CHAPTER 7
Incremental Analysis
ASSIGNMENT CLASSIFICATION TABLE
Study Objectives
Questions
Brief
Exercises
Exercises
A
Problems
B
Problems
1.
Identify the steps in
management’s decisionmaking process.
1, 2
1
1
2.
Describe the concept
of incremental analysis.
3, 4
2
1
3.
Identify the relevant
costs in accepting an
order at a special price.
5
3
2, 3, 4, 14
1A
1B
4.
Identify the relevant
costs in a make-or-buy
decision.
6, 7
4
5, 6, 14
2A
2B
5.
Identify the relevant costs
in determining whether to
sell or process materials
further.
8, 9, 10
5, 6
7, 8, 9, 14
3A
3B
6.
Identify the relevant costs
to be considered in
retaining or replacing
equipment.
11
7
10, 11, 14
4A
4B
7.
Identify the relevant costs
in deciding whether to
eliminate an unprofitable
segment.
12
8
12, 13, 14
5A
5B
© 2008
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7-1
ASSIGNMENT CHARACTERISTICS TABLE
Problem
Number
Description
Difficulty
Level
Time
Allotted (min.)
Simple
20–30
1A
Make incremental analysis for special order and identify
nonfinancial factors in the decision.
2A
Make incremental analysis related to make or buy,
consider opportunity cost, and identify nonfinancial
factors.
Moderate
30–40
3A
Determine if product should be sold or processed further.
Moderate
30–40
4A
Compute gain or loss, and determine if equipment should
be replaced.
Moderate
30–40
5A
Compute contribution margin and prepare incremental
analysis concerning elimination of divisions.
Moderate
30–40
1B
Make incremental analysis for special order and identify
nonfinancial factors in the decision.
Simple
20–30
2B
Make incremental analysis related to make or buy,
consider opportunity cost, and identify nonfinancial
factors.
Moderate
30–40
3B
Determine if product should be sold or processed further.
Moderate
30–40
4B
Compute gain or loss, and determine if equipment should
be replaced.
Moderate
30–40
5B
Compute contribution margin and prepare incremental
analysis concerning elimination of divisions.
Moderate
20–30
© 2008
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7-2
© 2008
For Instructor Use Only
Identify the relevant costs in
accepting an order at a special
price.
Identify the relevant costs in a
make-or-buy decision.
Identify the relevant costs in
determining whether to sell or
process materials further.
Identify the relevant costs to
be considered in retaining or
replacing equipment.
Identify the relevant costs in
deciding whether to eliminate
an unprofitable segment.
*3.
*4.
*5.
*6.
*7.
Broadening Your Perspective
Describe the concept of
incremental analysis.
*2.
Q7-8
Q7-9
Q7-10
Identify the steps in management’s BE7-1
decision-making process.
Real-World Focus Decision Making All About
Across the
You
Exploring the Web
Decision Making
Organization
Activity
Across the
Organization
BE7-8
Q7-12
E7-7
E7-8
E7-9
BE7-5
BE7-6
P7-5A
P7-5B
P7-4A
P7-4B
E7-14
P7-3A
P7-3B
P7-2A
P7-2B
Managerial Analysis
Decision Making
Across the
Organization
Ethics Case
Communication
E7-12
E7-13
E7-14
E7-10
E7-11
E7-14
E7-5
E7-6
E7-14
BE7-4
E7-14
P7-1A
P7-1B
Evaluation
E7-2
E7-3
E7-4
Synthesis
BE7-3
BE7-2
Analysis
BE7-7
E7-1
E7-1
Application
Q7-11
Q7-6
Q7-7
Q7-5
Q7-3
Q7-4
Q7-1
Q7-2
Knowledge Comprehension
*1.
Study Objective
Correlation Chart between Bloom’s Taxonomy, Study Objectives and End-of-Chapter Exercises and Problems
BLOOM’S TAXONOMY TABLE
7-3
ANSWERS TO QUESTIONS
1.
The following steps are frequently involved in management’s decision-making process:
(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.
2.
My roommate is incorrect. Accounting contributes to the decision-making process at Steps 2 and 4.
Prior to the decision, accounting provides relevant revenue and cost data for each course of action.
Following the decision, internal reports are prepared to show the actual impact of the decision on
net income.
3.
Disagree. Incremental analysis involves the identification of financial data that change under
alternative courses of action.
4.
In incremental analysis, the important point to consider is whether costs will differ (change)
between the two alternatives. As a result, sometimes (1) variable costs do not change under the
alternative courses of action and (2) fixed costs do change.
5.
The relevant data in deciding whether to accept an order at a special price are the incremental
revenues to be obtained compared to the incremental costs of filling the special order.
6.
The manufacturing costs that are relevant in the make-or-buy decision are those that will change
if the parts are purchased.
7.
Opportunity cost may be defined as the potential benefit that may be obtained by following an
alternative course of action. Opportunity cost is relevant in a make-or-buy decision when the
facilities used to make the part can be used to generate additional income.
8.
The decision rule in a decision to sell a product or to process it further is: Process further as
long as the incremental revenue from the additional processing exceeds the incremental
processing costs.
9.
Joint products are products that are produced from a single raw material and a common
production process. An accounting issue related to joint products is how to allocate the joint costs
incurred during the production process that creates the joint products.
10.
Joint costs are irrelevant to a sell-or-process-further decision because they are sunk costs and
will not change whether the decision is to sell the existing product or process it further. Therefore,
joint costs are ignored in this decision.
11.
A sunk cost is a cost that cannot be changed by any future decision. Sunk costs, such as the
book value of an old piece of equipment, therefore, are not relevant in a decision to retain or
replace equipment.
12.
