Cost and management accounting-I
CHAPTER FIVE
INCREMENTAL ANALYSIS
Cost classification for Decision making:
Business decisions involve choosing between alternative courses of actions. Each alternative will
have certain costs and benefits that must be compared to the costs and benefits of other available
alternatives. Managerial accountant often classify costs that are useful in decision making what
cost information is relevant to the decisions. Hence, we see such cost classification for decision
making, here under.
1.
2.
3.
4.
5.
Differential cost:
Incremental cost
Opportunity cost
Relevant and Irrelevant costs
Avoidable and Un-avoidable costs
Differential cost:
Differential cost may be defined as the increase or decrease in total cost that result from any
variations in operations. In simple words it is the difference between total costs of two
alternatives.
Differential cost is determined for the purpose of:
a) Choosing between two methods of production or distribution
b) Choosing between make or buy decisions etc.
Incremental cost:
Differential cost in often called as Incremental cost. However, from conceptual point of view,
differential cost refers to both incremental cost as well as decrement cost.
Incremental cost refers to increase in costs and benefits of any two alternatives.
Opportunity costs:
An opportunity cost is the benefit that could have been obtained by pursuing an alternative
course of action. In other words, it is the benefit that is given up or forgone when one alternative
is selected over the alternative. Managers must take opportunity costs into account while taking
decisions, although these are not recorded in accounting records.
1
Complied by Moti F.
Cost and management accounting-I
Relevant and Irrelevant costs:
To be relevant, costs and benefits must differ between the alternatives under consideration. That
is, relevant costs and benefits make a difference between alternatives. Conversely, costs and
benefits that are the same across all the available alternatives are irrelevant and have no bearing
on a decision.
To sum up, it can be said, “Only those predicted future costs and benefits that differ in total
among the alternatives under evaluation are relevant in a decision making”. If costs and benefits
will be the same regardless of the alternative selected, then the decision has no effect on such
costs or benefits and, therefore, they can be safely ignored or eliminated from the analysis, as
they are irrelevant.
Avoidable and Un-avoidable costs:
Avoidable costs:
Avoidable costs are those costs that can be eliminated in whole or in part by choosing one
alternative over another. Avoidable costs are frequently called relevant costs as they represent
future costs that differ among alternatives.
Unavoidable costs:
Costs that do not differ between alternatives are not avoidable and, therefore, are not relevant in
making decisions. These are costs that would continue to be incurred no matter which alternative
is selected and, therefore, are irrelevant in decision-making situation. The committed fixed costs
and allocated common costs are examples of unavoidable costs. In brief, costs that would be
incurred whether or not a decision is made are unavoidable costs.
Note: Avoidable costs, relevant costs, incremental costs and differential costs are often used
interchangeably.
Analysis of special decisions:
The following special decisions will covered in this unit.
1.
2.
3.
4.
Choosing between two alternatives
Make or Buy decisions
Special order decisions
Product Mix decisions
2
Complied by Moti F.
Cost and management accounting-I
I. Choosing between two alternatives:
1. Alex Trading Enterprises is thinking about changing its marketing method from its present
distribution through retailers to a proposed distribution by door-to-door direct sale.
Present distribution and proposed distribution costs and benefits are as follows:
Sales Revenue
Costs:
Cost of goods sold (v)
Sales commissions (v)
Advertising (f)
Warehouse expenses (f)
Other fixed expenses (f)
Total cost
Retailer Distribution
(Present)
1,100,000
Direct sale
(Proposed)
1,350,000
605,000
126,000
79,000
95,000
905,000
742,500
67,500
76,000
135,000
95,000
1,116,000
Should Alex Trading Enterprises change its marketing method from present distribution method
to proposed distribution method?
Solution:
Present
Sales Revenue
Less: Costs:
Cost of goods sold (v)
Sales commissions (v)
Advertising (f)
Warehouse exp. (f)
Other fixed exp.
Total costs
Net Income
Proposed
Differential costs and
Revenues
1,350,000
250,000
1,100,000
605,000
742,500
67,500
76,000
135,000
95,000
1,116,000
234,000
126,000
79,000
95,000
905,000
195,000
137,500
67,500
(50,000)
56,000
211,000
39,000
Decision:


Since proposed distribution method is having more Net Income than present distribution
method, proposed method in preferred.
OR
Under the proposed marketing plan, differential revenue is 250,000 and differential cost
total is 211,000 resulting in differential net income of 39,000. Hence proposed
distribution method is preferred to present method.
3
Complied by Moti F.
Cost and management accounting-I
2. Ethiopian Airlines presently is running a Non-stop flight between Addis to Nigeria route. The
manager of Ethiopian Airlines is considering a stop in Gambia, so that the route would attract
additional passengers if the stop is made. However, there would be some additional costs and
benefits are associated with proposed plan.
