CH 26

26-1
CHAPTER26
Incremental
Analysis and
Capital Budgeting
26-2
PreviewofCHAPTER26
26-3
Management’s Decision-Making Process
 Important management function.

 Does not always follow a set pattern.
 Decisions vary in scope, urgency, and importance.
 Steps usually involved in process include:
Illustration 26-1
26-4 SO 1 Identify the steps in management’s decision-making process.

Considers both:
 Financial information includes revenues and costs as

well as their effect on overall profitability.
 Non-financial information includes effect on

employee turnover, the environment, or overall
company image.
26-5 SO 1 Identify the steps in management’s decision-making process.

The Incremental Analysis Approach

 Decisions involve a choice among alternative actions.
 Process used to identify the financial data that change

under alternative courses of action.
► Both costs and revenues may vary.
► Only revenues may vary.
► Only costs may vary.
26-6 SO 2 Describe the concept of incremental analysis.

How Incremental Analysis Works

Illustration 26-2
Comparison of Alternative B with Alternative A:

► Incremental revenue is $15,000 less under Alternative B.
► Incremental cost savings of $20,000 is realized.
► Alternative B produces $5,000 more net income.


Important concepts used in incremental analysis:
 Relevant cost.
 Opportunity cost.
 Sunk cost.


 Sometimes involves changes that seem contrary to
intuition.
 Variable costs sometimes do not change under

alternatives.
 Fixed costs sometimes change between alternatives.
 Incremental analysis not the same as CVP analysis.

Question
Incremental analysis is the process of identifying the
financial data that
a. Do not change under alternative courses of action.
b. Change under alternative courses of action.
c. Are mixed under alternative courses of action.
d. None of the above.

26-11
Types of Incremental Analysis
Common Types of Decisions:

1. Accept an order at a special price.
2. Make or buy.
3. Sell or process further.
4. Retain or replace equipment.
5. Eliminate an unprofitable business segment.
6. Allocate limited resources.
26-12
Accept an Order at a Special Price

 Obtain additional business by making a major price
concession to a specific customer.
 Assumes that sales of products in other markets are

not affected by special order.
 Assumes that company is not operating at full

capacity.
26-13 SO 3 Identify the relevant costs in accepting an order at a special price.


Illustration: Sunbelt Company produces 100,000 automatic
blenders per month, which is 80 percent of plant capacity. Variable
manufacturing costs are $8 per unit. Fixed manufacturing costs
are $400,000, or $4 per unit. The blenders are normally sold
directly to retailers at $20 each. Sunbelt has an offer from Mexico
Co. (a foreign wholesaler) to purchase an additional 2,000
blenders at $11 per unit. Acceptance of the offer would not affect
normal sales of the product, and the additional units can be
manufactured without increasing plant capacity. What should
management do?


Illustration 26-3
 Fixed costs do not change since within existing capacity – thus

fixed costs are not relevant.
 Variable manufacturing costs and expected revenues change –

thus both are relevant to the decision.

Make or Buy
Illustration: Baron Company incurs the following annual costs in
producing 25,000 ignition switches for motor scooters.
Illustration 26-4
Annual product
cost data
Instead of making its own switches, Baron Company might

purchase the ignition switches at a price of $8 per unit. “What
should management do?”
26-16 SO 4 Identify the relevant costs in a make-or-buy decision.
Make or Buy
Illustration 26-5
 Total manufacturing cost is $1 higher than purchase price.
 Must absorb at least $50,000 of fixed costs under either option.

Opportunity Cost
 Potential benefit that may be obtained from following
an alternative course of action.
 Foregoing make-or-buy analysis is complete only if the

productive capacity used to make the ignition switches
cannot be converted to another purpose.

Make or Buy – Opportunity Cost

Illustration: Assume that through buying the switches, Baron
Company can use the released productive capacity to generate
additional income of $28,000 from producing a different product.
This lost income is an additional cost of continuing to make the
switches in the make-or-buy decision.
Illustration 26-6

Question
In a make-or-buy decision, relevant costs are:
a. Manufacturing costs that will be saved.
b. The purchase price of the units.
c. Opportunity costs.
d. All of the above.

26-21
Sell or Process Further

 May have option to sell product at a given point in
production or to process further and sell at a higher
price.
 Decision Rule:
Process further as long as the incremental revenue

from such processing exceeds the incremental
processing costs.
26-22 SO 5 Give the decision rule for whether to sell or process materials further.