Net income will be lower if an unprofitable product line is eliminated when the product line is
producing a positive contribution margin and its fixed costs cannot be avoided or reduced.
© 2008
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7-4
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
$150,000
100,000
$ 50,000
Alternative
B
$185,000
125,000
$ 60,000
Net Income
Increase
(Decrease)
($ 35,000)
(25,000)
$ 10,000
Accept
Order
Net Income
Increase
(Decrease)
Alternative B is better than Alternative A.
BRIEF EXERCISE 7-3
Reject
Order
Revenues
Costs—Variable manufacturing
Shipping
Net income
$0
0
0
$0
$72,000 *
60,000 **
6,000 ***
$ 6,000
($ 72,000)
( (60,000)
( (6,000)
($ 6,000)
The special order should be accepted.
*3,000 X $24
**3,000 X $20
***3,000 X $ 2
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7-5
BRIEF EXERCISE 7-4
Variable manufacturing costs
Fixed manufacturing costs
Purchase price
Total annual cost
Make
Buy
Net Income
Increase
(Decrease)
$45,000
30,000
-0$75,000
$ -030,000
50,000
$80,000
$ 45,000
0
(50,000)
($ (5,000)
The decision should be to make the part.
BRIEF EXERCISE 7-5
Sales per unit
Cost per unit
Variable
Fixed
Total
Net income per unit
Sell
Process
Further
Net Income
Increase (Decrease)
$60.00
$70.00
$10.00
35.00
10.00
45.00
$15.00
43.00
10.00
53.00
$17.00
( (8.00)
0
( (8.00)
$ 2.00
The bookcases should be processed further because the incremental
revenues exceed incremental costs by $2.00 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 $60,000 ($150,000 – $90,000) and only incur incremental costs of
$50,000. Therefore, the company should process AB1 further. If XY1 is
processed further, the company will earn incremental revenue of $40,000
($130,000 – $90,000) but will incur incremental costs of $50,000. Therefore,
the company should sell XY1 rather than process it further.
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7-6
BRIEF EXERCISE 7-7
Variable manufacturing costs
for 4 years
New machine cost
Total
Retain
Equipment
Replace
Equipment
Net 4-Year
Income
Increase
(Decrease)
$2,400,000
00,000,000
$2,400,000
$2,000,000
250,000
$2,250,000
($ 400,000)
( (250,000)
($ 150,000)
The old factory machine should be replaced.
BRIEF EXERCISE 7-8
Sales
Variable costs
Contribution margin
Fixed costs
Net income
Continue
Eliminate
$200,000
175,000
25,000
30,000
($ (5,000)
$
-0-0( -020,000)
$(20,000)
Net Income
Increase (Decrease)
$(200,000)
(175,000)
(25,000)
( 10,000)
$ (15,000)
The Big Bart product line should be continued because $25,000 of contribution margin will not be realized if the line is eliminated. This amount is
greater than the $10,000 savings of fixed costs.
© 2008
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7-7
SOLUTIONS TO EXERCISES
EXERCISE 7-1
1.
2.
3.
4.
5.
6.
7.
8.
9.
False. The first step in management’s decision-making process is “identify
the problem and assign responsibility”.
False. The final step in management’s decision-making process is to
review the results of the decision.
True.
False. In making business decisions, management ordinarily considers
both financial and nonfinancial information.
True.
True.
False. Costs that are the same under all alternative courses of action do
not affect the decision.
False. When using incremental analysis, either costs or revenues or both
will change under alternative courses of action.
False. Sometimes variable costs will not change under alternative courses
of action, but fixed costs will.
EXERCISE 7-2
(a)
Reject
Order
Revenues
Materials ($0.50)
Labor ($1.50)
Variable overhead ($1.00)
Fixed overhead
Sales commissions
Net income
$ -0-0-0-0-0-0$ -0-
Accept
Order
$23,750
(2,500)
(7,500)
(5,000)
(5,000)
-0$ 3,750
Net Income Effect
$23,750
(2,500)
(7,500)
(5,000)
(5,000)
-0$ 3,750
(b) As shown in the incremental analysis, Innova should accept the special
order because incremental revenue exceeds incremental expenses by
$3,750.
(c) It is assumed that sales of the golf discs in other markets would not be
affected by this special order. If other sales were affected. Innova would
have to consider the lost sales in making the decision. Second, if Innova
is operating at full capacity, it is likely that the special order would be
rejected.
© 2008
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7-8
EXERCISE 7-3
(a)
Revenues (15,000 X $7.50)
Cost of goods sold
Operating expenses
Net income
Reject
Order
$0
0
0
$0
Accept
Order
$112,500
75,000 (1)
29,250 (2)
$ 8,250
Net Income
Increase
(Decrease)
($112,500)
( (75,000)
( (29,250)
($ 8,250)
(1) Variable cost of goods sold = $2,500,000 X 70% = $1,750,000.
Variable cost of goods sold per unit = $1,750,000 ÷ 350,000 = $5.
Variable cost of goods sold for the special order = $5 X 15,000
= $75,000.
(2) Variable operating expenses = $875,000 X 70% = $612,500
$612,500 ÷ 350,000 = $1.75 per unit
15,000 X $1.75 = $26,250
$26,250 + $3,000 = $29,250
(b) As shown in the incremental analysis, Quick Company should accept
the special order because incremental revenues exceed incremental
expenses by $8,250.
EXERCISE 7-4
Revenues
Variable costs:
Direct materials
Direct labor
Variable overhead
Total variable costs
Net income
Reject
Order
$0
0
0
0
0
$0
Accept
Order
$900,000 (1)
400,000
100,000
200,000
700,000
$200,000
Net Income
Increase
(Decrease)
$900,000
(400,000)
(100,000)
(200,000)
(700,000)
$200,000
(1) [($2.00 + $0.50 + $1.00 + $1.00) X 200,000]
Hardy Fiber should accept the Army’s offer since it would increase net
income by $200,000.
