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MANAGERIAL

ACCOUNTING
Tools for Business Decision-Making
Third Canadian Edition

Weygandt-Kimmel-Kieso-Aly

Prepared by:
Jerry Zdril,
CGA CHAPTER 7
7
CHAPTER

Incremental Analysis
Study Objectives
1. Identify the steps in managements decision-making process.
2. Describe the concept of incremental analysis.
3. Identify the relevant costs in accepting an order at a special price.
4. Identify the relevant costs in a make-or-buy decision.
5. Identify the relevant costs in deciding whether to sell or process materials
further.
6. Identify the relevant costs in deciding whether to retain or replace
equipment.
7. Identify the relevant costs in deciding whether to eliminate an unprofitable
segment.
8. Determine the sales mix when a company has limited resources.

Prepared by:
Jerry Zdril, CGA CHAPTER 7
Managements
Decision-Making Process
Does not always follow a set pattern or process
Decisions vary in scope
Decisions vary in urgency and importance
However some steps can be identified:

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Managements
Decision-Making Process
Considers both financial and non-
financial information
Financial information

Revenues and costs


Overall profitability

Nonfinancial information
Effect of decision on employee turnover
Environment
Overall image of company

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Lets Review

The decision making process normally


includes:

a. identify, determine, make a decision and


review results.
b. selecting the best deal or offer.
c. analyses of sunk costs in order to choose the
best alternative.
d. Both b. and c.

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Lets Review: Solution

The decision making process normally


includes:

a. identify, determine, make a decision and


review results.
b. selecting the best deal or offer.
c. analyses of sunk costs in order to choose the
best alternative.
d. Both b. and c.

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Managements Decision-Making
Incremental Analysis Approach
Decisions involve a choice among alternative
actions
Financial data relevant to a decision are the data
that vary in the future among alternatives
Both costs and revenues may vary, or
Only revenues may vary, or
Only costs may vary
Incremental Analysis: Process to identify
financial data that change under alternative
actions
Identifies probable effects of decisions on future
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earnings Copyright John Wiley & Sons Canada, Ltd. CHAPTER 7
Managements Decision-Making
How Incremental Analysis Works
Example

Alternative Alternative Net Income


A B Increase (Decreas
venues $125,000 $110,000 $(15,000)
s 100,000 80,000 20,000
Net income $25,000 $30,000 $5,000

Alternative B is being compared to 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

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Managements Decision Making
How Incremental Analysis Works
Relevant cost: In incremental analysis, the only
factors to be considered are: (1) those costs and
revenues that are different for each alternative,
and (2) those costs and revenues that will occur
in the future.
Opportunity cost: In choosing to take one
action, the company must often give up the
opportunity to benefit from some other action.
This lost benefit is called an opportunity cost.
Sunk cost: Costs that have already been
incurred and will not be changed or avoided by
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any future decision are
Copyright John Wiley &called
Sons Canada,sunk
Ltd. costs. Sunk7
CHAPTER
Lets Review

When making decisions, a general rule


would be

a. fixed costs are always relevant.


b. variable (unit-level) costs are always
irrelevant.
c. future costs and revenues are always
relevant.
d. future revenues and costs which differ are
always relevant.
10 CHAPTER
Copyright John Wiley & Sons Canada, Ltd. 7
Lets Review: Solution

When making decisions, a general rule


would be

a. fixed costs are always relevant.


b. variable (unit-level) costs are always
irrelevant.
c. future costs and revenues are always
relevant.
d. future revenues and costs which differ are
always relevant.
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Copyright John Wiley & Sons Canada, Ltd. 7
Managements Decision-Making
Types of Incremental Analysis

1. Accept an order at a special price


2. Make or buy component parts or finished
products
3. Sell products or process further
4. Retain or replace equipment
5. Eliminate or retain an unprofitable
business segment
6. Allocate limited resources
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Incremental Analysis
Accept an Order at a Special Price

Obtain additional business by making price


concessions

Assumes sales of the products in other


markets would not be affected by special order

Assumes company is not operating at full


capacity

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Incremental Analysis
Accept an Order at a Special Price
Example
Customer offers to buy a special order of 2,000
blenders at $11 per unit from Sunbelt.
No effect on normal sales; sufficient plant
capacity
Operating at 80% capacity = 100,000 units
Current fixed manufacturing costs = $400,000 or
$4 per unit
Variable manufacturing cost = $8 per unit
Normal selling prince = $20 per unit
Based strictly on total cost of $12 per unit ($8 +
$4), reject offer as cost exceeds selling price of $11

