Incremental Analysis: Ninth Edition

Managerial Accounting
Ninth Edition
Weygandt Kimmel Mitchell
Chapter 7
Incremental Analysis
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Copyright ©2021 John Wiley & Sons, Inc.

Chapter Outline
Learning Objectives
LO 1 Describe management’s decision-making process and incremental
analysis.
LO 2 Analyze the relevant costs in accepting an order at a special price.
LO 3 Analyze the relevant costs in a make-or-buy decision.
LO 6 Analyze the relevant costs in deciding whether to eliminate an
unprofitable segment or product.
Copyright ©2021 John Wiley & Sons, Inc. 2

Decision-Making
LEARNING OBJECTIVE 1
Describe management’s decision-making process and
incremental analysis.
Making decisions is an important management function
• Does not always follow a set pattern
• Decisions vary in scope, urgency, and importance
• Steps usually involved in process include:
LO 1 Copyright ©2021 John Wiley & Sons, Inc. 3

Decision-Making Process
In making business decisions,
• Considers financial and non-financial information
• Financial information
o Revenues and costs, and
o Effect on overall profitability
• Nonfinancial information
o Effect on employee turnover
o The environment
o Overall company image

Incremental Analysis Approach
• Decisions involve a choice among alternative actions

• Process used to identify the financial data that change
under alternative courses of action
o Both costs and revenues may vary or
o Only revenues may vary or
o Only costs may vary

NET INCOME
Revenue
- Expenses
Net Income
Copyright ©2021
©2018 John Wiley & Sons, Inc. 6
How Incremental Analysis Works
Moving from Alternative A to B…..

Revenues DECREASE
This will DECREASE Net Income
Costs Decrease
This will INCREASE Net Income
Net the difference and you have an overall INCREASE in Net Income

Basic approach in incremental analysis
Illustration 7.2
• 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 costs and revenues

• Opportunity cost
• Sunk cost

Relevant Costs and Revenue
The factors to be considered in incremental analysis are

the costs and revenues that differ across alternatives.
These are relevant!

Opportunity Cost
The lost potential benefit that could have been obtained

from following an alternative course of action.
If there is an opportunity to use this productive capacity

in some other manner, then this opportunity cost must be
considered.
Opportunity costs are relevant costs.

Sunk Cost
Sunk costs are costs that have already been incurred and
cannot be changed or avoided by any future decision.
Sunk costs are NOT relevant costs.

Other items to consider
• Sometimes involves changes that seem contrary to

intuition
• Variable costs sometimes do not change under
alternatives
• Fixed costs sometimes change between alternatives

Types of Incremental Analysis
Common types of decisions involving incremental

analysis:
1. Accept an order at a special price
2. Make or buy component parts or finished products
3. Sell products or process them further
4. Repair, retain, or replace equipment
5. Eliminate an unprofitable business segment or product

Questions we will answer
Should I continue
Should I MAKE or or eliminate this
Should I reject BUY this part? unprofitable
or accept this segment?
special offer?

Review Question (1 of 2)
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

Review Answer (1 of 2)
Incremental analysis is the process of identifying the

financial data that
a. do not change under alternative courses of action.
b. Answer: change under alternative courses of action.
c. are mixed under alternative courses of action.
d. None of the above

DO IT! 1: Incremental Analysis
Owen T Corporation is comparing two different options. The
company currently operates under Option 1, with revenues of
$80,000 per year, maintenance expenses of $5,000 per year, and
operating expenses of $38,000 per year. Option 2 provides
revenues of $80,000 per year, maintenance expenses of $12,000
per year, and operating expenses of $32,000 per year. Option 1
employs a piece of equipment that was upgraded 2 years ago at a
cost of $22,000. If Option 2 is chosen, it will free up resources that
will increase revenues by $3,000.
Complete the following table to show the change in income from
choosing Option 2 versus Option 1. Designate any sunk costs with
an “S.”

Option 1
revenues of $80,000 per year
maintenance expenses of $5,000 per year
operating expenses of $38,000 per year
piece of equipment that was upgraded 2 years ago at a cost of $22,000
Option 2
revenues of $80,000 per year
maintenance expenses of $12,000 per year
operating expenses of $32,000 per year
will free up resources that will increase revenues by $3,000
Compare Option 2 versus Option 1

Designate any sunk costs with an “S”
Option 1 Option 2 Difference Sunk?