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7-9
EXERCISE 7-5
(a)
Make
Direct materials (30,000 X $5.00)
Direct labor (30,000 X $6.00)
Variable manufacturing costs
($180,000 X 70%)
Fixed manufacturing costs
Purchase price (30,000 X $15.50)
Total annual cost
Buy
$150,000
180,000
126,000
$
0
0
0
45,000
0
$501,000
45,000
465,000
$510,000
Net Income
Increase
(Decrease)
$ 150,000
180,000
126,000
0
( (465,000)
($ (9,000)
(b) No, Stahl Inc. should not purchase the shades. As indicated by the
incremental analysis, it would cost the company $9,000 more to purchase the lamp shades.
(c) Yes, by purchasing the lamp shades, a total cost saving of $26,000 will
result as shown below.
Total annual cost (above)
Opportunity cost
Total cost
Make
Buy
$501,000
35,000
$536,000
$510,000
0
$510,000
Net Income
Increase
(Decrease)
$ (9,000)
(35,000)
$(26,000)
EXERCISE 7-6
(a) (1)
Direct materials
Direct labor
Variable overhead
Fixed overhead
Purchase price
Total annual cost
Make
$ 800,000
600,000
120,000
500,000
0
$2,020,000
Buy
$
-0-0-0200,000
1,800,000
$2,000,000
Net Income
Increase
(Decrease)
$ 800,000
600,000
120,000
300,000
(1,800,000)
$
20,000
Yes. The offer should be accepted as net income will increase by $20,000.
© 2008
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7-10
EXERCISE 7-6 (Continued)
(2)
Buy
Make
$ 800,000 $
0
600,000
0
120,000
0
500,000
500,000
300,000
0
0 1,800,000
$2,320,000 $2,300,000
Direct materials
Direct labor
Variable overhead
Fixed overhead
Opportunity cost
Purchase price
Totals
Net Income
Increase
(Decrease)
$ 800,000
600,000
120,000
0
300,000
(1,800,000)
$
20,000
Yes. The offer should be accepted as net income would be $20,000 more.
(b) Qualitative factors include the possibility of laying off those employees
that produced the robot and the resulting poor morale of the remaining
employees, maintaining quality standards, and controlling the purchase
price in the future.
EXERCISE 7-7
Sell
(Basic Kit)
Process Further
(Stage 2 Kit)
Net Income
Increase
(Decrease)
Sales per unit
Costs per unit
Direct materials
Direct labor
Total
$28
( )$35( )
$ (7)
$14
0
$14
( ) $ 7 (1)
( ) 10 (2)
( ) $17 ( )
$ (7)
(10)
$ (3)
Net income per unit
$14
( ) $18 ( )
$ (4)
(1) The cost of materials decreases because Wanda can make two Stage
2 Kits from the materials for a basic kit.
(2) The total time to make the two kits is one hour at $20 per hour or
$10 per unit.
© 2008
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7-11
EXERCISE 7-7 (Continued)
Wanda should carry the Stage 2 Kits. The incremental revenue, $7, exceeds
the incremental processing costs, $3. Thus, net income will increase by
processing the kits further.
EXERCISE 7-8
(a)
Sales ($50,000 + $10,000 + $60,000)
Joint costs
Net income
$120,000
100,000
$ 20,000
(b) Sales ($190,000 + $35,000 + $220,000)
Joint costs
Additional costs ($100,000 + $30,000 + $150,000)
Net income
$ 445,000
(100,000)
(280,000)
$ 65,000
(c)
(1)
Incremental revenue
Incremental costs
Incremental profit (loss)
Product 12 Product 14 Product 16
$ 140,000
$ 25,000
$ 160,000
(30,000)
(150,000)
(100,000)
$ 40,000
$ (5,000)
$ 10,000
(1)
Sales value after further processing – Sales value @ split-off point
Products 12 and 16 should be processed further and product 14 should be
sold at the split-off point.
(d) Sales ($190,000 + $10,000 + $220,000)
Joint costs
Additional costs ($100,000 + $150,000)
Net income
$ 420,000
(100,000)
(250,000)
$ 70,000
Net income is $5,000 ($70,000 – $65,000) higher in (d) than in (b) because
product 14 is not processed further, thereby increasing overall profit $5,000.
© 2008
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7-12
EXERCISE 7-9
To determine whether each of the three joint products should be sold as is,
or processed further, we must determine the incremental profit or loss that
would be earned by each. The allocated joint costs are irrelevant to the
decision since these costs will not change whether or not the products are
sold as is or processed further.
Sarco
Incremental revenue
Incremental cost
Incremental profit (loss)
$100,000*
120,000
$ (20,000)
Barco
$100,000 **
89,000
$ 11,000
Larco
$400,000 ***
250,000
$150,000
From this analysis we see that Barco and Larco should be processed
further because the incremental revenue exceeds the incremental costs,
but Sarco should be sold as is.
*$300,000 – $200,000
**$400,000 – $300,000
***$800,000 – $400,000
EXERCISE 7-10
(a)
Cost
Accumulated depreciation
Book value
Sales proceeds
Loss on sale
$100,000
20,000*
80,000
30,000
$ 50,000
*One year’s depreciation: ($100,000 – $0) ÷ 5 years
(b)
Annual operating costs
New scanner cost
Old scanner salvage
Total
Retain
Scanner
$420,000*
$420,000
Replace
Scanner
$312,000**
120,000
(30,000)
$402,000
Net Income
Increase
(Decrease)
$ 108,000
(120,000)
30,000
$ 18,000
*(4 years X $105,000)
**[4 years X ($105,000 – $27,000)]
© 2008
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7-13
EXERCISE 7-10 (Continued)
Yes. Lucas Hospital should replace the old scanner because it will result in
a savings of $18,000 over the next four years.
