Chapter

20

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Incremental Analysis

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

Special
order
decisions
McGraw-Hill/Irwin

Product
mix
decisions

Make
or buy
decisions

Joint
product
decisions

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The
The Concept
Concept of
of
Relevant
Relevant Cost
Cost Information
Information

Will
Will you
you drive
drive or
or fly
fly to
to Florida
Florida for
for spring
spring break?
break?

You
You have
have gathered
gathered the
the following
following information
information to
to
help
help you
you with
with the
the decision.
decision.

Motel
Motelcost
costisis$80
$80per
pernight.
night.

Meal
Mealcost
costisis$20
$20per
perday.
day.

Your
Yourcar
carinsurance
insuranceisis$100
$100per
permonth.
month.

Kennel
Kennelcost
costfor
foryour
yourdog
dogisis$5
$5per
perday.
day.

Round-trip
Round-tripcost
costof
ofgasoline
gasolinefor
foryour
yourcar
carisis$200.
$200.

Round-trip
Round-tripairfare
airfareand
andrental
rentalcar
carfor
foraaweek
weekisis$500.
$500.

Driving
Driving requires
requires two
two days,
days, with
with an
an overnight
overnight stay,
stay,
cutting
cutting your
your time
time in
in Florida
Florida by
by two
two days.
days.
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The
The Concept
Concept of
of
Relevant
Relevant Cost
Cost Information
Information
Florida Spring Break
Drive/Fly Analysis
Cost
Motel
Eating out costs
Kennel cost
Car insurance
Gasoline
Airfare/rental car
McGraw-Hill/Irwin

Drive
$ 640
160
40
100
200
-

8 days @ $80
Fly
$ 640
160
40
100
500

8 days @ $20
8 days @ $5

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The
The Concept
Concept of
of
Relevant
Relevant Cost
Cost Information
Information
Florida Spring Break
Drive/Fly Analysis
Cost
Motel
Eating out costs
Kennel cost
Car insurance
Gasoline
Airfare/rental car
McGraw-Hill/Irwin

Drive
$ 640
160
40
100
200
-

Fly
$ 640
160
40
100
500

Costs do not differ,

so they are not
relevant to decision.
Also, car insurance
is not relevant to
the decision as it
is a past cost.

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The
The Concept
Concept of
of
Relevant
Relevant Cost
Cost Information
Information
Florida Spring Break
Drive/Fly Analysis
Cost
Motel
Eating out costs
Kennel cost
Car insurance
Gasoline
Airfare/rental car
McGraw-Hill/Irwin

Drive
$ 640
160
40
100
200
-

Fly
$ 640
160
40
100
500

Are
Arethe
theextra
extratwo
two
days
days in
inFlorida
Florida
worth
worththe
the$300
$300
extra
extracost
cost to
tofly?
fly?

Transportation
costs differ between
the two alternatives,
so they are relevant
to your decision

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Decision
Decision Making
Making
Decision making involves five steps:

Define the problem.

Identify the alternatives.
Collect information on alternatives.
Eliminate irrelevant information.
Make a decision with the
remaining relevant information.
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Relevant
Relevant Information
Information
in
in Business
Business Decisions
Decisions
Information that varies among the possible
courses of action being considered.
Incremental costs and revenues

Opportunity

Important cost concepts for

business decisions.

costs.

Sunk

costs.
Out-of-pocket costs.
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Opportunity
Opportunity Cost
Cost
The benefit that could have been attained by pursuing
an alternative course of action.
Example: If you were not
attending college, you could
be earning $20,000 per year.
Your opportunity cost of
attending college for one
year includes the $20,000.

Opportunity costs are not recorded in the accounting

records, but are relevant to decisions because they
are a real sacrifice.
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Sunk
Sunk Costs
Costs Versus
Versus
Out-of-Pocket
Out-of-Pocket Costs
Costs
All costs incurred in the past that cannot be changed by any decision made now or in the
future.
Sunk costs should not be considered in decisions.
Example: You bought an automobile that cost $10,000 two years ago. The $10,000 cost is sunk
because whether you drive it, park it, trade it, or sell it, you cannot change the $10,000 cost.