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Incremental Analysis
Accept an Order at a Special Price
Example: Continued
No change in fixed costs since within existing
capacity thus fixed costs are not relevant
Only total variable costs change thus they are
relevant

Revenue increases $22,000; variable costs


increase by $16,000;
Decision: Accept the offer. Income will increase
Thus, net income increases $6,000
by $6,000.
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Lets Review

Of several types of decisions that involve


incremental analysis, the most common
are:

a. accept an order at a special price.


b. make or buy component parts.
c. sell products or process further.
d. all of the above.
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Lets Review: Solution

Of several types of decisions that involve


incremental analysis, the most common
are:

a. accept an order at a special price.


b. make or buy component parts.
c. sell products or process further.
d. all of the above.
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Incremental Analysis
Make or Buy - Example
Outsourcing: The decision to buy parts or services
rather than making them
Baron Co. incurs the following costs to make 25,000
switches:
Direct materials $
50,000
Direct labour
75,000
Variable manufacturing overhead
40,000
Fixed manufacturing overhead
60,000 can be purchased for $8 per switch ($200,000)
Switches
Total manufacturing
Eliminates all variablecosts costs and $10,000 of fixed costs;
$225,000
however, $50,000 of fixed costs remain
Total cost per unit ($225,000 25,000) CHAPTER
18
$9.00
Copyright John Wiley & Sons Canada, Ltd. 7
Incremental Analysis
Make or Buy Example: Continued
Make Buy Incremental
Cost (Saving)
Direct materials $50,00 $0 $50,000
0
Direct labour 75,000 $0 75,000
Variable manufacturing 40,000 $0 40,000
costs
Fixed manufacturing 60,000 50,000 10,000
costs
Purchase price (25,000 200,000 (200,000)
x $8)
Based on analysis of costs under both alternatives:
Total Annual Cost 225,00 $250,000 ($25,000)
Purchasing adds $25,000
0 to cost of switches
Decision: Continue to make switches.
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Incremental Analysis
Opportunity Costs
Baron Company Example: Continued

Opportunity cost the potential benefit that


may be obtained from following an
alternative course of action

Example: Assume that buying the switches


allows Baron to use the released capacity to
generate $28,000 additional income.

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Incremental Analysis
Opportunity Costs
Baron Company Example: Continued

Thus, the $28,000 lost income is an


additional cost of making the switches
Incrementa
Make Buy Costs and Savin
l annual cost $225,000 $250,000 $(25,000)
rtunity cost 28,000 -0- 28,000
al cost $253,000 $250,000 $ 3,000

Decision: Based on the analysis, Baron


should buy the switches as the company
will earn an additional $3,000 in Net
Income.
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Lets Review

In a make-or-buy decision, the relevant


costs are:

a. the
manufacturing costs that will be
saved.
b. the purchase price of the units.
c. opportunity costs.
d. all of the above.
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Lets Review: Solution

In a make-or-buy decision, the relevant


costs are:

a. the
manufacturing costs that will be
saved.
b. the purchase price of the units.
c. opportunity costs.
d. all of the above.
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Incremental Analysis
Sell or Process Further

Manufacturers may have to decide, at a given


point in production, whether to sell now or to
process further and sell at a higher price later

Decision Rule:
Process further as long as the incremental
revenue from such processing exceeds the
incremental processing costs

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Incremental Analysis
Sell or Process Further
Single-Product Case
Cost to manufacture one unfinished table:
Direct materials $15
Direct labour 10
Variable manufacturing overhead
6
Fixed manufacturing overhead 4
Manufacturing cost per unit $35
Selling price of unfinished unit is $50
Unused capacity is available to enable the
company to finish the tables
Selling price of finished unit is $60

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Incremental Analysis
Sell or Process Further
Single-Product Case: Continued

Relevant unit costs of finishing tables:


Direct materials increase $2
Direct labour increase $4
Variable manufacturing overhead costs
increase by $2.40 (60% of direct labour
increase)
Fixed manufacturing costs will not
increase

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Incremental Analysis
Sell or Process Further
Single-Product Case: Continued

Decision: Process further. Incremental


revenue ($10) exceeds incremental
processing costs ($8.40); income increases
$1.60 per unit.
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Incremental Analysis
Sell or Process Further
Multiple-Product Case
Especially appropriate when multiple products
are produced simultaneously
Many end-products are produced from a single
raw material and a common production process
Joint products multiple end products
Petroleum gasoline, lubricating oil, kerosene
Meat Packing meat, hides, bones