(c) As shown in (a) above, replacing the old scanner will result in reporting
a loss of $50,000. Reluctance to report losses of this nature is the usual
reason for not recognizing that a poor decision was made in the past.
The remaining book value of the old scanner ($80,000) is a sunk cost. It
will be deducted in the future, if the scanner is retained, or written off
now if it is replaced. However, if it is replaced now, that cost will be
partially offset by the salvage value that Alliant is willing to pay ($30,000).
EXERCISE 7-11
Retain
Machine
Operating costs
New machine cost
Salvage value (old)
Total
Replace
Machine
$120,000 (1) ($ 90,000) (2)
0
( 25,000)
0
( (5,000)
$120,000
($110,000)
Net Income
Increase
(Decrease)
($ 30,000
( (25,000)
(
5,000)
($ 10,000)
(1) $24,000 X 5.
(2) $18,000 X 5.
The current machine should be replaced. The incremental analysis shows
that net income for the five-year period will be $10,000 higher by replacing the
current machine.
© 2008
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7-14
EXERCISE 7-12
Sales
Variable costs
Cost of goods sold
Operating expenses
Total variable
Contribution margin
Fixed costs
Cost of goods sold
Operating expenses
Total fixed
Net income (loss)
Continue
Eliminate
$100,000)
$(
0)
Net Income
Increase
(Decrease)
$(100,000)
( 60,000)
(25,000)
(85,000)
(15,000)
(
(
(
(
0)
0)
0)
0)
(60,000)
(25,000)
(85,000)
(15,000)
(16,500)
(23,000)
(39,500)
$(39,500)
(
0)
(
0)
(
0)
$ (15,000)
(16,500)
(23,000)
(39,500)
$(24,500)
Maggie is incorrect. The incremental analysis shows that net income will be
$15,000 less if the Erie Division is eliminated. This amount equals the
contribution margin that would be lost through discontinuing the division.
(Note: None of the fixed costs can be avoided.)
EXERCISE 7-13
(a)
$30,000 + $75,000 – $30,000 = $75,000
(b)
Stunner
Double-Set
Total
$300,000
150,000
150,000
142,500*
$ 7,500
$500,000
200,000
300,000
262,500**
$ 37,500
$800,000
350,000
450,000
405,000
$ 45,000
Sales
Variable expenses
Contribution margin
Fixed expenses
Net income
*$30,000 + [($300,000 ÷ $800,000) X $300,000]
**$75,000 + [($500,000 ÷ $800,000) X $300,000]
(c)
As shown in the analysis above, Shatner should not eliminate the
Mega-Power product line. Elimination of the line would cause net income
to drop from $75,000 to $45,000. The reason for this decrease in net
income is that elimination of the product line would result in the loss
of $60,000 of contribution margin while saving only $30,000 of fixed
expenses.
© 2008
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7-15
EXERCISE 7-14
1. Irrelevant. Unavoidable costs will be incurred regardless of the
decision made.
2. Relevant.
3. Irrelevant. This is a sunk cost and all sunk costs are irrelevant.
4. Irrelevant. These are sunk costs.
5. Relevant.
6. Relevant.
7. Relevant.
8. Relevant.
9. Irrelevant. If there is no change in the direct materials charge regardless
of the decision made, the cost is irrelevant.
10. Relevant.
© 2008
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7-16
SOLUTIONS TO PROBLEMS
PROBLEM 7-1A
(a)
Reject
Order
Revenues (10,000 X $28)
Cost of goods sold
Selling and administrative
expenses
Net income
Accept
Order
Net Income
Increase
(Decrease)
$0
0
$280,000
224,000 (1)
$ 280,000
( (224,000)
0
$0
25,000 (2)
$ 31,000
( (25,000)
$ 31,000
(1) Variable costs = $3,600,000 – $1,080,000 = $2,520,000;
$2,520,000 ÷ 112,500 units = $22.40 per unit;
10,000 X $22.40 = $224,000.
(2) Variable costs = $450,000 – $225,000 = $225,000;
$225,000 ÷ 112,500 units = $2.00 per unit;
10,000 X ($2.00 + $0.50) = $25,000.
(b) Yes, the special order should be accepted because net income will
increase by $31,000.
(c) Unit selling price = $22.40 (variable manufacturing costs) + $2.50 variable
selling and administrative expenses + $4.10 net income = $29.
(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.
© 2008
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7-17
PROBLEM 7-2A
(a)
Make WISCO
Direct material
Direct labor
Indirect labor
Utilities
Depreciation
Property taxes
Insurance
Purchase price
Freight and inspection
Receiving costs
Total annual cost
$33,600
30,100
3,010
2,800
3,000
700
1,500
0
0
0
$74,710
Buy WISCO
$
0
0
0
0
900
200
600
70,000
2,800
1,250
$75,750
Net Income
Increase
(Decrease)
($33,600)
( 30,100)
( 3,010)
( 2,800)
( 2,100)
(
500)
(
900)
( (70,000)
( (2,800)
( (1,250)
($ (1,040)
(b) The company should continue to make WISCO because net income
would be $1,040 less if WISCO were purchased from the supplier.