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Sunk
Sunk Costs
Costs Versus
Versus
Out-of-Pocket
Out-of-Pocket Costs
Costs

Cost = $10,000
two years ago

Trade ?

Cost = $25,000
today

The
Thedealer
dealerwill
will trade
tradefor
for$20,000
$20,000plus
plusyour
yourcar.
car.
What
What amount
amountis
isrelevant
relevantto
toyour
yourdecision,
decision,
the
the$10,000
$10,000 sunk
sunkcost
cost of
ofyour
your car
car or
or the
the
$20,000
$20,000 out-of-pocket
out-of-pocket cash
cashdifferential?
differential?
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Incremental
Incremental Analysis
Analysis in
in
Common
Common Business
Business Decisions
Decisions
We will now
examine
several
different types
of managerial
decisions.
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Special
Special Order
Order Decisions
Decisions
The decision to accept
additional business
should be based on
incremental costs and
incremental revenues.
Incremental amounts are
those that occur only if
the company decides to
accept the new business.
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Special
Special Order
Order Decisions
Decisions
JamCo currently sells 100,000 units of its
product. The company has revenue and costs
as shown below:
Sales
Direct materials
Direct labor
Factory overhead
Selling expenses
Administrative expenses
Total expenses
Operating income
McGraw-Hill/Irwin

Per Unit
$ 10.00
3.50
2.20
1.10
1.40
0.80
$
9.00
$
1.00

$
$

Total
1,000,000
350,000
220,000
110,000
140,000
80,000
900,000
100,000

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Special
Special Order
Order Decisions
Decisions
JamCo is approached by an overseas
company that offers to purchase
10,000 units at $8.50 per unit.
If JamCo accepts the offer, total factory
overhead will increase by $5,000; total selling
expenses will increase by $2,000; and total
administrative expenses will increase
by $1,000.
Should JamCo
accept the offer?

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Special
Special Order
Order Decisions
Decisions
First
First lets
lets look
look at
at incorrect
incorrect reasoning
reasoning
that
that leads
leads to
to an
an incorrect
incorrect decision.
decision.
Our cost is $9.00
per unit. I cant sell
for $8.50 per unit.

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Special
Special Order
Order Decisions
Decisions
Sales
Direct materials
Direct labor
Factory overhead
Selling expenses
Admin. expenses
Total expenses
Operating income

Current
Business
$ 1,000,000
$ 350,000
220,000
110,000
140,000
80,000
$ 900,000
$ 100,000

Additional
Business
$
85,000
$
35,000
22,000
5,000
2,000
1,000
$
65,000
$
20,000

Combined
$ 1,085,000
$ 385,000
242,000
115,000
142,000
81,000
$ 965,000
$ 120,000

This analysis leads to the correct decision.

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Special
Special Order
Order Decisions
Decisions
Sales
Direct materials
Direct labor
Factory overhead
Selling expenses
Admin. expenses
Total expenses
Operating income

Current
Business
$ 1,000,000
$ 350,000
220,000
110,000
140,000
80,000
$ 900,000
$ 100,000

Additional
Business
$
85,000
$
35,000
22,000
5,000
2,000
1,000
$
65,000
$
20,000

Combined
$ 1,085,000
$ 385,000
242,000
115,000
142,000
81,000
$ 965,000
$ 120,000

10,000 new units $8.50 selling price = $85,000

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Special
Special Order
Order Decisions
Decisions
Sales
Direct materials
Direct labor
Factory overhead
Selling expenses
Admin. expenses
Total expenses
Operating income

Current
Business
$ 1,000,000
$ 350,000
220,000
110,000
140,000
80,000
$ 900,000
$ 100,000

Additional
Business
$
85,000
$
35,000
22,000
5,000
2,000
1,000
$
65,000
$
20,000

Combined
$ 1,085,000
$ 385,000
242,000
115,000
142,000
81,000
$ 965,000
$ 120,000

