BBC Session

Incremental Analysis
 Incremental Analysis
After this session, you should be able to:
1 Identify the steps in management’s decision-making
process.
2 Describe the concept of incremental analysis.
3 Identify the relevant costs in accepting an order at a
special price.
4 Indicate the relevant costs in a make-or-buy
decision.
5 Identify the factors to be considered in retaining or
replacing equipment.
 Overview
Decision-Making Process
• Incremental Analysis Approach
• How Incremental Analysis
Works

INCREMENTAL Types of Incremental Analysis

ANALYSIS • Accept an Order at a Special
Price
• Make or Buy
• Retain or Replace Equipment
 Study Objective 1

Identify the steps in management’s

decision-making process.
 Management’s Decision-
Making Process
Management’s decision-making process
frequently involves the following steps:
1 Identify the problem and assign responsibility.
2 Determine and evaluate possible courses of
action.
3 Make a decision.
4 Review results of the decision.
 Management’s Decision-
Making Process
 In making decisions, management ordinarily
considers both financial and nonfinancial
information.
 Although nonfinancial information can be as
important as, and in some cases more important
than, financial information, the following
discussion will primarily be limited to financial
information that is relevant to decisions since
that is the kind of information accounting usually
provides.
Study Objective 2

Describe the concept of

incremental analysis.
 Incremental Analysis
 Business decisions involve a choice among alternative
courses of action.
 The process used to identify the financial data that change
under alternative courses of action is called incremental
analysis.
 In some cases, both costs and revenues will change under
alternative choices. In other cases only costs or revenues will
vary.
 It is important to recognize that
– variable costs may not change under the alternatives, and
– fixed costs may change.
 Incremental Analysis
 Incremental analysis involves not only
identifying relevant revenues and costs, but
also determining the probable effects of
decisions on future earnings.
 Data for incremental analysis often involves
estimates and uncertainty.
 Gathering data may involve market analysts,
engineers, and accountants.
 How Incremental Analysis
Works
The basic approach in incremental analysis is illustrated
in the following illustration:
Alternative Alternative Net Income
A B Increase (Decrease)
Revenues $125,000 $110,000 $(15,000)
Costs 100,000 80,000 20,000
Net income $ 25,000 $ 30,000 $ 5,000

In this illustration, alternative B is being compared with

alternative A. The net income column shows the
differences between the alternatives. Alternative B will
produce $5,000 more net income than alternative A.
 Key Cost Concepts in
Incremental Analysis
Three important cost concepts used in incremental
analysis follow:
 In incremental analysis, the only factors to be
considered are those costs and revenues that differ
across alternatives. Those factors are called
relevant. Costs and revenues that do not differ
across alternatives can be ignored when trying to
chose between alternatives.
 Key Cost Concepts in
Incremental Analysis
 Often in choosing one course of action, the company
must give up the opportunity to benefit from some
other course of action. This lost benefit is referred to
as opportunity cost.
 Costs that have already been incurred and will not be
changed or avoided by any future decision are
referred to as sunk costs. Sunk costs are not relevant
costs.
 Types of Incremental
Analysis
A number of different types of decisions involve
incremental analysis. The more common types of
decisions are whether to:
 Accept an order at a special price.
 Make or buy component parts or finished
products.
 Retain or replace equipment.
 Study Objective 3

Identify the relevant costs in

accepting an order at a special price.
 Accept an Order at a
Special Price
 Sometimes a company may have an opportunity to obtain
additional business if it is willing to make major price
concessions to a specific customer.
 An order at a special price should be accepted when the
incremental revenue from the order exceeds the incremental
costs.
 It is assumed that sales in other markets will not be affected
by the special order. If other sales were affected, the lost
sales would have to be considered in making the decision.
 If the units can be produced within existing plant capacity,
generally only variable costs will be affected.
Accept an Order at a
Special Price
To illustrate, assume that Sunbelt Company
produces 100,000 automatic blenders per
month, which is 80% of plant capacity.
Variable manufacturing costs are $8 per
unit, and fixed manufacturing costs are
$400,000, or $4 per unit. The blenders are
normally sold to retailers at $20 each.

Question:
Sunbelt has an offer from Mexico Co.
to purchase an additional 2,000
blenders at $11 per unit. Acceptance
of this offer would not affect normal
sales of the product, and the
additional units can be manufactured
without increasing plant capacity.
 Accept an Order at a
Special Price: Incremental Analysis
If management makes its decision on the basis of total cost per unit of
$12 ($8 + $4), the order would be rejected, because costs ($12) would
exceed revenues ($11) by $1 per unit. However, since the units can be
produced within existing plant capacity, the special order will not
increase fixed costs. The relevant data for the decision, therefore, are the
variable manufacturing costs per unit of $8 and the expected revenue of
$11 per unit.
Reject Accept Net Income
Order Order Increase (Decrease)
Revenues $ -0- $22,000 $ 22,000
Costs -0- 16,000 (16,000)
Net income $ -0- $ 6,000 $ 6,000

Decision:
Sunbelt will increase its net income by $6,000 when accepting this
special order.
 Study Objective 4

Indicate the relevant costs in a

make-or-buy decision.
 Make or Buy

 When a manufacturer assembles component parts

in producing a finished product, management must
decide whether to make or buy the components.
 This is often referred to as an outsourcing
decision.
 If there is an opportunity to use the productive
capacity for another purpose, opportunity costs
should be considered.
 The decision to make or buy components should be
made on the basis of incremental analysis.
 Make or Buy
Assume that Baron Co. incurs the following
annual costs in producing 25,000 ignition
switches for motor scooters.

