance? This cost has already been incurred
and will not be affected by whether Kevin drives
or flies.
Such past costs, which cannot be affected by
future decisions, are termed sunk costs.
Sunk costs are not relevant to making decisions
about the future.
21-9
Decision (concluded)
 In financial terms, Kevin’s decision can be made by
comparing the $300 he would spend for gasoline if he drives
to the $500 he would spend for a round-trip airline ticket and
taxi if he flies.
 Thus we may be tempted to tell him to drive and save $200.
 However, there are other nonfinancial factors Kevin may
wish to consider.
◦ How much does he value the two extra days he can spend on the
beach if he flies?
◦ What physical condition will he be in if he decides to drive?
◦ How much wear-and-tear must his car endure if he drives?
◦ Might his car break down and spoil his plans?
◦ Which mode of transportation is the safest?
21-10
Relevant Information in Business
Decisions
 Identifying all of the information relevant to a
particular business decision is a challenging task,
because relevance is a broad concept.
 The process requires the following:
◦ An understanding of quantitative and qualitative

information.
◦ A grasp of legal issues.
◦ Sensitivity to ethical concerns.
◦ An ability to discern fact from opinion.
21-11
Illustration: Relevant Costs
Assume that Redstar Ketchup Company is closed for a
labor strike. During the strike, Redstar is incurring costs of
approximately $15,000 per week for utilities, interest, and
salaries of nonstriking employees. A major film company
has offered to rent the ketchup factory for a week at a price
of $10,000 to shoot several scenes of a new superhero
action movie. If the factory is rented, Redstar’s
management estimates that its cleanup costs will amount
to nearly $2,000. Solely on the basis of this information,
would it be profitable to rent the ketchup factory to the
film company?
21-12
Illustration: Relevant Costs (cont. 1)
If the factory is rented, Redstar’s profitability for the week
may be measured as follows.
 Does an anticipated operating loss of $7,000 mean that

Redstar should refuse the film company’s offer?
 A closer examination reveals that not all of the
information in this income statement is relevant to this
particular decision.
21-13
Illustration: Relevant Costs (cont. 2)
 The $15,000 in weekly factory expenses will
continue whether or not the factory is rented to the
film company.
 Thus the relevant factors in this decision are the
differences in the costs incurred and the revenue
earned under the alternative courses of action
(renting or not renting).
 These differences are referred to often as
incremental (or differential) costs and revenues.
21-14
Illustration: Relevant Costs (concluded)
 Our analysis shows that accepting the film company’s

offer will result in $10,000 of incremental revenue but
only $2,000 in incremental costs.
 Thus renting the ketchup factory to the film company
will benefit Redstar by reducing its operating loss for
the week by $8,000.
21-15
Opportunity Costs
 An opportunity cost is the benefit that could have
been obtained by pursuing an alternative course of
action.
◦ For example, assume that you pass up a summer
job that pays $4,000 and instead attend summer
school. The $4,000 may be viewed as an
opportunity cost of attending summer school.
 Although opportunity costs are not recorded in a
company’s accounting records, they are important
factors to consider in many business decisions.
21-16
Sunk Costs vs. Out-of-Pocket Costs
 A sunk cost is one that has already been incurred
and cannot be changed by future actions.
 An out-of-pocket cost describes a cost that has not
yet been incurred and that may vary among the
possible courses of action.
KEY POINT
The only costs relevant to a decision are those that vary

