ACCT 202: Managerial Accounting

Chapter 7
Incremental Analysis

09/23/2021
Learning Objectives

1 Describe management’s decision-making process and

incremental analysis.

2 Analyze the relevant costs in accepting an order at a special

price.

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

4 Analyze the relevant costs in determining whether to sell or

process materials further.

5 Analyze the relevant costs to be considered in repairing,

retaining, or replacing equipment.

6 Analyze the relevant costs in deciding whether to eliminate an

unprofitable segment or product.

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Decision Making and Cost Classifications
• When making business decisions, both financial and non-financial
information should be considered.

• Financial information
▫ Revenues and costs
▫ Effect on overall profitability

• Non-financial information
▫ Effect on employee turnover
▫ The environment
▫ Overall company image
▫ Others…….

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Decision Making and Cost Classifications (cont’d)
• Incremental analysis for decision making
▫ Also called differential analysis, and it’s an approach used to identify the
financial data that change under alternative course of action.
 Both costs and revenue may vary, or
 Only revenue may vary, or
 Only costs may vary

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Decision Making and Cost Classifications (cont’d)
• 3 important concepts
▫ Relevant cost (and revenue)
▫ Opportunity cost
▫ Sunk cost

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Decision Making and Cost Classifications (cont’d)
• Relevant cost and revenue
▫ Cost and revenue that differ among alternatives.
▫ Only differential cost/revenue are relevant when selecting among
alternatives.

• Example
▫ You have a job paying $1,500 per month in your hometown. You have a
job offer in a neighboring city that pays $2,000 per month. The
commuting cost to the city is $300 per month

Differential revenue is: Differential cost is:

$2,000 – $1,500 = $500 $300

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Decision Making and Cost Classifications (cont’d)
• Opportunity cost
▫ The potential benefit that is given up when one alternative is selected
over another.

• Example
▫ If you were not attending college, you could be earning $15,000 per year.

Your opportunity cost of attending college for one year is $15,000

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Decision Making and Cost Classifications (cont’d)
• Sunk cost
▫ Sunk costs have already been incurred and cannot be changed now or in
the future.
▫ These costs should be ignored when making decisions.

• Example
▫ The tuition you paid for the summer session is a sunk cost because it
has incurred and cannot be changed regardless you come to the class or
not.

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Decision Making and Cost Classifications (cont’d)
• Common types of decisions involving incremental analysis:
▫ Accept an order at a special price.
▫ Make or buy component parts or finished products.
▫ Sell or process further them further.
▫ Repair, retain, or replace equipment.

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Special Orders
• A special order
▫ Obtains additional business by making a major price concession to a
specific customer.

• Assumption
▫ Sales of products in other markets are not affected by special order.
▫ The company is not operating at full capacity.

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Example
• Sunbelt Company produces 100,000 smoothie blenders per month,
which is 80% 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 Kensington 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?

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Example (cont’d)

▫ 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.

Yes, Sunbelt Company should accept the special order, because incremental
net income increases.

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Make-or-Buy Decision

When a company is involved in more than one activity

activity in
in the
the
entire
entire value chain, it is vertically integrated. A decision to
carry out one of the activities in the
the value
value chain
chain internally,
internally,
rather
rather than
than to
to buy
buy externally
externally from
from aa supplier
supplier is called aa
“make or buy” decision.

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Example
• Baron Company incurs the following annual costs in producing 25,000 ignition
switches for motor scooters.

▫ Instead of making its own switches, Baron Company might purchase the ignition switches
at a price of $8 per unit.
▫ A review of operations indicates that if the ignition switches are purchased from Ignition,
Inc., $10,000 of its fixed manufacturing costs will be avoided.
▫ What should management do?

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Example (cont’d)

Baron Company incurs $25,000 of additional costs by buying the ignition

switches rather than making them. Hence, Baron should continue to make the
switches.

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Example with Opportunity Cost
• 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.

Baron Company’s income will increase by $13,000 by buying the switches from
Ignition, Inc. Hence, Baron should purchase the switches.
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Exercise 3
• 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 will be eliminated.
a) Prepare an incremental analysis showing whether the company should
make or buy the electrical cords.
b) Will your answer be different if the released productive capacity will
generate additional income of $5,000?