Illustration: Woodmasters Inc. makes tables. The cost to manufacture
an unfinished table is $35. The selling price per unfinished unit is $50.
Illustration 26-7 Management concludes
that some of the
unused capacity may be used to finish the tables
and sell them at $60 per unit. For a finished table, direct materials will
increase $2 and direct labor costs will increase $4. Variable
manufacturing overhead costs will increase by $2.40 (60% of direct
labor). No increase is anticipated in fixed manufacturing overhead.

Incremental analysis on a per unit basis is as follows.
Illustration 26-8
Should Woodmasters sell or process further?
Question
The decision rule is a sell-or-process-further decision.
Process further as long as the incremental revenue from
processing exceeds:
a. Incremental processing costs.
b. Variable processing costs.
c. Fixed processing costs.
d. No correct answer is given.
Retain or Replace Equipment

Illustration: Jeffcoat Company is considering replacing a factory
machine with a new machine. The existing factory machine has a
book value of $40,000 and a remaining useful life of four years. A
new machine is available that costs $120,000. It is expected to
have zero salvage value at the end of its four-year useful life. If
Jeffcoat acquires the new machine, variable manufacturing costs
are expected to decrease from $160,000 to $125,000 annually,
and the old unit will be scrapped. Prepare the incremental
analysis for the four-year period.
26-26 SO 6 Identify the factors to be considered in retaining or replacing equipment.


Prepare the incremental analysis for the four-year period.
Illustration 26-9
Retain
RetainororReplace?
Replace?


Additional Considerations
 Book value of old machine does not affect the decision.
► Book value is a sunk cost.
► Costs which cannot be changed by future decisions

(sunk cost) are not relevant in incremental analysis.
 Any trade-in allowance or cash disposal value of the

existing asset is relevant.

Eliminate an Unprofitable Segment

 Key: Focus on Relevant Costs.
 Consider effect on related product lines.
 Fixed costs allocated to the unprofitable segment must
be absorbed by the other segments.
 Net income may decrease when an unprofitable
segment is eliminated.
 Decision Rule: Retain the segment unless fixed costs
eliminated exceed contribution margin lost.
26-29 SO 7 Explain the relevant factors in whether to eliminate an unprofitable segment.


Illustration: Martina Company manufactures three models of
tennis rackets:
► Profitable lines: Pro and Master Should Champ
be eliminated?
► Unprofitable line: Champ
Illustration 26-10
Segment
income
data


Prepare income data after eliminating Champ product line.
Assume fixed costs are allocated 2/3 to Pro and 1/3 to Master.
Illustration 26-11
Income data after eliminating
unprofitable product line
Total income is decreased by $10,000.

Incremental analysis of Champ provided the same results:
Do Not Eliminate Champ

Illustration 26-12

Question
If an unprofitable segment is eliminated:
a. Net income will always increase.
b. Variable expenses of the eliminated segment will
have to be absorbed by other segments.
c. Fixed expenses allocated to the eliminated
segment will have to be absorbed by other
segments.
d. Net income will always decrease.

26-34
Allocate Limited Resources

 Resources are always limited.
► Floor space for a retail firm.
► Raw materials, direct labor hours, or machine

capacity for a manufacturing firm.
 Management must decide which products to make

and sell to maximize net income.
26-35 SO 8 Determine which products to make and sell when resources are limited.

Illustration: Collins Company manufactures deluxe and standard
pen and pencil sets. The limiting resource is machine capacity,
which is 3,600 hours per month. Relevant data consist of the
following.
Illustration 26-13
Contribution margin and
machine hours
Compute contribution margin per unit of limited resource.

Compute contribution margin per unit of limited resource.
Illustration 26-14
Company should shift the sales mix to standard sets or should

increase machine capacity.

Illustration: Assume Collins is able to increase machine capacity
from 3,600 hours to 4,200 hours, the additional 600 hours could be
used to produce either the standard or deluxe pen and pencil sets.
Determine the total contribution margin under each alternative.
Illustration 26-14
Capital Budgeting
 Capital Budgeting is the process of making capital

expenditure decisions in business.
 Amount of possible capital expenditures usually

exceeds the funds available for such expenditures.
 Involves choosing among various capital projects to find

the one(s) that will maximize a company’s return on
investment.
26-39
Evaluation Process
Many companies follow a carefully prescribed process in

capital budgeting. Illustration 26-16
Corporate capital budget
authorization process
26-40
Evaluation Process
 Providing management with relevant data for capital

budgeting decisions requires familiarity with quantitative
techniques.
 Most common techniques are:
1. Annual Rate of Return
2. Cash Payback
3. Discounted Cash Flow
26-41
26-42
Annual Rate of Return
Indicates the profitability of a capital expenditure by dividing

expected annual net income by the average investment.
Illustration 26-18
26-43 SO 9 Contrast annual rate of return and cash payback in capital budgeting.
Illustration: Tappan Company is considering an investment of

