CHAPTER REVIEW
Incremental Analysis
1.
(L.O. 1) Management’s decision-making process frequently involves the following steps:
a. Identify the problem and assign responsibility.
b. Determine and evaluate possible courses of action.
c. Make a decision.
d. Review the results of the decision.
Accounting’s contribution to the decision-making process occurs primarily in steps (b) and (d).
2.
(L.O. 2) Business decisions involve a choice among alternative courses of action. In making such
decisions, management ordinarily considers both financial and nonfinancial information. The process
used to identify the financial data that change under alternative courses of action is called incremental
analysis.
a. Incremental analysis involves not only identifying relevant revenues and costs, but also determining
the probable effects of the decision on future earnings.
b. Data for incremental analysis involves estimates and uncertainty.
c. Gathering data may involve market analysts, engineers, and accountants.
3.
Three important cost concepts used in incremental analysis include:
a. Relevant costs are those costs and revenues that differ across alternatives.
b. Often in choosing one course of action, a company must give up the opportunity to benefit from
some other course of action, this is known as opportunity cost.
c. Sunk costs are costs that have already been incurred and will not be changed or avoided by any
present or future decision.
4.
In incremental analysis, both costs and revenues may change. However, in some cases
(1) variable costs may not change under the alternative courses of action, and (2) fixed costs may
change.
Accept an Order at a Special Price
5.
(L.O. 3) An order at a special price should be accepted when the incremental revenue from the order
exceeds the incremental costs.
a. It is assumed that sales in other markets will not be affected by the special order.
b. If the units can be produced within existing plant capacity, generally only variable costs will be
affected.
Make or Buy
6.
(L.O. 4) In a make or buy decision, management must determine the costs which are different under the
two alternatives. If there is an opportunity to use the productive capacity for another purpose, opportunity
cost should be considered. Opportunity cost is the potential benefit that may be obtained by following
an alternative course of action. This cost is an additional cost of making the component.
Sell or Process Further
7.
(L.O. 5) The basic decision rule in a sell or process further decision is: Process further as long as the
incremental revenue from such processing exceeds the incremental processing costs. Incremental
revenue is the increase in sales which results from processing the product further.
8.
Sell-or-process-further decisions are particularly applicable to production processes that produce multiple
products simultaneously. In these types of decisions, all costs incurred prior to the point at which the joint
products are separately identifiable (the split-off point) are called joint costs. Joint product costs are
sunk costs.
Repair, Retain or Replace Equipment
9.
(L.O. 6) 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.
a. The book value of the old machine is a sunk cost which does not affect the decision.
b. However, any trade-in allowance or cash disposal value of the existing asset must be considered.
Eliminate an Unprofitable Segment or Product
10. (L.O. 7) In deciding whether to eliminate an unprofitable segment, management should choose the
alternative which results in the highest net income. Often fixed costs allocated to the unprofitable
segment must be absorbed by the other segments. It is possible, therefore, for net income to decrease
when what appears to be an unprofitable segment is eliminated.
11. Many of the decisions involving incremental analysis also have important qualitative features.
SOLUTIONS TO BRIEF EXERCISES
BRIEF EXERCISE 7-1
The correct order is:
1.
2.
3.
4.
Identify the problem and assign responsibility.
Determine and evaluate possible courses of action.
Make a decision.
Review results of the decision.
BRIEF EXERCISE 7-2
Revenues
Costs
Net income
Alternative
A
$160,000
100,000
$ 60,000
Alternative A is better than Alternative B.
Alternative
B
$180,000
125,000
$ 55,000
Net Income
Increase
(Decrease)
($ 20,000)
(25,000)
($ 5,000)
BRIEF EXERCISE 7-3
Revenues
Costs—Variable manufacturing
Shipping
Net income
Reject
Order
$0
0
0
$0
The special order should be accepted.