among the courses of action being considered. Sunk costs
are not relevant because they cannot be changed,
regardless of what decision is made.
21-17
Special Order Decisions
Assume that Par Four manufactures golf balls that it distributes
exclusively through professional golf shops in the United States.
Although the company has the capacity to manufacture two
million balls per month, its current sales volume requires that
only 800,000 units be produced. At this level of output, monthly
manufacturing costs average approximately $480,000, or $0.60
per ball as follows.
21-18
Special Order Decisions (cont. 1)
 Assume that Par Four receives a special order from NGC,
a company that sells golf products in Japan, for 500,000
“special label” golf balls per month.
 The balls would be imprinted with the NGC name and logo
and would not in any way be identified with Par Four.
 To avoid direct competition with Par Four’s regular
customers, NGC has agreed not to sell these balls outside
of Japan.
 However, it is willing to pay Par Four only $250,000 per
month for the special order, which amounts to $0.50 per
ball.
 Would it be profitable for Par Four to accept this order?
21-19
 At first glance, the order appears to be unprofitable.
 Not only is NGC’s offer of $0.50 per ball much less
than the regular sales price of $1.25, it is even less
than Par Four’s $0.60 per-unit manufacturing cost.
 However, before we decide to reject NGC’s order, let
us first perform an incremental analysis of the costs
and revenue relevant to this decision.
21-20
21-21
Special Order Decisions (concluded)
 The relevant factors in this type of decision are the
incremental (additional) revenue that will be earned
and the incremental costs that will be incurred by
accepting the order.
 Only the additional variable costs of $0.20 per unit
are relevant to this decision, because the fixed costs
remain $320,000 regardless of whether the order is
accepted or not.
 The special order should increase operating
income by $150,000 per month (500,000 balls ×
$0.30 per unit).
21-22
Production Constraint Decisions
Assume that Fran’s Studio creates three products: (1)
watercolor paintings, (2) oil paintings, and (3) custom
frames. Total output, however, is limited to what can be
produced in 6,000 hours of direct labor. The contribution
margin per direct labor hour required to complete each of
the studio’s products is as follows.
21-23
Production Constraint Decisions (cont. 1)
 Notice that oil paintings generate the highest
contribution margin on a per-unit basis ($100).
 However, watercolors are the studio’s most
profitable product in terms of their contribution
margin per direct labor hour.
 In general, when capacity is constrained by the
limited availability of a particular input, a company
should attempt to maximize its contribution margin
per unit of that input.
21-24
Production Constraint Decisions (cont. 2)
The table below shows the total contribution margin Fran’s
Studio would earn if it used all 6,000 of its annual labor
hours to create a single product line. The studio can
maximize its total contribution margin and, therefore, its
operating income, by creating only watercolor paintings.
21-25
Production Constraint Decisions
(concluded)
 In most cases, however, a company cannot simply
manufacture the single product that is most profitable.
 For example, the demand for watercolors may not be
sufficient to allow Fran’s Studio to sell all of the
watercolor paintings it is capable of producing.
◦ In this case, operating income would be maximized by
creating oil paintings once the demand for watercolors
is satisfied.
◦ If the demand for oil paintings is also met, any
remaining direct labor hours would be devoted to
producing custom frames.
21-26
Use of Limited Resources
Wilson Sports produces two models of baseball bats using
white ash wood. Due to weather problems, wood supply is
limited and Wilson is able to obtain only 24,000 board feet
of white ash. Which bat should Wilson produce given the
following information?
Deluxe Basic
Bats Bats
Unit selling price $75 $54
Unit variable costs 34 25
Unit contribution margin $41 $29
Number of board feet of wood needed per
bat 3.40 2.20
continued
21-27
Use of Limited Resources
Determine the contribution margin per board foot fo
each product:
Deluxe Basic
Bats Bats
Unit contribution margin $41 $29
Number of board feet of wood needed per bat 3.40 2.20

Contribution margin per board foot:
$41 ÷ 3.40 = $12.06
$29 ÷ 2.20 = $13.18
Deluxe bats generate $12.06 of profit for