10,000 new units $3.50 = $35,000

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Special
Special Order
Order Decisions
Decisions
Sales
Direct materials
Direct labor
Factory overhead
Selling expenses
Admin. expenses
Total expenses
Operating income

Current
Business
$ 1,000,000
$ 350,000
220,000
110,000
140,000
80,000
$ 900,000
$ 100,000

Additional
Business
$
85,000
$
35,000
22,000
5,000
2,000
1,000
$
65,000
$
20,000

Combined
$ 1,085,000
$ 385,000
242,000
115,000
142,000
81,000
$ 965,000
$ 120,000

10,000 new units $2.20 = $22,000

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Special
Special Order
Order Decisions
Decisions
Current
Additional
Business
Business
Combined
Sales
$ 1,000,000
$
85,000
$ 1,085,000
Even
though the$$8.50
selling price
is less than
Direct
materials
350,000
$
35,000
$ the
385,000
normal
JamCo should
Direct
labor $10 selling price,
220,000
22,000accept the
242,000
offer
because net income
by $20,000.
Factory
overhead
110,000will increase
5,000
115,000
Selling expenses
140,000
2,000
142,000
Admin. expenses
80,000
1,000
81,000
Total expenses
$ 900,000
$
65,000
$ 965,000
Operating income $ 100,000
$
20,000
$ 120,000

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Special
Special Order
Order Decisions
Decisions
We can also look at this decision
using contribution margin.
Special order revenue
Direct materials
Direct labor
Contribution margin
Increase in fixed costs:
Factory overhead
Selling expenses
Administrative expenses
Special order profit
McGraw-Hill/Irwin

Per Unit
$
8.50
3.50
2.20
$
2.80

Total
$ 85,000
35,000
22,000
$ 28,000
$

5,000
2,000
1,000
20,000

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Production
Production Constraint
Constraint Decisions
Decisions
Managers often face the problem of deciding
how scarce resources are going to be utilized.
Usually, fixed costs are not affected by this
particular decision, so management can focus
on maximizing total contribution margin.
Lets look at the Kaser Company example.

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Production
Production Constraint
Constraint Decisions
Decisions
Kaser Company produces two products and
selected data is shown below:
Products
1
Selling price per unit
Less: variable expenses per unit
Contribution margin per unit
Current demand per week (units)
Contribution margin ratio
Processing time required
on machine A1 per unit

McGraw-Hill/Irwin

60
36
$
24
2,000
40%
1.00 min.

50
35
$
15
2,200
30%
0.50 min.

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Production
Production Constraint
Constraint Decisions
Decisions
Machine A1 is the scarce resource because
there is excess capacity on other machines.
Machine A1 is being used at 100% of its
capacity.
Machine A1 capacity is 2,400 minutes per week.

Should Kaser focus its efforts on Product

1 or 2?
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Production
Production Constraint
Constraint Decisions
Decisions
Lets calculate the contribution margin per unit of
the scarce resource, machine A1.
Products
1
Contribution margin per unit
Time required to produce one unit
Contribution margin per minute

McGraw-Hill/Irwin

24

1.00 min.
$ 24

15
?
?

min.

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Production
Production Constraint
Constraint Decisions
Decisions
Lets calculate the contribution margin per unit of
the scarce resource, machine A1.
Products
1
Contribution margin per unit
Time required to produce one unit
Contribution margin per minute

24

1.00 min.
$ 24

15

0.50 min.
$ 30

Product 2 should be emphasized. It is the more

valuable use of the scarce resource, machine A1,
yielding a contribution margin of $30 per minute as
opposed to $24 for Product 1.
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Production
Production Constraint
Constraint Decisions
Decisions
Lets calculate the contribution margin per unit of
the scarce resource, machine A1.
Products
1
Contribution margin per unit
Time required to produce one unit
Contribution margin per minute

24

1.00 min.
$ 24

15

0.50 min.
$ 30

If there are no other considerations, the best plan would

be to produce to meet current demand for Product 2 and
then use any capacity that remains to make Product 1.
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Production
Production Constraint
Constraint Decisions
Decisions
Lets see how this plan would work.
Allotting Our Scarce Resource (Machine A1)
Weekly demand for Product 2
Time required per unit
Total time required to make
Product 2

McGraw-Hill/Irwin

2,200 units
0.50 min.
1,100 min.