(c) The decision would be different. Because of the opportunity cost of
$5,000, net income will be $3,960 higher if WISCO is purchased as
shown below:
Net Income
Increase
Make WISCO
Buy WISCO
(Decrease)
Total annual cost
$75,750
$(1,040)
$74,710
Opportunity cost
0
(5,000)
5,000
$79,710
$75,750
$(3,960)
Total cost
(d) Nonfinancial factors include: (1) the adverse effect on employees if
WISCO is purchased, (2) how long the supplier will be able to satisfy
the Borealis 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 Borealis.
© 2008
For Instructor Use Only
7-18
PROBLEM 7-3A
(a) (1)
Table Cleaner Not Processed Further
Sales:
FloorShine (600,000 ÷ 30) X $20
Table Cleaner (300,000 ÷ 30) X $25
Total revenue
Costs:
CDG
Additional costs of FloorShine
Total costs
Gross profit
(2)
$400,000
250,000
$650,000
210,000
250,000
460,000
$190,000
Table Cleaner Processed Further
Sales:
FloorShine
Table Stain Remover (300,000 ÷ 30) X $18
Table Polish (300,000 ÷ 30) X $18
Total revenue
Costs:
CDG
Additional costs of FloorShine
TCP
Total costs
Gross profit
$400,000
180,000
180,000
$760,000
210,000
250,000
100,000
560,000
$200,000
(3) If the table cleaner is processed further overall company profits will
be $10,000 higher. Therefore, management made the wrong decision
by choosing to not process table cleaner further.
© 2008
For Instructor Use Only
7-19
PROBLEM 7-3A (Continued)
(b)
Incremental revenue
Incremental costs
Totals
Don’t Process
Table Cleaner
Further
$250,000
0
$250,000
Process
Table Cleaner
Further
$360,000
100,000
$260,000
Net Income
Increase
(Decrease)
$110,000
(100,000)
$ 10,000
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.
© 2008
For Instructor Use Only
7-20
PROBLEM 7-4A
(a)
Cost
Accumulated depreciation
Book value
Sales proceeds
Loss on sale
$120,000
20,000*
100,000
(25,000)
$ 75,000
*$120,000 ÷ 6 years = $20,000
(b) (1)
Sales ($240,000 X 5 yrs.)
Less costs:
Variable costs ($35,000 X 5)
Fixed costs ($23,000 X 5)
Selling & administrative
Depreciation
Net income
Retain Old Elevator
$1,200,000
$175,000
115,000
145,000*
100,000
535,000
$ 665,000
*($29,000 X 5)
(2)
Sales
Less costs:
Variable costs ($12,000 X 5)
Fixed costs ($8,400 X 5)
Selling and administrative
Depreciation
Operating income
Less: Loss on old elevator
Net income
Replace Old Elevator
$1,200,000
$ 60,000
42,000
145,000
180,000
427,000
773,000
75,000
$ 698,000
(c)
Variable operating costs
Fixed operating costs
New elevator cost
Salvage on old elevator
Totals
© 2008
For Instructor Use Only
Retain
Old Elevator
$175,000
115,000
.
$290,000
Replace
Old Elevator
$ 60,000
42,000
180,000
(25,000)
$257,000
Net Income
Increase
(Decrease)
$ 115,000
73,000
(180,000)
25,000
$ 33,000
7-21
PROBLEM 7-4A (Continued)
(d)
MEMO
TO: Cab Calway
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
$75,000 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 $100,000 would
be deducted as depreciation expense over the next five 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 $100,000 book value will be expensed under
either alternative, making it irrelevant.
© 2008
For Instructor Use Only
7-22
PROBLEM 7-5A
(a)
Sales
Variable costs
Cost of goods sold
Selling and administrative
Total variable expenses
Contribution margin
Division I
Division II
$250,000
$200,000
140,000
26,000
166,000
($ 84,000)
170,100
42,000
212,100
$ (12,100)
(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
$(84,000)
$(
0)
$(84,000)
(60,000)
(39,000)
(99,000)
$(15,000)
(30,000)
(19,500)
(49,500)
$(49,500)
30,000
19,500
49,500
$(34,500)
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
$(12,100)
$(
0)
$12,100
(18,900
( 18,000
( 36,900
$(49,000)
( 9,450)
( 9,000)
(18,450)
$(18,450)
( 9,450
( 9,000
18,450
$30,550
Division II should be eliminated as its negative contribution margin is
$12,100. Income from operations would increase $30,550 if Division II
is eliminated.
Division I should be continued because it is producing positive contribution margin of $84,000. Income from operations will decrease
$34,500 by discontinuing this division.
© 2008
For Instructor Use Only
7-23
PROBLEM 7-5A (Continued)
(c)
LEWIS MANUFACTURING COMPANY
CVP Income Statement
For the Quarter Ended March 31, 2008
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
$400,000
$1,150,000
140,000
240,000
187,500
567,500
26,000
30,000
30,000
86,000
166,000
84,000
270,000
230,000
217,500
182,500
653,500
496,500
63,150
63,150
65,650
191,950
42,000
33,000
23,000
98,000
105,150
96,150
88,650
289,950
$(21,150) $133,850
$ 93,850
$ 206,550
(1) Division’s fixed cost of goods sold plus 1/3 of Division II’s
unavoidable fixed cost of goods sold [$189,000 X (100% – 90%) X
50% = $9,450]. Each division’s share is $3,150.
(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 $176,000 (given) plus
incremental income of $30,550 from eliminating Division II = $206,550
income from operations without Division II.
© 2008
For Instructor Use Only
7-24
PROBLEM 7-1B
(a) Production capacity = 22,500 units (18,000 ÷ 80%).
Units for special order = 4,500 = (22,500 – 18,000).
Current selling price = $24 = ($432,000 ÷ 18,000).
Special order price = $19.20 = ($24 X 80%).
(b) Variable manufacturing costs per unit.............................................
