Chapter
20
McGraw-Hill/Irwin
Incremental Analysis
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The Challenge of
Changing 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
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Product
mix
decisions
Make
or buy
decisions
Joint
product
decisions
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The Concept of
Relevant Cost Information
 Will you drive or fly to Florida for spring break?
 You have gathered the following information to
help you with the decision.






Motel cost is $80 per night.
Meal cost is $20 per day.
Your car insurance is $100 per month.
Kennel cost for your dog is $5 per day.
Round-trip cost of gasoline for your car is $200.
Round-trip airfare and rental car for a week is $500.
 Driving requires two days, with an overnight stay,
cutting your time in Florida by two days.
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The Concept of
Relevant Cost 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
© The McGraw-Hill Companies, Inc., 2002
The Concept of
Relevant Cost 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.
© The McGraw-Hill Companies, Inc., 2002
The Concept of
Relevant Cost 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 the extra two
days in Florida
worth the $300
extra cost to fly?
Transportation
costs differ between
the two alternatives,
so they are relevant
to your decision
© The McGraw-Hill Companies, Inc., 2002
Decision 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 Information
in Business Decisions
Information that varies among the possible
courses of action being considered.
— Incremental costs and revenues —
Important cost concepts for
business decisions.
 Opportunity
costs.
 Sunk
costs.
 Out-of-pocket costs.
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Opportunity 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 Costs Versus
Out-of-Pocket 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 Costs Versus
Out-of-Pocket Costs
Cost = $10,000
two years ago
Trade ?
Cost = $25,000
today
The dealer will trade for $20,000 plus your car.
What amount is relevant to your decision,
the $10,000 sunk cost of your car or the
$20,000 out-of-pocket cash differential?
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Incremental Analysis in
Common Business Decisions
We will now
examine
several
different types
of managerial
decisions.
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Special Order 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 Order 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
© The McGraw-Hill Companies, Inc., 2002
Special Order 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 Order Decisions
First let’s look at incorrect reasoning
that leads to an incorrect decision.
Our cost is $9.00
per unit. I can’t sell
for $8.50 per unit.
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Special Order 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.
McGraw-Hill/Irwin
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Special Order 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 Order 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
McGraw-Hill/Irwin
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Special Order 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 Order 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 Order 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
© The McGraw-Hill Companies, Inc., 2002
Production Constraint 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.
Let’s look at the Kaser Company example.
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Production Constraint 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
2
$
60
36
$
24
2,000
40%
1.00 min.
$
50
35
$
15
2,200
30%
0.50 min.
© The McGraw-Hill Companies, Inc., 2002
Production Constraint 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 Constraint Decisions
Let’s 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
2
$
24
÷
1.00 min.
$ 24
$
÷
15
?
min.
?
© The McGraw-Hill Companies, Inc., 2002
Production Constraint Decisions
Let’s 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
$
2
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 Constraint Decisions
Let’s 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
$
2
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 Constraint Decisions
Let’s 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.
© The McGraw-Hill Companies, Inc., 2002
Production Constraint Decisions
Let’s 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
© The McGraw-Hill Companies, Inc., 2002
Production Constraint Decisions
Let’s 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
© The McGraw-Hill Companies, Inc., 2002
Production Constraint 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 or Buy 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?
© The McGraw-Hill Companies, Inc., 2002
Make or Buy 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 or Buy Decisions
Exitel makes computer chips used in
one of its products. Unit costs, based on
production of 20,000 chips per year, 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
© The McGraw-Hill Companies, Inc., 2002
Make or Buy 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?
McGraw-Hill/Irwin
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Make or Buy 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.
McGraw-Hill/Irwin
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Make or Buy 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 or Buy 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 Exitel’s facilities?”
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Sell, Scrap, or Rebuild 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, Scrap, or Rebuild 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, Scrap, or Rebuild 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, Scrap, or Rebuild 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
McGraw-Hill/Irwin
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Sell, Scrap, or Rebuild 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 Product Decisions
Two or more products produced from a
common input are called joint products.
Product 1
Joint Costs
Product 2
Joint costs are
the costs of
processing prior to
the split-off point.
Product 3
The split-off point is the point in a process where
joint products can be recognized as separate products.
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Joint Product 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 Product 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
B
© The McGraw-Hill Companies, Inc., 2002
Joint Product 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.
McGraw-Hill/Irwin
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Joint Product 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.
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2002
Joint Product 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 of Chapter 20
Hey dude,
it’s party time!
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