The following are the costs to benefits details of two alternatives.
Revenues: Passenger Revenue
Cargo Revenue
Costs:
Landing fees in Gambia
Use of airport gate facilities
Flight crew cost
Fuel cost
Meals and services
Aircraft maintenance
Non-stop Route
With stop in Gambia
$ 300,000
$ 360,000
100,000
110,000
4,500
18.000
8,000
2,500
12,000
7,000
4,500
25,000
9,000
2,500
Should the Ethiopian Airlines make a stop in Gambia? Advise the manager using differential
costing?
Solution:
Differential cost statement or Incremental Analysis:
Revenues:
Increase in passenger revenue
Increase in Cargo revenue
Increase in Total revenue
Less: Increase in costs:
Landing fees in Gambia
Use of airport gate facilities
Fuel
Meals and services
Net benefit of stopping at Gambia
Amount in $
12,000
7,000
7,000
1,000
Amount in $
60,000
10,000
70,000
27,000
43,000
Hence, the manager is advised to a make decision of stopping flight at Gambia.


Differential costs are interchangeably used with incremental costs, avoidable costs and
relevant costs.
Non-relevant costs are unavoidable costs or that do not differ between two alternatives.
In the above illustration Flight crew cost and aircraft maintenance cost are irrelevant
costs since they are same ( not differing) under both the alternatives.
4
Complied by Moti F.
Cost and management accounting-I
II. Make or buy decisions:


Avoidable costs < outside purchase price = Make internally
Avoidable costs > outside purchase price = Buy from outside
1. A Television Manufacturing Company is currently producing a spare part called X007.
The cost structure to manufacture the spare part is as under.
Direct material
32 per unit
Direct wages
12 per unit
Variable overheads
5 per unit
Fixed cost
7 per unit
_________
Total cost
56 per unit
__________
The same spare part is offered by an outside seller for Br. 45 per unit with assured
supply. Should the company make or buy the spare part.
Answer:
Production cost per unit
Direct material
Direct wages
Variable
overheads
Fixed cost
Outside
supply
price
Per unit differential cost
Make
32
12
5
32
12
5
7
Buy
-
-
45
49
45
The company should buy the component since avoidable costs (Birr 49 per unit) are
more than outside supply price (Birr 45 per unit).
2. Tata Motors Company is an automobile manufacturing company. The company is
currently producing tyres used for its automobiles. The cost of manufacturing 60,000
tyres per annum is as follows:
Direct material
480,000
Direct labor
360,000
Variable overheads
180,000
Fixed overheads
360,000
________
1,380,000
5
Complied by Moti F.
Cost and management accounting-I
An outside supplier specialized in manufacturing tyres has offered to sell the same tyres
to Tata motors company for $ 25 per tyre. The entire fixed overheads will continue
unchanged if Tata motors company purchases the tyres from supplier, except $ 120,000
pertaining to supervisory and other personnel salaries which can be avoided.
a) Assuming that the capacity (space & Manufacturing facilities) currently used to make
the tyres internally will become idle if they purchase, should the company continue to
make or buy the tyres?
b) Assuming that the capacity now used to make the tyres if used to make another
product that will contribute $ 250,000 per annum, should the company continue to
make or buy the tyres?
Answer to situation “a”:
Item
Direct material
Direct labor
Variable overheads
Fixed over heads
Outside purchase price
Production Per unit Differential cost
cost
per
unit
Make tyres Buy tyres
8
8
6
6
3
3
6
2
21
23
19
21
Total Differential costs for
60,000 units
Make tyres
Buy tyres
480,000
360,000
180,000
120,000
1,260,000
1,140,000
1,260,000
Decision: Tata Motors Company should reject the outside supplier’s offer and continue to make
the tyres because it costs (21-19) $ 2 less and $ 120,000 in total (1,260,000 – 1,140,000) if tyres
are produced.
Answer to situation “b”:
Make tyres
Cost to make and buy tyres
Opportunity cost or
Profit contribution from another product
1,140,000
Buy tyres and
use idle capacity for another
product
1,260,000
1,140,000
(250,000)
1,010,000
Differential cost $130,000(1,140,000 – 1,010,000) favoring purchase of tyres.
Decision: The Company should buy the tyres from outside supplier and use idle space for
producing another product. By doing so the company gets benefit of $ 130,000 per annum.
6
Complied by Moti F.
Cost and management accounting-I
III. Special order decisions:
A special order is a one-time order that is not considered as part of the company’s normal
ongoing business. Occasionally, a company may receive these orders but not from a company’s
customers.