Fixed manufacturing costs per unit ($72,000 ÷ 18,000)..............
Total manufacturing costs per unit..........................................
(c)
$0
Accept
Order
$86,400
Net Income
(Increase
(Decrease)
($ 86,400)
0
59,400
( (59,400)
0
0
0
0
$0
4,000
9,000
5,000
77,400
$ 9,000
( (4,000)
( (9,000)
( (5,000)
( (77,400)
($ 9,000
Reject
Order
Revenues (4,500 X $19.20)
Costs
Variable manufacturing
(4,500 X $13.20)
Sales commission
Shipping (4,500 X $2.00)
Stamping machine
Total costs
Net income
$13.20
4.00
$17.20
The Oakbrook Company should accept the special order because it
will produce $9,000 of incremental net income.
(d) The cost of the special order = $77,400 ÷ 4,500 = $17.20. Thus, the minimum selling price to produce net income of $1.20 per unit is $18.40.
(e) Nonfinancial factors to be considered are: (1) possible effects 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.
© 2008
For Instructor Use Only
7-25
PROBLEM 7-2B
(a)
0
0
Net Income
Increase
(Decrease)
$ 77,000
72,000
6,000
1,500
1,800
1,000
0
0
0
0
0
140,000
6,000
1,500
1,800
1,000
( (140,000)
0
0
4,000
$163,300
8,500
17,500
0
$166,000
( (8,500)
( (17,500)
4,000
($ (2,700)
Make
Direct material (35,000 X $2.20)
Direct labor (2,000 X 3 X $12.00)
Manufacturing costs
Indirect labor
Utilities
Depreciation
Property taxes & insurance
Purchase price
(35,000 X $4)
Receiving
Freight (35,000 X $.50)
Storage (5,000 X $.80)
Total annual cost
$ 77,000
72,000
Buy
$
Decision: Continue to make the part. The cost to make the part and
rent storage space for the finished product is $163,300, while the cost
to buy the part and use the excess space for storage is $166,000.
Hence, continuing to make the part will result in an annual cost
savings of $2,700.
(b)
Total annual cost
Opportunity cost
Total cost
Make
Buy
$163,300
12,000
$175,300
$166,000
0
$166,000
Net Income
Increase
(Decrease)
($ (2,700)
( 12,000)
($ 9,300)
Decision: Buy the part since that will result in a $9,300 increase in net
income.
(c) Nonfinancial factors include: (1) the adverse effect on employees if the
part is purchased, (2) how long the supplier will be able to satisfy
the Dunham 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.
© 2008
For Instructor Use Only
7-26
PROBLEM 7-3B
(a) (1)
Glass Cleaner Not Processed Further
Sales
MetalShine (750,000 ÷ 25) X $15
Glass Cleaner (250,000 ÷ 25) X $24
Total revenue
Costs
TLC
Additional costs for MetalShine
Total costs
Gross profit
(2)
$450,000
240,000
$690,000
200,000
270,000
470,000
$220,000
Glass Cleaner is Processed Further
Sales
MetalShine (750,000 ÷ 25) X $15
Plastic Cleaner (250,000 ÷ 25) X $20
Plastic Polish (250,000 ÷ 25) X $20
Total revenue
Costs
TLC
Additional costs for MetalShine
MST
Total costs
Gross profit
$450,000
200,000
200,000
$850,000
200,000
270,000
140,000
610,000
$240,000
(3) If the glass cleaner is processed further overall company profits will be
$20,000 higher. Therefore, management made the wrong decision by
choosing to not process glass cleaner further.
© 2008
For Instructor Use Only
7-27
PROBLEM 7-3B (Continued)
(b)
Incremental revenue
Incremental costs
Totals
Don’t Process
Glass Cleaner
Further
$240,000
0
$240,000
Process
Glass Cleaner
Further
$400,000
140,000
$260,000
Net Income
Increase
(Decrease)
$ 160,000
(140,000)
$ 20,000
When trying to decide if the glass cleaner should be processed further into
PC and PP, only the relevant data need be considered. All of the costs that
occurred prior to the creation of the glass 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.
© 2008
For Instructor Use Only
7-28
PROBLEM 7-4B
(a)
Cost
Accumulated depreciation
Book value
Sales proceeds
Loss on sale
$120,000
20,000*
100,000
(10,000)
$ 90,000
*$120,000 ÷ 6 years = $20,000
(b) (1)
Sales ($200,000 X 5)
Less costs:
Variable costs ($30,000 X 5)
Fixed costs ($20,000 X 5)
Selling and administrative
Depreciation
Net income
Retain Old Press
$1,000,000
$150,000
100,000
120,000*
100,000
470,000
$ 530,000
*($24,000 X 5)
(2)
Sales
Less costs:
Variable costs ($10,000 X 5)
Fixed costs ($7,000 X 5)
Selling and administrative expenses
Depreciation
Operating income
Less: Loss on old press
Net income
© 2008
For Instructor Use Only
Replace Old Press
$1,000,000
$ 50,000
35,000
120,000
150,000
355,000
645,000
90,000
$ 555,000
7-29
PROBLEM 7-4B (Continued)
(c)
Variable costs
Fixed costs
New press cost
Salvage value of old press
Totals
(d)
Replace
Retain
Old Press Old Press
$150,000 $ 50,000
100,000
35,000
150,000
(10,000)
$250,000 $225,000
Net Income
Increase
(Decrease)
$ 100,000
65,000
(150,000)
10,000
$ 25,000
MEMO
TO:
Jill Jabowski
FROM:
Student
SUBJECT: Relevant Data for Decision to Replace Old Press
When deciding whether or not to replace any old equipment, the analysis
should only include cost data relevant to the replacement decision. The
$90,000 loss that would be experienced if we replace the old press with the
newer model is related to a sunk cost, namely the cost of the old press.