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Production
Production Constraint
Constraint Decisions
Decisions
Lets see how this plan would work.
Allotting Our Scarce Resource (Machine A1)
Weekly demand for Product 2
Time required per unit
Total time required to make
Product 2
Total time available
Time used to make Product 2

McGraw-Hill/Irwin

2,200 units
0.50 min.
1,100 min.
2,400 min.
1,100 min.
1,300

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Production
Production Constraint
Constraint Decisions
Decisions
Lets see how this plan would work.
Allotting Our Scarce Resource (Machine A1)
Weekly demand for Product 2
Time required per unit
Total time required to make
Product 2
Total time available
Time used to make Product 2
Time available for Product 1
Time required per unit
Production of Product 1
McGraw-Hill/Irwin

2,200 units
0.50 min.
1,100 min.

2,400
1,100
1,300
1.00
1,300

min.
min.
min.
min.
units

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Production
Production Constraint
Constraint Decisions
Decisions
According to the plan, we will produce 2,200 units
of Product 2 and 1,300 of Product 1. Our
contribution margin looks like this.
Production and sales (units)
Contribution margin per unit
Total contribution margin

Product 1
1,300
$
24
$ 31,200

Product 2
2,200
$ 15.00
$ 33,000

The total contribution margin for Kaser is $64,200.

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Make
Make or
or Buy
Buy Decisions
Decisions
Should I
continue to make
the part, or should
I buy it?

I suppose I
should compare
the outside purchase
price with the additional
costs to manufacture
the part.

McGraw-Hill/Irwin

What will I
do with my
idle facilities if
I buy the part?

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Make
Make or
or Buy
Buy Decisions
Decisions
Incremental costs also are important in the

decision to make a product or buy it from a

supplier.
The cost to produce an item must include
(1) direct materials, (2) direct labor and
(3) incremental overhead.
We should not use the predetermined
overhead rate to determine product cost.

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Make
Make or
or Buy
Buy Decisions
Decisions
Exitel
Exitel makes
makes computer
computer chips
chips used
used in
in
one
one of
of its
its products.
products. Unit
Unit costs,
costs, based
based on
on
production
production of
of 20,000
20,000 chips
chips per
per year,
year, are:
are:
Unit Costs
Direct Material
Direct Labor
Variable Overhead
Fixed Overhead
Total
McGraw-Hill/Irwin

9.00
5.00
1.00
13.00
$ 28.00

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Make
Make or
or Buy
Buy Decisions
Decisions
An outside supplier has offered to provide
the 20,000 chips at a cost of $25 per chip.
Fixed overhead costs will not be avoided if
the chips are purchased. Exitel has no
alternative use for the facilities.
Should Exitel accept the offer?

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Make
Make or
or Buy
Buy Decisions
Decisions
Differential costs of making (costs avoided
if bought from outside supplier)
Unit Cost
Direct Material
Direct Labor
Variable Overhead
Total

9.00
5.00
1.00
$ 15.00

Exitel should not pay $25 per unit to an outside

supplier to avoid the $15 per unit differential cost of
making the part. Fixed costs are irrelevant to decision.
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Make
Make or
or Buy
Buy Decisions
Decisions
If Exitel buys the chips from the outside
supplier, the idle facilities could be leased
to another company for $250,000 per year.
Should Exitel buy the chips and
lease the facilities?

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Make
Make or
or Buy
Buy Decisions
Decisions
Disadvantage of buying
20,000 units ($25 - $15)
Opportunity cost of facilities:
The lease revenue
Advantage of buying part
and leasing facilities

200,000
250,000

50,000

The opportunity cost of facilities changes the decision.