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

Alternatively, Baron may purchase the

ignition switches from Ignition, Inc., at
a price of $8 per unit.

Question:
Should Baron make or buy the
ignition switches?
 Make or Buy:
Incremental Analysis
At first glance, it appears that management should buy the switches for
$8 instead of make for $9. However, a review of operations indicates that
if the switches are purchased all of Baron’s variable costs, but only
$10,000 of its fixed manufacturing costs, will be eliminated. Thus,
$50,000 of fixed costs will remain. The incremental costs are:
Net Income
Make Buy Increase (Decrease)
Direct materials $ 50,000 $ - 0 - $ 50,000
Direct labor 75,000 -0- 75,000
Variable manufacturing costs 40,000 -0- 40,000
Fixed manufacturing costs 60,000 50,000 10,000
Purchase price -0- 200,000 (200,000)
Total annual cost $225,000 $250,000 $ (25,000)

Decision:
Barton Company will incur $25,000 of additional costs by buying the
switches. Therefore, Barton should continue to make the switches.
 Make or Buy with Opportunity
Cost: Incremental Analysis
Assume that through buying the switches, Baron Co. can use the
released productive capacity to generate additional income of
$28,000. This lost income is an additional cost of continuing to
make the switches in the make-or-buy decision. This opportunity
cost is added to the “Make” column, for comparison.
Net Income
Make Buy Increase (Decrease)
Total annual cost $225,000 $250,000 $(25,000)
Opportunity cost 28,000 -0- 28,000
Total cost $253,000 $250,000 $ 3,000

Decision:
It is now advantageous to buy the switches. Barton will save $3,000
worth of costs with this alternative.
 Study Objective 5

Identify the factors to be considered

in retaining or replacing equipment.
 Retain or Replace
Equipment
 Management often has to decide whether to continue
using an asset or replace it.
 In a decision to retain or replace equipment,
management compares the costs which are affected
by the two alternatives. Generally, these are variable
manufacturing costs and the cost of the new
equipment.
 The book value of the old machine is a sunk cost
which is a cost that cannot be changed by any present
or future decision. Sunk costs are not relevant in
incremental analysis.
 Any trade-in allowance or cash disposal value of the
existing asset is relevant, however.
Retain or Replace
Equipment
Assume that Jeffcoat Company has a
factory machine with a book value of
$40,000 and a remaining useful life of four
years. A new machine is available that costs
$120,000 and is expected to have zero
salvage value at the end of its 4-year useful
life. If the new machine is acquired, variable
manufacturing costs are expected to
decrease from $160,000 to $125,000 annually
and the old unit will be scrapped.

Question:
Should Jeffcoat Company
retain or replace the machine?
 Retain or Replace:
Incremental Analysis
The incremental analysis for the 4-year period is as follows:
Net Income
Retain Replace Increase (Decrease)
Variable manufacturing costs $640,000a $500,000b $140,000
New machine cost 120,000 (120,000)
Total $640,000 $620,000 $ 20,000

a(4 years x $160,000)

b(4 years x $125,000)

Decision:
In this case, it would be to the company’s advantage to replace the
equipment. The lower variable manufacturing costs due to
replacement more than offset the cost of the new equipment.
 Limited Resources
 When a company has limited resources (floor space, raw
materials, or machine hours), management must decide
which products to make and sell in order to maximize net
income.
 In an allocation of limited resources decision, it is necessary
to find the contribution margin per unit of limited
resource.
 This is obtained by dividing the contribution margin per unit
of each product by the number of units of the limited
resource required for each product.
 Production should be geared to the product with the highest
contribution margin per unit of limited resource.
Limited Resources
Assume that Collins Co. manufactures deluxe
and standard pen and pencil sets. The limited
resource is machine capacity, which is 3,600
hours per month. Relevant data consists of:

Deluxe Standard
Contribution margin per unit $8 $6
Machine hours required per unit .4 .2

Question:
Should Collins Co. shift its sales mix
toward deluxe or standard sets?
 Limited Resources
Based on the previous data, it might appear that deluxe
is more profitable since they have a higher contribution
margin. However, standard sets take fewer machine
hours. Therefore, it is necessary to find the contribution
margin per unit of limited resource, as shown below:

Deluxe Standard
Contribution margin per unit (a) $8 $6
Machine hours required per unit (b) .4 .2

Contribution margin per unit of

limited resource (a  b) $20 $30

Decision: Since the standard set has

the higher contribution margin per
unit of limited resource, sales mix
should shift towards that product.
 Limited Resources:
Incremental Analysis
This result is confirmed by the following incremental analysis:
If Produce If Produce
Deluxe Sets Standard Sets
Machine hours (a) 600 600
Contribution margin per unit of
limited resource (b) $20 $30
Contribution margin (a x b) $12,000 $18,000

Decision:
Once again, it is clear that standard sets produce more contribution
margin. Thus, given adequate demand for standard sets, the sales
mix should shift to that product in order to maximize Collins
Company’s income.
 Other Considerations in
Decision Making
 In this unit, the focus was primarily on
the quantitative (those attributes that
can be easily expressed in terms of
numbers) factors that affect a decision.
 Many of the decisions involving
incremental analysis have important
qualitative features that, while not
easily measured, should not be
ignored.