Sunk costs are irrelevant in decision making.
The loss occurs when comparing the book value of the old press to the
cash proceeds that would be received. The book value of $100,000 would
be deducted as depreciation expense over the next five years if the press
were retained. If the press 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 $100,000 book value will be expensed under either
alternative, making it irrelevant.
© 2008
For Instructor Use Only
7-30
PROBLEM 7-5B
(a)
Sales
Variable expenses
Cost of goods sold
Selling and administrative
Total variable expenses
Contribution margin
Taos
Olympia
$405,000
$500,000
360,000
60,000
420,000
$ (15,000)
370,500
96,000
466,500
$ 33,500
(b) (1)
Net Income
Increase
(Decrease)
Taos Division
Continue
Eliminate
Contribution margin (above)
Fixed costs
Cost of goods sold
Selling and administrative
Total fixed expenses
Income (loss) from operations
$(15,000)
$(
(40,000)
(40,000)
(80,000)
$(95,000)
(12,000)
(12,000)
(24,000)
$(24,000)
(28,000)
(28,000)
(56,000)
$71,000
Net Income
Increase
(Decrease)
0)
(2)
$15,000
Olympia Division
Continue
Eliminate
Contribution margin (above)
Fixed costs
Cost of goods sold
Selling and administrative
Total fixed costs
Income (loss) from operations
$ 33,500)
$(
0)
$(33,500)
(19,500)
(24,000)
(43,500)
$(10,000)
( 5,850)
( 7,200)
(13,050)
$(13,050)
(13,650
16,800
30,450
$ (3,050)
The Taos Division should be eliminated because it is producing
negative contribution margin ($15,000). Income from operations will
increase $71,000 if the division is discontinued.
The Olympia Division should be continued as its contribution margin,
$33,500, is greater than the savings in fixed costs ($43,500 – $13,050 =
$30,450) that would result from elimination. Therefore, income from
operations would decrease $3,050 if the Olympia Division were eliminated.
© 2008
For Instructor Use Only
7-31
PROBLEM 7-5B (Continued)
(c)
HINDU MANUFACTURING COMPANY
CVP Income Statement
For the Quarter Ended March 31, 2008
Divisions
Sales
Variable expenses
Cost of goods sold
Selling and
administrative
Total variable
expenses
Contribution margin
Fixed expenses
Cost of goods sold (1)
Selling and
administrative (2)
Total fixed
expenses
Income (loss) from
operations
Boseman
Salem
Olympia
Total
$730,000
$920,000
$500,000
$2,150,000
384,000
518,400
370,500
1,272,900
124,200
172,200
96,000
392,400
508,200
221,800
690,600
229,400
466,500
33,500
1,665,300
484,700
99,600
63,600
21,900
185,100
86,400
79,800
26,400
192,600
186,000
143,400
48,300
377,700
$ 35,800
$ 86,000
$ (14,800) $ 107,000
(1) Division’s own fixed costs plus its share of Taos’s unavoidable
fixed costs of $12,000. (Boseman $3,600, Salem $6,000, and Olympia
$2,400).
(2) Division’s own fixed costs plus its share of Taos’s unavoidable
fixed costs of $12,000. (Boseman $3,600, Salem $6,000, and
Olympia $2,400).
(d) Total income from operations with the Taos Division is $36,000 (given).
Without the Taos Division, income from operations is $107,000. The
difference of $71,000 = ($107,000 – $36,000) is the incremental income
that is gained through elimination of the Taos Division.
© 2008
For Instructor Use Only
7-32
BYP 7-1
GROUP DECISION CASE
Sales
Costs and expenses
Cost of goods sold
Selling expenses
Administrative expenses
Purchase price
Total costs and expenses
Net income
(1)
(2)
(3)
(4)
(5)
Retain
Purchase
Old Machine
New Machine
$4,800,000 (1)
$5,760,000 (2)
3,600,000 (3)
720,000
400,000
—
4,720,000
$ 80,000
4,032,000 (4)
792,000
452,000
135,000 (5)
5,411,000
$ 349,000
Net Income
Increase
(Decrease)
($ 960,000
( (432,000)
( (72,000)
( (52,000)
( (135,000)
( (691,000)
($ 269,000
12,000 X $100 X 4 years = $4,800,000.
$4,800,000 X 120% = $5,760,000.
$4,800,000 X (100% – 25%) = $3,600,000.
$5,760,000 X (100% – 30%) = $4,032,000.
$125,000 + $4,000 + $6,000 = $135,000.
The new machine should be purchased. The incremental analysis shows
that net income will increase from $80,000 to $349,000 over the four years
with the new machine.
© 2008
For Instructor Use Only
7-33
BYP 7-2
MANAGERIAL ANALYSIS
(a)
Sales Revenue
Variable Manufacturing Cost:
Circuit Board
Plastic Case
Alarms (4 @ $.10 each)
Labor
Overhead
Purchase Cost
Fixed Manufacturing Cost:
Total Manufacturing Cost
Profit per Unit
Total Profit
Make
Buy—
Silver Star
Buy—
Alpha
$14.50
$14.50
$14.50
2.00
0.75
0.40
3.00
0.50
0
—
6.65
$ 7.85
$39,250
0
0
0
0
0
11.00
1.00*
12.00
$ 2.50
$12,500
0
0
0
0
0
4.00
1.00
5.00
$ 9.50
$47,500
*The $5,000 cost that will continue to be incurred, even if the product is
not manufactured, divided by the 5,000 units.