$130,000 in new equipment. The new equipment is expected to
last 10 years. It will have zero salvage value at the end of its useful
life. Tappan uses the straight-line method of depreciation for
accounting purposes. The expected annual revenues and costs of
the new product that will be produced from the investment are:
Illustration 26-17
Computing Average Investment Illustration 26-19

Formula for computing
average investment
130,000 + 0
= $65,000
2
Expected annual $13,000

= 20%
rate of return $65,000
A project is acceptable if its rate of return is greater than

management’s required rate of return.
Principal advantages:
 Simplicity of calculation.
 Management’s familiarity with the accounting terms

used in the computation.
Major limitation:
 Does not consider the time value of money.
Cash Payback
Cash payback technique identifies the time period required to

recover the cost of the capital investment from the net annual
cash inflow produced by the investment.
Illustration 26-21
Computation of net annual
cash flow
Illustration 26-20
Cash payback formula
$130,000 ÷ $26,000 = 5 years
Cash Payback
The shorter the payback period, the more attractive the

investment.
In the case of uneven net annual cash flows, the company

determines the cash payback period when the cumulative net
cash flows from the investment equal the cost of the
investment.
Cash Payback
Illustration: Chen Company proposes an investment in a new

website that is estimated to cost $300,000. Illustration 26-22
Net annual cash flow
schedule
Cash payback should not be the only basis for capital budgeting
decision as it ignores expected profitability of the project.
Cash Payback
Rochelle Company is considering purchasing new

equipment for $250,000. The equipment has a
5-year useful life, and depreciation would be $50,000 (assuming
straight-line depreciation and zero salvage value). The purchase of the
equipment should increase net income by $25,000 each year for 5
years. (a) Compute the annual rate of return. (b) Compute the cash
payback period.
(a) Average investment = ($250,000 + 0) ÷ 2 = $125,000
Annual rate of return = $25,000 ÷ $125,000 = 20%
(b) Net annual cash flow = $25,000 + $50,000 = $75,000
Cash payback period = $250,000 ÷ $75,000 = 3.3 years
Cash Payback
Question
A $100,000 investment with a zero scrap value has an 8-
year life. Compute the payback period if straight-line
depreciation is used and net income is determined to be
$20,000.
a. 8.00 years.
b. 3.08 years.
c. 5.00 years.
d. 13.33 years.
Discounted Cash Flow
Discounted cash flow technique:

 Generally recognized as the best approach.
 Considers both the estimated total cash inflows and

the time value of money.
 Two methods:
► Net present value.
► Internal rate of return.
26-52 SO 10 Distinguish between the net present value and internal rate of return methods.
Net Present Value Method

 Cash inflows are discounted to their present value and
then compared with the capital outlay required by the
investment.
 Interest rate used in discounting is the required minimum

rate of return.
 Proposal is acceptable when NPV is zero or positive.
 The higher the positive NPV, the more attractive the

investment.
Illustration 26-23
A proposal is Net present value decision
criteria
acceptable when net
present value is zero
or positive.
26-54 SO 10
Equal Net Annual Cash Flows

Illustration: Tappen Company’s annual cash flows are $26,000.
If we assume this amount is uniform over the asset’s useful life,
we can compute the present value of the net annual cash flows.
Illustration 26-24
Calculate the net present value.
Equal Net Annual Cash Flows

Illustration: Calculate the net present value.
Illustration 26-25
The proposed capital expenditure is acceptable at a required rate

of return of 12% because the net present value is positive.
Unequal Net Annual Cash Flows

Illustration: Tappan Company management expects the same
aggregate net annual cash flow ($260,000) over the life of the
investment. But because of a declining market demand for the
new product over the life of the equipment, the net annual cash
flows are higher in the early years and lower in the later years.
Illustration 26-26
Unequal Net Annual Cash Flows Computing present value of
unequal annual cash flows
26-58 SO 10
Unequal Net Annual Cash Flows

Illustration: Calculate the net present value. Illustration 26-27
Analysis of proposal using net
present value method
The proposed capital expenditure is acceptable at a required rate

of return of 12% because the net present value is positive.
26-60
Internal Rate of Return Method

 IRR method finds the interest yield of the potential
investment.
 IRR is the rate that will cause the PV of the proposed
capital expenditure to equal the PV of the expected
annual cash inflows.
 Two steps in method:
► Compute the interval rate of return factor.
► Use the factor and the PV of an annuity of 1 table to
find the IRR.

