Global Financial and

Managerial Accounting
Chapter 8
Incremental Analysis-
Relevant Costs for Decision
Making
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Contents
INTRODUCTION
-1 The Challenge of changing markets
-2 The concept of relevant information
-3 Incremental Analysis in common business decisions
-Special order decisions
-Make-or-buy decisions
-Add or Drop decision
-Production constraint decision
-Joint product decisions

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Introduction
Use differential analysis to analyze decisions.

Differential Analysis
The process of estimating revenues and costs
of alternative actions available to decision makers
and of comparing these estimates to the status quo

Short Run
The period of time over which capacity will be
unchanged, usually one year

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Differential Costs

Are costs that change in response to an alternative

course of action

Differential costs differ between actions.

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Differential Costs versus Total Costs

Information presented to management can show

the detailed costs that are included for making a
decision, or it can show just the differences
between alternatives, as follows.

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Sunk Costs
Costs incurred in the past that cannot be
changed by present or future decisions

A sunk cost is NOT relevant for making decisions.

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The Challenge of Changing
Markets

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 Product markets can change quickly due to
competitor price cuts, changing customers
preferences, and introduction of new products by
competitors.
 Managers must make short-run decisions with
fixed set of resources, to react to the changing
market place.

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The Concept of Relevant
Information

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Some cost concepts

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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.

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Incremental Analysis to Common
Business Decisions

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Short-Run Vs Long-Run Pricing Decisions

Year 0 Year 1

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 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
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Special Orders Decisions
Condition I: Analysis of Special Order: Idle capacity

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The special order should be accepted
 Special Orders Decisions
Condition II: Analysis of Special Order: No Idle capacity

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The special order should be rejected
 Use of Differential Analysis for
Production Decision
Understand how to apply differential analysis to production
decisions.

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Make-or-Buy Decisions
XYZ company’s current costs of developing prints:

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
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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.

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 Condition I
Make-or-Buy Decisions 100,000
prints

a
100,000 units purchased at Br.0.25 = Br.25,000
b
These common costs remain unchanged for these volumes.
Because they do not change, they could be omitted from the analysis.

Differential costs increase by Br.1,000, so reject

alternative to buy.
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 Condition II
Make-or-Buy Decisions 50,000
prints

a
50,000 units purchased at Br.0.25 = Br.12,500
b
These common costs remain unchanged for these volumes.
Because they do not change, they could be omitted from the analysis.

Differential costs decrease by Br.1,500, so accept

alternative to buy.

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Add or Drop a product/service

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Add or Drop Decisions
XYZ Co.
Product Line Income Statement

*Half of the Marketing and Administrative cost is fixed. 23

Add or Drop Decisions
XYZ Co.
Differential Analysis

Profits decrease Br.750, so keep prints.

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Product Choice Decisions

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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.

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Product Choice Decisions
XYZ Co
Revenue and Cost Information

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Product Choice Decisions
XYZ Co.
Revenue and Cost Information

Metal Frames have a higher contribution margin

per machine hour.

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Product Choice Decisions
Suppose XYZ Co. has 200 machine hours per
month available.

Selling metal frames will result in higher profits than

selling wooden frames.
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Joint Product Decisions

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 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.
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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

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 Joint Product Decisions
Addis Mfg Co. produces two products, X and Y, from this process.

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

Joint Common
Cost Production
Br. 120,000
Process

Y Revenue Further
Processing
Final
Sale
Br. 70,000
Br. 40,000 Br.115,000
Split-Off
Point

Should the products be sold at split-off or processed further?33

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.
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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.
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Joint Product Decisions
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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 End of Chapter 8

Wish You Good Work

and Luck!!

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