*3,000 X $25
**3,000 X $20
***3,000 X $ 2
Accept
Order
$75,000*
60,000**
6,000***
$ 9,000
Net Income
Increase
(Decrease)
($ 75,000)
( (60,000)
( (6,000)
($ 9,000)
BRIEF EXERCISE 7-4
Variable manufacturing costs
Fixed manufacturing costs
Purchase price
Total annual cost
Make
$50,000
30,000
–0–
$80,000
Buy
$ –0–
30,000
60,000
$90,000
Net Income
Increase
(Decrease)
$ 50,000
0
(60,000)
($(10,000)
The decision should be to make the part.
BRIEF EXERCISE 7-5
Sales price per unit
Cost per unit
Variable
Fixed
Total
Net income per unit
Sell
$62.00
Process
Further
$70.00
Net Income
Increase (Decrease)
$8.00
36.00
10.00
46.00
$16.00
43.00
10.00
53.00
$17.00
( (7.00)
0
( (7.00)
$1.00
The bookcases should be processed further because the incremental revenues
exceed incremental costs by $1.00 per unit.
BRIEF EXERCISE 7-6
The allocated joint costs are irrelevant to the sell or process further decisions. If
AB1 is processed further, the company will earn incremental revenue of $50,000
($150,000 – $100,000) and only incur incremental costs of $45,000. Therefore, the
company should process AB1 further and sell AB2. If XY1 is processed further,
the company will earn incremental revenue of $35,000 ($130,000 – $95,000) but
will incur incremental costs of $50,000. Therefore, the company should sell XY1
rather than process it further.
BRIEF EXERCISE 7-7
Variable manufacturing costs
for 4 years
New machine cost
Sell old machine
Total
Retain
Equipment
Replace
Equipment
Net 4-Year
Income
Increase
(Decrease)
$3,000,000
(30,000)
$2,500,000
300,000
(30,000)
$2,770,000
($ 500,000
((300,000)
30,000
$ 230,000
$3,000,000
The old factory machine should be replaced.
BRIEF EXERCISE 7-8
Sales
Variable costs
Contribution margin
Fixed costs
Net income
Continue
$200,000
180,000
20,000
30,000
($ (10,000)
Eliminate
$
–0–
–0–
( –0–
20,000)
$(20,000)
Net Income
Increase (Decrease)
$(200,000)
(180,000)
(20,000)
( 10,000)
$ (10,000)
The Big Bart product line should be continued because $20,000 of contribution
margin will not be realized if the line is eliminated. This amount is greater than
the $10,000 savings of fixed costs.
SOLUTIONS TO PROBLEMS
PROBLEM 7-1A
(a)
Revenues (10,000 X $27)
Cost of goods sold
Selling and administrative
expenses
Net income
Reject
Order
$0
0
Accept
Order
$270,000
220,000 (1)
Net Income
Increase
(Decrease)
$ 270,000
( (220,000)
0
$0
20,000 (2)
$ 30,000
( (20,000)
$ 30,000
(1) Variable costs = $3,600,000 – $960,000 = $2,640,000;
$2,640,000 ÷ 120,000 units = $22.00 per unit;
10,000 X $22.00 = $220,000.
(2) Variable costs = $405,000 – $225,000 = $180,000;
$180,000 ÷ 120,000 units = $1.50 per unit;
10,000 X ($1.50 + $0.50) = $20,000.
(b) Yes, the special order should be accepted because net income will increase
by $30,000.
(c) Unit selling price = $22.00 (variable manufacturing costs) + $2.00 variable
selling and administrative expenses + $4.00 net income = $28.
(d) Nonfinancial factors to be considered are: (1) possible effect on domestic sales,
(2) possible alternative uses of the unused plant capacity, and (3) ability to
meet customer’s schedule for delivery without increasing costs.