The company will make the most profit if the clocks are purchased
from Alpha Company. The company will make $8,250 less if the clocks
are manufactured by Technology Plus. The company will make $35,000
less if the clocks are purchased from Silver Star.
(b) There are several important nonfinancial factors described in the case.
Other factors might be identified as well. The factors described are:
The company is having serious difficulty manufacturing the clocks.
Therefore, it would probably be willing to have someone else manufacture the clocks, even if it cost more to do so. The most promising
company appears to be Alpha; however, there is a serious question
about Alpha’s ability to remain in business. However, the company
could purchase just this one order from Alpha, and then continue to
search for another manufacturer, or stop manufacturing the clocks.
Silver Star’s stringent requirements for preferred customer status, in
the form of large sales requirements, appear to limit the possibilities
for Technology Plus to use it as a supplier. However, if Technology
Plus does desire to continue to offer the clocks because of their
popularity, then perhaps Silver Star could be used in the future.
© 2008
For Instructor Use Only
7-34
BYP 7-2 (Continued)
(c) Many answers are possible, depending upon each student’s assessment
of the seriousness of the issues mentioned in (b). One answer would
be: The company should use Alpha to manufacture the Kmart order.
After that, the company should not offer the clocks any longer. Especially since the clocks are no longer very profitable, it does not seem
like a good idea to keep spending money to modify the process.
© 2008
For Instructor Use Only
7-35
BYP 7-3
REAL-WORLD FOCUS
(a) Before building the special-order new ceiling fans, company management must consider the effect of the new lines on current production
capacity, existing and available channels of distribution, the effect on
manufacturing efficiency, the effect on sales of current lines of
product, and the supply of materials and labor.
(b) Incremental analysis would provide a financial comparison of income
with the special-order ceiling fans to income without the special orders.
© 2008
For Instructor Use Only
7-36
BYP 7-4
EXPLORING THE WEB
(a) According to Trowbridgegroup, outsourcing can strengthen the overall
performance of the company by improving:
•
•
•
•
•
•
•
•
•
•
Competitive edge
Increase flexibility
Improve productivity
Increase market share
Access to vendor’s resources
Improve customer satisfaction
Drive organizational strategy
Reduce capital investment
Improve management control
Reduce costs
(b) Some of the common problems of outsourcing are:
•
•
•
•
•
•
•
•
•
•
© 2008
Undisciplined and poorly thought outsourcing process
Insufficient and qualified vendors to base selection
Being tied into a sub-optimal contract lacking workable service
level agreements
Not knowing the true base business case
Service transition—service delivery failure
Supplier’s sophistication and solution development capability
Poor post-contract audit approach
Unintentionally creating unsustainable “alliances”
Poor definition of the total business improvement goals
Insufficient bandwidth/experience/skills
For Instructor Use Only
7-37
BYP 7-5
COMMUNICATION ACTIVITY
To:
Nathan Peas—Plant Manager
From:
Jeff Howell—Production Manager
I have spent considerable time thinking about the dilemma created by the
new PDD1130 machine. Clearly, it is far superior to our existing machine.
There is no question that it would save us tremendous amounts of money.
I hope I am not overstepping my bounds here, but I just reviewed a chapter
in my managerial accounting text on incremental analysis which has made
me think we need to reconsider this decision.
The key to incremental analysis is identifying relevant costs. Relevant
costs are those costs that vary depending on the course of action taken. In
our situation, a relevant cost would be the savings that we would
experience were we to purchase the new machine. The book value of the
existing machine is not a relevant cost since it would not be changed by
purchasing or not purchasing the new machine. Costs incurred in the past
that do not change are referred to as sunk costs. Sunk costs are irrelevant
to incremental analysis.
I would really like to lay out an analysis of our options to decide the proper
course of action. I am concerned that by using the old machine for a couple
of years the profitability of the plant could be impacted negatively.
© 2008
For Instructor Use Only
7-38
BYP 7-6
ETHICS CASE
(a) Many factors need to be considered when determining whether to
close a division. The loss of jobs can have a devastating impact on a
community and on the morale of remaining employees. From a
financial perspective, closing a division that is reporting losses will not
necessarily increase the reported net income of the company. The
reason: if fixed costs that have been allocated to a division that is
closed are reallocated to the remaining divisions, the company’s net
income might actually decrease. This sounds like it would most likely
be the case at Phelps.
(b) It is not unusual to reevaluate fixed cost allocations periodically. However,
the allocation should be based on the underlying economics of the
situation rather than the motives of individuals.
(c) Robert should explain to the board of directors that the change in
income is due to a reallocation and that closing the plumbing division
is not advisable. In this case, being honest is not only the ethical thing
to do, but it will also maximize the company’s net income.
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For Instructor Use Only
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BYP 7-7
ALL ABOUT YOU
(a) Chronic homelessness is defined as being on the streets for a year
or more.
(b) Homelessness costs cities money because the chronic homeless have
frequent jail time, shelter costs, emergency room visits and hospital stays.
Some costs per city per homeless person are: New York $40,000; Dallas
$50,000; San Diego $150,000.
(c) The first step is to try to identify the size of the problem by doing street
counts. From this count, benchmarks can be set, enabling a reward
system for meeting goals. Next is to identify what the homeless people
want. What do they think they need to help them address their problem?
They typically want adequate housing with some privacy.
(d) It has been estimated that in New York this approach costs about $22,000
per year. New York has documented a 88% success rate (defined as
not returning to the streets for five years).
(c) In terms of incremental analysis, two alternatives are to either continue
with the current situation, with the costs presented in part (b) or to implement the approach outlined in part (d). From a purely financial perspective
the approach in (d) appears to have significant merit also (d) does not
even take into account the intangible benefits of improving the quality
of life for this segment of the population.
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For Instructor Use Only
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