every board foot of white ash wood used,
while basic bats generate $13.18. Basic bats
should be produced.
21-28
Outsourcing
Outsourcing is the procurement of services,
products, components from an external source
Reasons for Outsourcing
21-29
Make or Buy Decisions
 In many manufacturing operations, a company must
decide whether to produce a certain part required in
the assembly of its finished products or to buy the
part from outside suppliers.
 If the company is currently producing a part that
could be purchased at a lower cost from outsiders,
profits may be increased by a decision to buy the
part and utilize the company’s own manufacturing
resources for other purposes.
21-30
Make or Buy Decisions (cont. 1)
If a company can buy for $5 per unit a part that costs the
company $6 per unit to produce, the choice seems to be clearly
in favor of buying. But the astute reader will quickly raise the
question, “What is included in the cost of $6 per unit?” Assume
that the $6 unit cost of producing a normal required volume of
10,000 units per month was determined as follows.
21-31
Make or Buy Decisions (cont. 2)
Assume that a review of operations indicates that if the production of
this part were discontinued, all of the cost of direct materials and
direct labor plus $9,000 of variable overhead would be eliminated. In
addition, $2,500 of the fixed overhead would be eliminated. These,
then, are the relevant costs in producing the 10,000 units of the
component part.
21-32
Make or Buy Decisions (concluded)
 Our analysis shows that making the part will cost $60,000
per month, while buying the part will cost $78,000.
 Thus the company will save $18,000 per month by
continuing to make the part.
KEY POINT
In addition to evaluating the opportunity costs associated with a
make or buy decision, managers must evaluate other important
concerns that are nonfinancial in nature including:
• Product quality
• Production scheduling and flexibility
• Product availability
• Supplier relationships
21-33
Example 2: Make or Buy
A manufacturer has offered to supply KonnectCo with all the
flash drives it needs for one year at a cost of €9 each. If
accepted, KonnectCo could eliminate production supervisor
salaries that currently cost $1,000 per month. Normal
production is 4,200 units each month. Should KonnectCo
outsource?
Variable Costs per Unit
KonnectCo’s Direct materials
Costs
€3
Direct labor
Fixed Costs per Month 4
Manufacturing overhead Manufacturing overhead
continued
€20,000 21-34
There are no relevant revenues in outsourcing decisions.
Cost to buy (€9 × 4,200 × 12 months) €453,600

Cost to make:
Direct materials (€3 × 4,200 × 12) €151,200
Direct labor (€4 × 4,200 × 12) 201,600
Variable manufacturing overhead
(€2 × 4,200 × 12) 100,800
Fixed manufacturing overhead .

(€1,000 × 12) 12,000 .
Total €465,600 €453,600
Advantage of buying € 12,000
KonnectCo should consider outsourcing as profits will be
higher by $12,000.
21-35
If the space currently used to manufacture can be rented
for €15,000 per year, what should KonnectCo do?
Cost to buy (€9 × 4,200 × 12 months) €453,600

Cost to make:
Direct materials (€3 × 4,200 × 12) € 151,200
Direct labor (€4 × 4,200 × 12) 201,600
Variable manufacturing overhead (€2 × 4,200 × 12) 100,800
Fixed manufacturing overhead (€1,000 × 12) 12,000
Opportunity cost of lost rental income if manufactured 15,000 0
Total € 480,600 €453,600
Advantage of buying € 27,000
KonnectCo should consider outsourcing to increase