PROBLEM 7-2A
(a)
Make CISCO
Direct materials
(8,000 X $4.80)
Direct labor
(8,000 X $4.30)
Indirect labor
(8,000 X $.43)
Utilities (8,000 X $.40)
Depreciation
Property taxes
Insurance
Purchase price
Freight and inspection
(8,000 X $.35)
Receiving costs
Total annual cost
$38,400
Buy CISCO
$
Net Income
Increase
(Decrease)
0
($38,400)
34,400
0
( 34,400)
3,440
3,200
3,000
700
1,500
0
0
0
900
200
600
80,000
( 3,440)
( 3,200)
( 2,100)
(
500)
(
900)
( (80,000)
0
0
$84,640
2,800
1,300
$85,800
( (2,800)
( (1,300)
($ (1,160)
(b) The company should continue to make CISCO because net income would
be $1,160 less if CISCO were purchased from the supplier.
(c) The decision would be different. Because of the opportunity cost of $3,000,
net income will be $1,840 higher if CISCO is purchased as shown below:
Net Income
Increase
Make CISCO
Buy CISCO
(Decrease)
Total annual cost
$84,640
$85,800
$(1,160)
Opportunity cost
3,000
0
(3,000)
Total cost
$87,640
$85,800
$(1,840)
(d) Nonfinancial factors include: (1) the adverse effect on employees if CISCO is
purchased, (2) how long the supplier will be able to satisfy
the Shatner Manufacturing Company’s quality control standards at the
quoted price per unit, and (3) whether the supplier will deliver the units
when they are needed by Shatner.
PROBLEM 7-3A
(a) (1)
Table Cleaner Not Processed Further
Sales:
FloorShine (600,000 ÷ 30) X $20
Table Cleaner (300,000 ÷ 25) X $18
Total revenue
Costs:
CDG
Additional costs of FloorShine
Total costs
Gross profit
(2)
$400,000
216,000
$616,000
210,000
240,000
450,000
$166,000
Table Cleaner Processed Further
Sales:
FloorShine
Table Stain Remover (300,000 ÷ 25) X $14
Table Polish (300,000 ÷ 25) X $14
Total revenue
Costs:
CDG
Additional costs of FloorShine
TCP
Total costs
Gross profit
$400,000
168,000
168,000
$736,000
210,000
240,000
100,000
550,000
$186,000
(3) If the table cleaner is processed further overall company profits will be
$20,000 higher. Therefore, management made the wrong decision by
choosing to not process table cleaner further.
PROBLEM 7-3A (Continued)
(b)
Incremental revenue
Incremental costs
Totals
Don’t Process
Table Cleaner
Further
$216,000
0
$216,000
Process
Table Cleaner
Further
$336,000
100,000
$236,000
Net Income
Increase
(Decrease)
$120,000
(100,000)
$ 20,000
When trying to decide if the table cleaner should be processed further into TSR
and TP, only the relevant data need be considered. All of the costs that occurred
prior to the creation of the table cleaner are sunk costs and can be ignored. The
decision should be made by comparing the incremental revenue from further
processing to the incremental costs.
PROBLEM 7-4A
(a)
Cost
Accumulated depreciation
Book value
Sales proceeds
Loss on sale
$120,000
(24,000*)
96,000
(25,000)
$ 71,000
*$120,000 ÷ 5 years = $24,000
(b) (1)
Revenues ($240,000 X 4 yrs.)
Less costs:
Variable costs ($35,000 X 4)
Fixed costs ($23,000 X 4)
Selling & administrative
Depreciation
Net income
Retain Old Elevator
$960,000
$140,000
92,000
116,000*
96,000
444,000
$516,000
*($29,000 X 4)
(2)
Revenues
Less costs:
Variable costs ($10,000 X 4)
Fixed costs ($8,500 X 4)
Selling and administrative
Depreciation
Operating income
Less: Loss on old elevator
Net income
Replace Old Elevator
$960,000
$ 40,000
34,000
116,000
160,000
350,000
610,000
71,000
$539,000
(c)
Variable operating costs
Fixed operating costs
New elevator cost
Salvage on old elevator
Totals
Retain
Replace
Old Elevator Old Elevator
$140,000
$ 40,000
92,000
34,000
160,000
(25,000)
$232,000
$209,000
.