Revenues
Maintenance
expense
Operating expense
Cost of equipment
Opportunity cost
Total Difference


Revenues $80,000
Maintenance 5,000
expense
Operating expense 38,000
Cost of equipment S
upgrade
Opportunity cost
Total Difference


Revenues $80,000 $80,000
Maintenance 5,000 12,000
expense
Operating expense 38,000 32,000
Cost of equipment
upgrade
Opportunity cost
Total Difference

Revenues $80,000 $80,000 $0
Maintenance 5,000 12,000 (7,000)
expense
Operating expense 38,000 32,000 6,000
Cost of equipment 22,000 0 0 S
upgrade
Opportunity cost 3,000 0 3,000
Total Difference $2,000
Option 2 increase Net Income by $2,000 per year as compared to Option 1
If option 1 is selected, the opportunity to earn 3,000 is lost, therefore the opportunity cost
is recorded for the option where extra profit is not available

Solution
Complete the following table to show the change in income from

choosing Option 2 versus Option 1. Designate any sunk costs with
an “S.”

Special Orders
Analyze the relevant costs in accepting an order at a
special price.
• To 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

Special Orders
Sunbelt Company produces 100,000 Smoothie blenders per
month, which is 80% of factory capacity. Variable
manufacturing costs are $8 per unit. Fixed manufacturing
costs are $400,000, or $4 per unit. The Smoothie blenders are
normally sold directly to retailers at $20 each. Kensington Co.
(a foreign wholesaler) has offered to purchase an additional
2,000 blenders from Sunbelt at $11 per unit. Management
has determined that acceptance of the offer would not affect
normal sales of the product, and the additional units can be
manufactured without increasing factory capacity. What
should management do?

Special Orders
Sunbelt Company Should I reject
or accept this
Produces 100,000 blenders per month (80% of capacity) special offer?
Variable manufacturing costs are $8 per unit
Fixed manufacturing costs are $400,000, or $4 per unit
Selling price to retailers is $20 per blender
Kensington Co. (a foreign wholesaler)

Wants to buy 2,000 blenders from Sunbelt at $11 per unit
Management has determined that acceptance of the offer would not affect normal sales
of the product, and the additional units can be manufactured without increasing factory
capacity.
What should management do?

Reject? Or Accept?
Special Orders
Illustration 7.3
Remember,
this is
asking how
NI is
What changes if I accept the affected.
If I reject the special order,
offer? Will Revenue go up?
nothing changes! I go on
Will Costs go up?
with business as usual
making my normal profit!
*Fixed costs are already
covered by normal operations!

Special Orders
Solution
Illustration 7.3
• 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
DO IT! 2: Special Orders
Cobb Company incurs costs of $28 per unit ($18 variable and $10 fixed) to
make a product that normally sells for $42. A foreign wholesaler offers to
buy 5,000 units at $25 each. The special-order results in additional
shipping costs of $1 per unit. Compute the increase or decrease in net
income Cobb realizes by accepting the special order, assuming Cobb has
excess operating capacity.
Should Cobb Company accept the special?
Revenue: 5,000 units @ $25 = Should I reject

Costs: (VC $18 = $1 Shipping) * 5,000 units = or accept this
special offer?

DO IT! 2: Special Orders
Cobb Company incurs costs of $28 per unit ($18 variable and $10 fixed) to
make a product that normally sells for $42. A foreign wholesaler offers to
buy 5,000 units at $25 each. The special-order results in additional
shipping costs of $1 per unit. Compute the increase or decrease in net
income Cobb realizes by accepting the special order, assuming Cobb has
excess operating capacity.
Should Cobb Company accept the special?
Net Income Increase
Reject Accept (Decrease)
Revenues $─0─ $125,000* $125,000
Costs ─0─ 95,000** (95,000)
Net income $─0─ $ 30,000 $ 30,000
*5,000 × $25
**(5,000 × $18) + (5,000 × $1)
The analysis indicates net income increases by $30,000; therefore,

Cobb Company should accept the special order.
Make or Buy
Analyze the relevant costs in a make-or-buy decision.
Should I MAKE or
BUY this part?
This Photo by Unknown Author is licensed under CC BY-NC-ND

Make or Buy
Illustration: Baron Company incurs the following annual costs in

producing 25,000 ignition switches for motorcycles.
Cost to Make Cost to Buy
Direct materials $ 50,000

Direct labor 75,000
Variable manufacturing overhead 40,000
Fixed manufacturing overhead 60,000
Total manufacturing costs $225,000
Total cost per unit ($225,000 ÷ 25,000) $9.00
Instead of making switches, Baron might purchase ignition switches

at a price of $8 per unit. If they do this, all variable costs and
$10,000 of fixed costs will be eliminated.
What should Baron do?