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Incremental Analysis
Sell or Process Further
Multiple-Product Case: Continued
Joint costs
all costs incurred prior to split-off point
allocate to individual products based on
relative sales value

Sunk costs
already incurred and cannot be changed
Irrelevant for sell or process further decisions
Joint costs are sunk costs for sell or process
further decisions.
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Incremental Analysis
Sell or Process Further
Multiple-Product Case: Continued
Marais Creamery Decision Example
Sell cream and skim milk
or
Process them further before selling

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Incremental Analysis
Sell or Process Further
Multiple-Product Case: Continued
Marais Creamery Decision Example
Sell cream or process further into cottage cheese?

Joint cost allocated to cream $9,000

Processing cream into cottage cheese
$10,000

Expected revenue per day:
Cream $19,000
Cottage cheese $27,000

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Incremental Analysis
Sell or Process Further
Multiple-Product Case: Continued
Marais Creamery Decision Example
Process Inc
Sell Further Reve
Sales per day $19,000 $27,000
Cost per day
Processing cream into
cottage cheese -0- 10,000
$19,000 $17,000

Decision: Do not process the cream further.


Incremental revenue ($8,000) is less than
incremental costs ($10,000); income
decreases by $2,000.
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CHAPTER
Incremental Analysis
Sell or Process Further
Multiple-Product Case: Continued
Marais Creamery Decision Example
Sell skim milk or process further into
condensed milk?
Joint cost allocated to skim milk
$5,000
Processing skim milk into condensed milk
$8,000
Expected revenue per day:
Skim milk $11,000
Condensed milk $26,000
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Incremental Analysis
Sell or Process Further
Multiple-Product Case: Continued
Marais Creamery Decision Example
Process Incre
Sell Further Revenu
Sales per day $11,000 $26,000 $ 15
Cost per day
Processing skim milk into
condensed milk -0- 8,000 (8
$11,000 $18,000 $

Decision: Process the skim milk further.


Incremental revenue ($15,000) exceeds
incremental costs ($8,000); Income
increases by $7,000.
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Lets Review

The decision rule in a sell or process further


decision is to process further as long as the
incremental revenue from processing is
more than the:

a. incremental processing costs.


b. variable processing costs.
c. fixed processing costs.
d. no correct answer given.

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Lets Review: Solution

The decision rule in a sell or process further


decision is to process further as long as the
incremental revenue from processing is
more than the:

a. incremental processing costs.


b. variable processing costs.
c. fixed processing costs.
d. no correct answer given.

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Incremental Analysis
Retain or Replace Equipment Example

Assessment of replacement of a factory machine:


Old Machine New Machine
Book value $40,000
Cost of new machine $120,000
Remaining useful life 4 years 4 years
Scrap value -0- -0-

Variable costs:
Decrease from $160,000
to $125,000 annually

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Incremental Analysis
Retain or Replace Equipment
Example: Continued
Incremen
Retain Replace Revenue or
ble manufacturing costs $640,000a $500,000b $140,000
w machine cost 120,000 (120,0
$640,000 $620,000 $20,000

a
(4 years x $160,000) b
(4 years x $125,000)

Decision: Replace equipment.


Lower variable manufacturing costs more
than offsets the cost of new equipment. The
book value of the old machine does not
affect the decision.
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Lets Review

What is the salvage value of old equipment


considered to be?

a. A relevant cost

b. A non-incremental cost

c. An opportunity cost

d. A cost that is not differential

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Lets Review: Solution

What is the salvage value of old equipment


considered to be?

a. A relevant cost

b. A non-incremental cost

c. An opportunity cost

d. A cost that is not differential

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Incremental Analysis
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 the contribution margin
lost

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Incremental Analysis
Eliminate an Unprofitable Segment
Martina Company Example

Manufactures three models of tennis racquets:


Profitable lines: Pro and Master
Unprofitable line: Champ
Condensed Income Statement data:
Pro Master Champ
Sales $800,000 $300,000 $100,000 $1
Variable expenses 520,000 210,000 90,000
Contribution margin 280,000 90,000 10,000
Fixed expenses 80,000 50,000 30,000
Net income $200,000 $40,000 $(20,000) $ 220,000
Should Champ line be eliminated?