Net Income
Increase
(Decrease)
$ 100,000
58,000
(160,000)
25,000
$ 23,000
PROBLEM 7-4A (Continued)
(d)
MEMO
TO: Ron Richter
FROM: Student
SUBJECT: Relevant Data for Decision to Replace Old Elevator
When deciding whether or not to replace any old equipment, the analysis should
only include cost data relevant to the replacement decision. The $71,000 loss
that would be experienced if we replace the old elevator with the newer model is
related to a sunk cost, namely the cost of the old elevator. Sunk costs are
irrelevant in decision making.
The loss occurs when comparing the book value of the old elevator to the cash
proceeds that would be received. The book value of $96,000 would be deducted
as depreciation expense over the next four years if the elevator were retained. If
the elevator is replaced with the newer model, the book value will be expensed in
the current year, less the cash proceeds received on disposal. Therefore, the
$96,000 book value will be expensed under either alternative, making it
irrelevant.
PROBLEM 7-5A
(a)
Sales
Variable costs
Cost of goods sold
Selling and administrative
Total variable expenses
Contribution margin
Division I
$250,000
Division II
$200,000
150,000
30,000
180,000
($ 70,000)
172,800
42,000
214,800
$ (14,800)
(b) (1)
Net Income
Increase
(Decrease)
Division I
Continue
Eliminate
Contribution margin (above)
Fixed costs
Cost of goods sold
Selling and administrative
Total fixed expenses
Income (loss) from operations
$(70,000)
$(
0)
$(70,000)
(50,000)
(45,000)
(95,000)
$(25,000)
(25,000)
(22,500)
(47,500)
$(47,500)
25,000
22,500
47,500
$(22,500)
Net Income
Increase
(Decrease)
(2)
Division II
Continue
Eliminate
Contribution margin (above)
Fixed costs
Cost of goods sold
Selling and administrative
Total fixed expenses
Income (loss) from operations
$(14,800)
$(
0)
$14,800
(19,200
( 18,000
( 37,200
$(52,000)
( 9,600)
( 9,000)
(18,600)
$(18,600)
( 9,600
9,000
18,600
$33,400
Division II should be eliminated as its negative contribution margin is
$14,800. Income from operations would increase $33,400 if Division II is
eliminated.
Division I should be continued because it is producing positive contribution
margin of $70,000. Income from operations will decrease $22,500 by
discontinuing this division.
PROBLEM 7-5A (Continued)
(c)
GUTIERREZ COMPANY
CVP Income Statement
For the Quarter Ended March 31, 2014
Divisions
Sales
Variable costs
Cost of goods sold
Selling and
administrative
Total variable
costs
Contribution margin
Fixed costs
Cost of goods sold (1)
Selling and
administrative (2)
Total fixed
costs
Income (loss) from
operations
I
III
IV
Total
$250,000
$500,000
$450,000
$1,200,000
150,000
240,000
187,500
577,500
30,000
30,000
30,000
90,000
180,000
70,000
270,000
230,000
217,500
232,500
667,500
532,500
53,200
63,200
65,700
182,100
48,000
33,000
23,000
104,000
101,200
96,200
88,700
286,100
$(31,200) $133,800
$143,800
$ 246,400
(1) Division’s fixed cost of goods sold plus 1/3 of Division II’s unavoidable
fixed cost of goods sold [$192,000 X (100% – 90%) X 50% = $9,600].
Each division’s share is $3,200.
(2) Division’s fixed selling and administrative expense plus 1/3 of Division
II’s unavoidable fixed selling and administrative expenses [$60,000 X
(100% – 70%) X 50% = $9,000]. Each division’s share
is $3,000.
(d) Income from operations with Division II of $213,000 (given) plus
incremental income of $33,400 from eliminating Division II = $246,400 income
from operations without Division II.