profits by $27,000.
21-36
Sell, Scrap, or Rebuild Decisions
Assume that Computex, Inc., has in its inventory 500 laptop
computers that cost $325,000 to produce. Unfortunately, their
processors are technologically obsolete. Consequently
management must decide what to do with these machines. It
is considering the following options.
1. Sell the laptop computers “as is” to Television Shopping
Network (TSN) for $250,000.
2. Sell them for $235,000 to surrounding school districts for
use in their computer labs.
3. Scrap the existing processor in each machine and replace it
with faster, state-of-the-art equipment at a total cost of
$190,000. If this option is selected, the rebuilt laptops could
be sold for $450,000.
21-37
Sell, Scrap, or Rebuild Decisions (cont. 1)
 Regardless of which option Computex chooses, the
$325,000 originally incurred to manufacture these
laptops is a sunk cost and is therefore irrelevant to the
decision at hand.
 The only relevant costs and revenue are those that vary
among the alternatives under consideration.
21-38
Sell, Scrap, or Rebuild Decisions
(concluded)
 Notice that no matter which option Computex selects, it will not
be able to fully recover the $325,000 that it already has invested
in these laptop computers.
 Rebuilding the computers with state-of-the-art equipment
appears to be the company’s most profitable course of action.
 However, management may wish to consider several other
factors.
◦ If rebuilding these laptops interferes with the production of other
products, then the company may want to sell these computers to
TSN and use its production facilities to manufacture other
products.
◦ There may be a long-term advantage in selling the laptops to
schools, as the students and their parents may become customers
of Computex products.
21-39
Adding/Dropping Segments
One
One of
of the
the most
most important
decisions
decisions managers
managers make
make isis
whether
whether toto add or drop a
business
business segment.
segment.
Ultimately,
Ultimately, a decision to drop an
old
old segment
segment oror add
add aa new
new one is
going
going to
to hinge primarily
primarily onon the
the
impact
impact the
the decision
decision will
will have
have on
on To
To assess
assess this
this impact,
impact, itit is
is
net
net operating
operating income.
income. necessary
necessary to
to carefully
carefully analyze
analyze
the
the costs.
costs.
21-40
Due to the declining popularity of digital watches,

Lovell Company’s digital watch line has not
reported a profit for several years. Lovell is
considering discontinuing this product line.
21-41
A Contribution Margin Approach
DECISION RULE
Lovell
Lovell should
should drop
drop the
the digital
digital watch
watch segment
segment only
only ifif its
its
profit
profit would
would increase.
increase.
Lovell
Lovell will
will compare
compare the
the contribution
contribution margin
margin that
that would
would
be
be lost
lost to
to the
the costs
costs that
that would
would be
be avoided
avoided ifif the
the line
line
was
was to
to be
be dropped.
dropped.
21-42
Segment Income Statement

Digital Watches
Sales $ 500,000
Less: variable expenses
Variable manufacturing costs $ 120,000
Variable shipping costs 5,000
Commissions 75,000 200,000
Contribution margin $ 300,000
Less: fixed expenses
General factory overhead $ 60,000
Salary of line manager 90,000
Depreciation of equipment 50,000
Advertising - direct 100,000
Rent - factory space 70,000
General admin. expenses 30,000 400,000
Net operating loss $ (100,000)
21-43
An
An investigation
investigation has
has revealed
revealed that that the
the fixed
fixed general
general factory
factory
overhead
overhead andand fixed
fixed general
general
administrative
administrative expenses
expenses willwill not
not bebe affected
affected by
by dropping
dropping the
the
digital
digital watch
watch line.
line. The
The fixed
fixed general
general factory
factory overhead
overhead andand
general
general administrative
administrative expenses
expenses assigned
assigned to to this
this product
product
would
would be
be reallocated
reallocated to to other
other product
product lines.
lines.
The equipment used to manufacture digital

watches has no resale value or alternative use.
21-44
A Contribution Margin Approach
Contribution Margin
Solution
Contribution margin lost if digital
watches are dropped $ (300,000)
Less fixed costs that can be avoided
Salary of the line manager $ 90,000
Advertising - direct 100,000
Rent - factory space 70,000 260,000
Net disadvantage $ (40,000)
RRe
ettaai
inn
21-45
End of Chapter 21
21-46

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Chapter 21

◦ An understanding of quantitative and qualitative

 Does an anticipated operating loss of $7,000 mean that

 Our analysis shows that accepting the film company’s

The only costs relevant to a decision are those that vary

Number of board feet of wood needed per bat 3.40 2.20

Deluxe bats generate $12.06 of profit for

Reasons for Outsourcing

Cost to buy (€9 × 4,200 × 12 months) €453,600

Fixed manufacturing overhead .

Cost to buy (€9 × 4,200 × 12 months) €453,600

KonnectCo should consider outsourcing to increase

Due to the declining popularity of digital watches,

Segment Income Statement

The equipment used to manufacture digital

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