Make or Buy
• Manufacturing cost is $1 higher per unit than purchase price

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

Make or Buy Decision
Review 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

Make or Buy Decision
Review Answer
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. Answer: All of the above

Opportunity Cost
The lost potential benefit that could have been obtained

from following an alternative course of action.
If there is an opportunity to use this productive capacity
in some other manner, then this opportunity cost must be
considered.

Opportunity Cost- Where does it go?
Assume that through buying the switches, Baron Company can use
the released productive capacity to generate additional income of
$38,000 from producing a different product. This lost income is an
additional cost of continuing to make the switches in the make-or-buy
decision.

Opportunity Cost
Illustration
Assume that through buying the switches, Baron Company can

use the released productive capacity to generate additional
income of $38,000 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 7.6

DO IT! 3: Make or Buy
Juanita Company must decide whether to make or buy some
of its components for the appliances it produces. The costs of
producing 166,000 electrical cords for its appliances are as
follows.
Direct materials $90,000 Variable overhead $32,000
Direct labor 20,000 Fixed overhead 24,000
Instead of making the electrical cords at an average cost per unit of

$1.00 ($166,000 ÷ 166,000), the company has an opportunity to
buy the cords at $0.90 per unit. If the company purchases the
cords, all variable costs and one-fourth of the fixed costs are
eliminated.
Make or Buy?
Part a. solution
a. Prepare an incremental analysis showing whether the
company should make or buy the electrical cords.
Net Income Increase
Make Buy (Decrease)
Direct materials $90,000 $ ─0─ $ 90,000
Direct labor 20,000 ─0─ 20,000
Variable manufacturing costs 32,000 ─0─ 32,000
Fixed manufacturing costs 24,000 18,000* 6,000
Purchase price ─0─ 149,400** (149,400)
Total cost $166,000 $167,400 $ (1,400)
*$24,000 × .75
**166,000 × $0.90
Juanita Company should make the components.

Part b. solution
b. Will your answer be different if the released productive
capacity of the production facility will generate additional
income of $5,000?
Make Buy Net Income Increase (Decrease)
Total cost $166,000 $167,400 $(1,400)
Opportunity cost 5,000 ─0─ 5,000
Total cost $171,000 $167,400 $ 3,600
Yes, the answer is different. The analysis shows that net

income increases by $3,600 if Juanita Company purchases the
electrical cords rather than making them.
Juanita Company should buy the components.

Eliminate Unprofitable Segment or Product
Analyze the relevant costs in deciding whether to eliminate an

unprofitable segment or product.
Should I continue
or eliminate this
unprofitable
segment?

Eliminate Unprofitable Segment or Product
• 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

Eliminate Unprofitable Segment
Segment income data
Illustration: Venus Company manufactures three models of tennis
rackets:
• Profitable lines: Pro and Master Should Champ be
eliminated?
• Unprofitable line: Champ
Pro Master Champ Total
Sales $800,000 $300,000 $100,000 $1,200,000
Variable costs 520,000 210,000 90,000 820,000
Contribution margin 280,000 90,000 10,000 380,000
Fixed costs 80,000 50,000 30,000 160,000
Net income $200,000 $ 40,000 $ (20,000) $ 220,000

Income data after eliminating Champ
Prepare income data after eliminating Champ product line. Assume
fixed costs are allocated 2/3 to Pro and 1/3 to Master.
Pro Master Total
Sales $800,000 $300,000 $1,100,000
Variable costs 520,000 210,000 730,000
Contribution margin 280,000 90,000 370,000
Fixed costs 100,000 60,000 160,000
Net income $180,000 $ 30,000 $ 210,000
Total income is decreased by $10,000.

Incremental analysis-no reduction in fixed costs
Incremental analysis of Champ provided the same results:

Do Not Eliminate Champ

Incremental analysis-reduction in fixed costs
Assume that $22,000 of the fixed costs attributed to the Champ

line can be eliminated if the line is discontinued.
Eliminate Champ

Review Question (2 of 2)
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.

Review Answer (2 of 2)
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. Answer: fixed expenses allocated to the eliminated
segment will have to be absorbed by other segments.
d. net income will always decrease.

DO IT! 6: Unprofitable Segments
Lambert, Inc. manufactures several types of accessories.