The real question to answer is,
What is the best use of Exitels facilities?
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Sell,
Sell, Scrap,
Scrap, or
or Rebuild
Rebuild Decisions
Decisions
Costs incurred in manufacturing units of product that do not meet quality standards
are sunk costs and cannot be recovered.
As long as rebuild costs are recovered through sale of the product, and rebuilding
does not interfere with normal production, we should rebuild.

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Sell,
Sell, Scrap,
Scrap, or
or Rebuild
Rebuild Decisions
Decisions
OserCo has 10,000 defective units that
cost $1.00 each to make. The units can be
scrapped now for $.40 each or rebuilt at an
additional cost of $.80 per unit.
If rebuilt, the units can be sold for the normal
selling price of $1.50 each. Rebuilding the 10,000
defective units will prevent the production of
10,000 new units that would also sell for $1.50.
Should OserCo scrap or rebuild?

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Sell,
Sell, Scrap,
Scrap, or
or Rebuild
Rebuild Decisions
Decisions

Sale of defects
Less rebuild costs
Less opportunity cost
Net return

Scrap
Now
$ 4,000
$ 4,000

Rebuild
$ 15,000

10,000 units $0.40 per unit

10,000 units $1.50 per unit
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Sell,
Sell, Scrap,
Scrap, or
or Rebuild
Rebuild Decisions
Decisions
10,000 units $0.80 per unit

Sale of defects
Less rebuild costs
Less opportunity cost
Net return

Scrap
Now
$ 4,000
$ 4,000

Rebuild
$ 15,000
(8,000)
(5,000)
2,000

10,000 units ($1.50 - $1.00) per unit

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Sell,
Sell, Scrap,
Scrap, or
or Rebuild
Rebuild Decisions
Decisions
OserCo should scrap the units now.

Sale of defects
Less rebuild costs
Less opportunity cost
Net return

Scrap
Now
$ 4,000
$ 4,000

Rebuild
$ 15,000
(8,000)
(5,000)
2,000

If OserCo fails to include the opportunity cost,

the rework option would show a return of $7,000,
mistakenly making rebuild appear more favorable.
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Joint
Joint Product
Product Decisions
Decisions
Two
Twoor
ormore
moreproducts
productsproduced
producedfrom
fromaa
common
commoninput
inputare
arecalled
called joint
joint products.
products.

Product 1
Joint Costs

Product 2

Joint
Joint costs
costs are
are
the
thecosts
costsof
of
processing
processingprior
priorto
to
the
thesplit-off
split-off point.
point.

Product 3
The
The split-off
split-off point
point is
isthe
the point
point in
inaaprocess
processwhere
where
joint
jointproducts
productscan
canbe
berecognized
recognizedas
asseparate
separateproducts.
products.
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Joint
Joint Product
Product Decisions
Decisions
Businesses 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
Joint Product
Product Decisions
Decisions
Ames Co. produces two products, A and B, from this process.
Should the products be
sold at split-off or
processed further?
Joint
Cost
$100,000

Common
Production
Process

Revenue
$70,000

McGraw-Hill/Irwin

Final
Sale
$120,000

Additional
Processing
$20,000

Final
Sale
$65,000

A
Revenue
$50,000

Split-Off
Point

Additional
Processing
$40,000

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Joint
Joint Product
Product Decisions
Decisions
Product
A
B

Incremental
Revenue
$

Incremental
Cost

Difference

50,000

$ 40,000

$ 10,000

15,000

20,000

(5,000)

Product A incremental revenue = $120,000 - $70,000

Product B incremental revenue = $65,000 - $50,000
Decision: Process product A, but sell product B at the
split-off point. Note that the $100,000 joint cost is
irrelevant to the processing decision.
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Joint
Joint Product
Product Decisions
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
Joint Product
Product Decisions
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
End of
of Chapter
Chapter 20
20

Hey dude,
its party time!

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