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Incremental Analysis
Eliminate an Unprofitable Segment
Martina Company Example: Continued
If Champ is eliminated, allocate its $30,000
fixed costs: 2/3 to Pro and 1/3 to Master
Revised Income Statement data:
Pro Master
Total
Sales $800,000 $300,000
$1,100,000
Variable expenses 520,000 210,000
730,000
Contribution margin 280,000 90,000
Total 370,000
income has decreased by $10,000
Fixed expenses
($220,000 - $210,000) 100,000 60,000
43 160,000 Copyright John Wiley & Sons Canada, Ltd. CHAPTER 7
Incremental Analysis
Eliminate an Unprofitable Segment
Martina Company Example: Continued
Incremental analysis of Champ provides the same results

Incremen
Continue Eliminate
Sales $100,000 $ -0-
Variable expenses 90,000 -0-
Contribution margin 10,000 -0-
Fixed expenses 30,000 30,000
Net income $(20,000) $(30,000)
Decrease in net income is due to Champs
contribution margin of $10,000 that will not
be realizedDo
if the segment is discontinued
Decision: not eliminate
Champ.
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Lets Review

How should that portion of fixed costs that are unavoidable


be handled when making a decision on whether to
eliminate an unprofitable segment?
a. They should be subtracted from the contribution
margin and if that results in a net loss, the segment
should be eliminated.
b. They should not be considered as they are not relevant.
c. They should be allocated to other segments. If that
causes a loss in another segment, that segment should
be eliminated as well.
d. Fixed costs are never relevant.

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Lets Review: Solution

How should that portion of fixed costs that are unavoidable


be handled when making a decision on whether to
eliminate an unprofitable segment?
a. They should be subtracted from the contribution
margin and if that results in a net loss, the segment
should be eliminated.
b. They should not be considered as they are not relevant.
c. They should be allocated to other segments. If that
causes a loss in another segment, that segment should
be eliminated as well.
d. Fixed costs are never relevant.

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Incremental Analysis
Allocate Limited Resources

Resources are always limited


floor space for a retail firm
raw material, direct labour hours, or
machine capacity for a manufacturing firm
Management must decide which products to
make and sell to maximize net income

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Incremental Analysis
Allocate Limited Resources
Collins Company Example

Produces standard and deluxe pen and


pencil sets
Limiting resource 3,600 machine hours
per month Deluxe set
Standard set
Contribution margin per unit $8
$6
Machine hours required 0.4 per unit
Deluxe setunit
0.2 per has higher contribution margin: $8
Standard set takes fewer machine hours per
unit
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Incremental Analysis
Allocate Limited Resources
Collins Company Example: Continued

Must calculate contribution margin per unit


of limited resource
Deluxe Sets
Standard Sets
Contribution margin per unit (a) $8
$6
Machine hours required (b) 0.4
0.2
Standard sets
Contribution haveper
margin higher
unitcontribution
of margin
per unit of limited resources
limited resource
Decision: Shift[(a) (b)]
sales mix to standard $sets20
or increase$ 30machine capacity.
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Incremental Analysis
Allocate Limited Resources
Collins Company Example: Continued

Alternative: Increase machine capacity from 3,600


to 4,200 hours
Produce
Produce
Deluxe Sets
Standard Sets
Machine hours (a) 600
600
Contribution margin per unit
ofTolimited
maximize net income,
resource (b) all 600 hours
$20should be
used to produce standard sets.
$30
Contribution margin [(a) x (b)] $12,000
$18,000
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Incremental Analysis
Theory of Constraints

Approach used to identify and manage


constraints so as to achieve company goals

Requires identification of constraints

Continual attempts to reduce or eliminate


constraints

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Managements Decision-Making
Other Considerations
Qualitative factors
Potential effects of decision on employees

and community
Low morale
Employee turnover

Incremental Analysis and Activity-Based


Costing
Completely consistent with each other
ABC better identifies relevant costs
resulting in better incremental analysis
52 Copyright John Wiley & Sons Canada, Ltd. CHAPTER 7
Lets Review

Which of the following is not a qualitative


factor?

a. Employee satisfaction

b. Quality control process

c. Customer satisfaction

d. Cost of labour per unit

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Lets Review: Solution

Which of the following is not a qualitative


factor?

a. Employee satisfaction

b. Quality control process

c. Customer satisfaction

d. Cost of labour per unit

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Copyright

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55 Copyright John Wiley & Sons Canada, Ltd. CHAPTER 7