When special orders are received by a company, the management must assess whether the
special order should be accepted or rejected by considering the additional benefits (revenues) and
additional costs that will be incurred by a company. Special order decisions are made by
comparing the incremental revenue and incremental costs. If


Incremental revenue > Incremental cost = accept the order
Incremental revenue < Incremental cost = Reject the order.
In special order decisions, consideration of plant capacity is vital. If the company is having
excess (idle) capacity, then only special orders can be accepted.
For example: A company’s manufacturing capacity per month is 15,000 units due to market
demand, the company presently producing and selling only 12,000 units per month (80%
capacity only), it means company is having 20% idle capacity.
Illustration1: Paramount Company manufactures Tennis Balls that it distributes exclusively
through professional shops in U.S.A. Although the company has the capacity to manufacture 1.5
million balls per month, its current sales require that only 800,000 units be produced. At this
level of output, the manufacturing costs are as follows:
Manufacturing costs:
Variable costs ($0.20 per ball x 800,000)
Fixed costs
Total manufacturing cost
Selling price per ball
Amount in $
160,000
320,000
480,000
1.25
The company received an export order from Japan Company for 500,000 balls at $ 0.50 per ball.
Whether Paramount Company should accept or reject this order?
7
Complied by Moti F.
Cost and management accounting-I
Solution:
Without special
With special order Incremental
Order (800,000 (800,000+500,000) Analysis
balls)
1,300,000 balls
Sales:
Regular sales @ 1.25 per ball
Special order @ 0.50 per ball
Less: Manufacturing costs:
Variable @ 0.20 per ball
Fixed manufacturing cost
Profit
1,000,000
(160,000)
(320,000)
520,000
1,000,000
250,000
(260,000)
(320,000)
670,000
250,000
(100,000)
150,000
Decision: Paramount Company should accept the special order since incremental revenue is i.e.
250,000 is more than incremental cost i.e. 100,000. By accepting the order the company gets
additional profit of $ 150,000.
Illustration 2: National Textiles is producing 50,000 units per month with a monthly production
capacity of 75,000 units per month. The cost of production per unit in Birr is as under:
Direct material
7.00
Direct wages
10.00
Variable overheads
5.00
Fixed overheads
150,000
Selling price per unit
30.00
The company received an export order for 20,000 units at price of Br. 20.00 per unit.
Advice the company whether to accept the order or not?
Solution:
Incremental revenue
= 20,000 X 20 = 400,000
Incremental costs (7+10+5)
= 20,000 X 22 = 440,000
_________
Loss
(40,000)
Decision: Since incremental costs are more than incremental revenue, the export order should be
rejected.
8
Complied by Moti F.
Cost and management accounting-I
IV. Product mix decisions:
A business unit may engage in producing multiple products. A change in the product mix derives
change in profits. Product mix means the ratio in which various products are produced and sold.
The management has to take wise decisions regarding appropriate product mix by using variable
costing technique. The most profitable mix is the one which yields highest contribution.
Illustration1: Technical director of a company has submitted the following three proposals of
sales mix.
a) 100 units of product ‘X’ and 300 units of product ‘Y’
b) 300 units of product ‘X’ and 100 units of product ‘Y’
c) 200 units of product ‘X’ and 200 units of product ‘Y’
The cost structure of two products as under:
Product X
Direct material
Product Y
25
22
Direct wages
7
5
Variable cost
7
5
Selling price
50
40
Fixed expenses
Br. 1,000
Advice the company which sales mix is more profitable?
Solution:
1. Calculation of variable cost per unit
Product X = 25 + 7 + 7= 39
Product X = 22 + 5 + 5 = 32
2. Calculation of sales revenue of three proposals:
Proposal A = (100 x 50) + (300 x 40)
= 5,000
+ 12,000 = 17,000
Proposal B = (300 x 50) + (100 x 40)
= 15,000 + 4,000 = 19,000
Proposal C = (200 x 50) + (200 x 40)
= 10,000 + 8,000 = 18,000
9
Complied by Moti F.
Cost and management accounting-I
3. Calculation of variable cost of three proposals:
Proposal A = (100 x 39) + (300 x 32)
= 3,900 + 9,600 = 13,500
Proposal B = (300 x 39) + (100 x 32)
= 11,700 + 3,200 = 14,900
Proposal C = (200 x 39) + (200 x 32)
= 7,800 + 6,400 = 14,200
Proposal A
Proposal B
Proposal C
Sales
17,000
19,000
18,000
Less: Variable cost
13,500
14,900
14,200
3,500
4,100
3,800
Contribution
Less: Fixed expenses
1,000
1,000
1,000
2,500
3,100
2,800
Profit
Decision: Since Proposal “B”( i.e. product mix of 300units of Product X and 100 units of
Product Y) is yielding more contribution or profit that product mix is preferable.
10
Complied by Moti F.