For the year, the knit hats and scarves line had sales of
$400,000, variable expenses of $310,000, and fixed
expenses of $120,000. Therefore, the knit hats and
scarves line had a net loss of $30,000. If Lambert
eliminates the knit hats and scarves line, $20,000 of fixed
costs will remain.
Prepare an analysis showing whether the company
should eliminate the knit hats and scarves line.

DO IT! 6: Unprofitable Segments
Solution
Prepare an analysis showing whether the company
should eliminate the knit hats and scarves line.
Should Eliminate
Continue Eliminate Net Income Increase (Decrease)

Sales $400,000 $ 0 $(400,000)
Variable costs 310,000 0 310,000
Contribution margin 90,000 0 (90,000)
Fixed costs 120,000 20,000 100,000
Net income $(30,000) $(20,000) $ 10,000

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Managerial Accounting

Weygandt Kimmel Mitchell

Copyright ©2021 John Wiley & Sons, Inc.

Copyright ©2021 John Wiley & Sons, Inc. 2

LO 1 Copyright ©2021 John Wiley & Sons, Inc. 3

LO 1 Copyright ©2021 John Wiley & Sons, Inc. 4

• Decisions involve a choice among alternative actions

LO 1 Copyright ©2021 John Wiley & Sons, Inc. 5

Moving from Alternative A to B…..

LO 1 Copyright ©2021 John Wiley & Sons, Inc. 7

• Incremental revenue is $15,000 less under Alternative B

LO 1 Copyright ©2021 John Wiley & Sons, Inc. 8

• Relevant costs and revenues

LO 1 Copyright ©2021 John Wiley & Sons, Inc. 9

The factors to be considered in incremental analysis are

These are relevant!

LO 3 Copyright ©2021 John Wiley & Sons, Inc. 10

The lost potential benefit that could have been obtained

If there is an opportunity to use this productive capacity

Opportunity costs are relevant costs.

LO 3 Copyright ©2021 John Wiley & Sons, Inc. 11

Sunk costs are NOT relevant costs.

LO 3 Copyright ©2021 John Wiley & Sons, Inc. 12

• Sometimes involves changes that seem contrary to

LO 1 Copyright ©2021 John Wiley & Sons, Inc. 13

Common types of decisions involving incremental

LO 1 Copyright ©2021 John Wiley & Sons, Inc. 14

LO 1 Copyright ©2021 John Wiley & Sons, Inc. 15

Incremental analysis is the process of identifying the

LO 1 Copyright ©2021 John Wiley & Sons, Inc. 16

Incremental analysis is the process of identifying the

LO 1 Copyright ©2021 John Wiley & Sons, Inc. 17

LO 1 Copyright ©2021 John Wiley & Sons, Inc. 18

Compare Option 2 versus Option 1

Option 1 Option 2 Difference Sunk?

LO 1 Copyright ©2021 John Wiley & Sons, Inc. 20

Option 1 Option 2 Difference Sunk?

LO 1 Copyright ©2021 John Wiley & Sons, Inc. 21

Option 1 Option 2 Difference Sunk?

LO 1 Copyright ©2021 John Wiley & Sons, Inc. 22

Total Difference $2,000

Option 2 increase Net Income by $2,000 per year as compared to Option 1

LO 1 Copyright ©2021 John Wiley & Sons, Inc. 23

Complete the following table to show the change in income from

LO 1 Copyright ©2021 John Wiley & Sons, Inc. 24

• To obtain additional business by making a major price

LO 2 Copyright ©2021 John Wiley & Sons, Inc. 25

LO 2 Copyright ©2021 John Wiley & Sons, Inc. 26

Kensington Co. (a foreign wholesaler)

What should management do?

LO 2 Copyright ©2021 John Wiley & Sons, Inc. 28

• Fixed costs do not change since within existing capacity –

Revenue: 5,000 units @ $25 = Should I reject

LO 2 Copyright ©2021 John Wiley & Sons, Inc. 30

The analysis indicates net income increases by $30,000; therefore,

Analyze the relevant costs in a make-or-buy decision.

This Photo by Unknown Author is licensed under CC BY-NC-ND

LO 3 Copyright ©2021 John Wiley & Sons, Inc. 32

Illustration: Baron Company incurs the following annual costs in

Direct materials $ 50,000

Instead of making switches, Baron might purchase ignition switches

LO 3 Copyright ©2021 John Wiley & Sons, Inc. 33

• Manufacturing cost is $1 higher per unit than purchase price