Step 1. Compute the internal rate of return factor.
Illustration 26-28
For Tappan Company:
$130,000 ÷ $26,000 = 5.0

Step 2. Use the factor and the present value of an annuity
of 1 table to find the internal rate of return.
Assume a minimum rate of return for Tappan of 10%.
Decision Rule: Accept the project when the IRR is equal to or

greater than the required rate of return.
Illustration 26-29
Comparing Discounted Cash Flow Methods

Illustration 26-30
Question
A positive net present value means that the:
a. Project’s rate of return is less than the cutoff rate.
b. Project’s rate of return exceeds the required rate

of return.
c. Project’s rate of return equals the required rate of

return.
d. Project is unacceptable.
Watertown Paper Corporation is considering

adding another machine for the manufacture of
corrugated cardboard. The machine would cost $900,000. It would
have an estimated life of 6 years and no salvage value. The
company estimates that annual revenues would increase by
$400,000 and that annual expenses excluding depreciation would
increase by $190,000. Management has a required rate of return of
9%. Calculate the net present value on this project.
26-67
Calculate the net present value on this project.
Watertown should accept the project.
26-68
Copyright
“Copyright © 2011 John Wiley & Sons, Inc. All rights reserved.
Reproduction or translation of this work beyond that permitted in
Section 117 of the 1976 United States Copyright Act without the
express written permission of the copyright owner is unlawful.
Request for further information should be addressed to the
Permissions Department, John Wiley & Sons, Inc. The purchaser
may make back-up copies for his/her own use only and not for
distribution or resale. The Publisher assumes no responsibility for
errors, omissions, or damages, caused by the use of these
programs or from the use of the information contained herein.”
26-69

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26-1

 Important management function.

26-4 SO 1 Identify the steps in management’s decision-making process.

 Financial information includes revenues and costs as

 Non-financial information includes effect on

26-5 SO 1 Identify the steps in management’s decision-making process.

The Incremental Analysis Approach

 Process used to identify the financial data that change

► Only revenues may vary.

► Only costs may vary.

26-6 SO 2 Describe the concept of incremental analysis.

How Incremental Analysis Works

Comparison of Alternative B with Alternative A:

26-7 SO 2 Describe the concept of incremental analysis.

How Incremental Analysis Works

26-8 SO 2 Describe the concept of incremental analysis.

How Incremental Analysis Works

 Variable costs sometimes do not change under

 Fixed costs sometimes change between alternatives.

 Incremental analysis not the same as CVP analysis.

26-9 SO 2 Describe the concept of incremental analysis.

a. Do not change under alternative courses of action.

b. Change under alternative courses of action.

c. Are mixed under alternative courses of action.

d. None of the above.

26-10 SO 2 Describe the concept of incremental analysis.

Common Types of Decisions:

3. Sell or process further.

4. Retain or replace equipment.

5. Eliminate an unprofitable business segment.

6. Allocate limited resources.

Accept an Order at a Special Price

 Assumes that sales of products in other markets are

 Assumes that company is not operating at full

26-13 SO 3 Identify the relevant costs in accepting an order at a special price.

Accept an Order at a Special Price

26-14 SO 3 Identify the relevant costs in accepting an order at a special price.

Accept an Order at a Special Price

 Fixed costs do not change since within existing capacity – thus

 Variable manufacturing costs and expected revenues change –

26-15 SO 3 Identify the relevant costs in accepting an order at a special price.

Instead of making its own switches, Baron Company might

 Total manufacturing cost is $1 higher than purchase price.

 Must absorb at least $50,000 of fixed costs under either option.

26-17 SO 4 Identify the relevant costs in a make-or-buy decision.

 Foregoing make-or-buy analysis is complete only if the

26-18 SO 4 Identify the relevant costs in a make-or-buy decision.

Make or Buy – Opportunity Cost

26-19 SO 4 Identify the relevant costs in a make-or-buy decision.

b. The purchase price of the units.

d. All of the above.

26-20 SO 4 Identify the relevant costs in a make-or-buy decision.

Sell or Process Further

Process further as long as the incremental revenue

Sell or Process Further

Sell or Process Further

Should Woodmasters sell or process further?

a. Incremental processing costs.

b. Variable processing costs.

c. Fixed processing costs.

d. No correct answer is given.

Retain or Replace Equipment

26-26 SO 6 Identify the factors to be considered in retaining or replacing equipment.