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Sell or Process Further
• The 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.

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Example
• Woodmasters Inc. makes tables. The cost to manufacture an
unfinished table is $35. The selling price per unfinished unit is $50.
Woodmasters has unused capacity that can 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. Should Woodmasters sell or process further?

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Example (cont’d)
• The incremental analysis on a per unit basis is as follows.

Woodmasters should process the tables further, because the incremental

revenue is higher than the incremental cost.
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Example – Multi-Product Case
• Joint product situation for Marais Creamery. Cream and skim milk
are products that result from the processing of raw milk.

• The common process costs are irrelevant for any sell-or-process-

further decisions, because they are sunk costs.

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Example – Multi-Product Case (cont’d)
• Cost and revenue data per day for cream.

▫ Determine whether the company should simply sell the cream or process
it further into cottage cheese.

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Example – Multi-Product Case (cont’d)
• Analysis of whether to sell cream or process into cottage cheese.

Marais should NOT process the cream further because it will sustain an
incremental loss of $2,000.

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Exercise 4

• Easy Does It manufactures unpainted furniture for the do-it-yourself

(DIY) market. It currently sells a child’s rocking chair for $25.
Production costs are $12 variable and $8 fixed. Easy Does It is
considering painting the rocking chair and selling it for $35. Variable
costs to paint each chair are expected to increase by $9, and fixed
costs are expected to increase by $2. Prepare an analysis showing
whether Easy Does It should sell unpainted or painted chairs.

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Repairing, Retaining, or Replacing Equipment
• Management often has to decide whether to continue using an
asset, repair, or replace it.

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Example
• Jeffcoat Company is considering replacing a factory machine with a
new machine. Jeffcoat Company has a factory machine that
originally cost $110,000. It has a balance in Accumulated
Depreciation of $70,000, so its book value is $40,000. It has a
remaining useful life of four years. The company is considering
replacing this machine with a new machine. 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 the new machine is
acquired, variable manufacturing costs are expected to decrease
from $160,000 to $125,000 and the old unit could be sold for
$5,000. Prepare the incremental analysis for the four-year period.

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Example (cont’d)

Illustration 7-10

Jeffcoat should replace the equipment because net income will increase by
$25,000.

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Example (cont’d)
• Additional considerations:
▫ The book value the old machine does not affect the decision, because it
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.

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Exercise 5
• Twilight Hospital purchased a special radiology scanner that
originally cost $100,000. The scanner has a remaining useful life of
3 years and is estimated to have no salvage value at the end of its
useful life. Annual operating costs with this scanner are $105,000.
Twilight is also considering a new scanner that will cost $110,000.
The new scanner will save Twilight $25,000 in annual operating
expense over its remaining 3-year useful life. If the new scanner is
acquired, Twilight can sell the old unit for $50,000. Prepare the
incremental analysis for the three-year period.

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Continue or Eliminate an unprofitable segment /product

Decision rule:
• The relevant costs are the variable costs that drive
the contribution margin, if any, produced by the
segment or product.
• Opportunity cost and reduction of fixed expenses
must also be considered.

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Continue or Eliminate an unprofitable segment or product

Example
Venus Company manufactures three models: Pro, Master, and Champ.
Pro and Master are profitable lines.
Champ operates at a loss.

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

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Continue or Eliminate an unprofitable segment or product
Example (con’t):
Assume that the $30,000 of fixed costs applicable to the unprofitable segment
are allocated 2/3 to the Pro model and 1/3 to the Master model if the Champ
model is eliminated.

Pro Master Total

Sales 800,000 300,000 1,200,000

Variable costs 520,000 210,000 820,000
Contribution margin 280,000 90,000 370,000
Fixed costs 100,000 60,000 160,000
Net income 180,000 30,000 210,000

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Continue or Eliminate an unprofitable segment or product
Example (con’t):

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Continue or Eliminate an unprofitable segment or product

Example (con’t):
Assume that $22,000 of the fixed costs attributed to the Champ line can be
eliminated if the line is discontinued.

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