ACC3200
Incremental Analysis for Short-Term Decision
Making
Learning Objectives
 Describe the five steps in the decision-making process
 Define and identify relevant costs and benefits
 Analyze a special-order decision.
 Analyze a make-or-buy decision
 Analyze the decision to eliminate an unprofitable business
segment
 Analyze a sell-or-process further decision.
 Prioritize products to maximize short-term profit with constrained
resources
7-3
Steps in the Decision-Making
Process
Improve
future decisions
7-4
Relevant versus Irrelevant Costs
and Benefits
Relevant costs are costs that
will change depending on the
alternative selected.
Relevant costs are also called
differential costs, incremental
costs, or avoidable costs.
7-5
Relevant versus Irrelevant Costs
and Benefits
Irrelevant costs are costs that
do not differ between alternatives.
Costs that have been
incurred in the past.
(sunk costs)
Costs that are the
same regardless of the
alternative chosen.
7-6
Opportunity Costs and Capacity
Considerations
An opportunity cost is a benefit that is
given up when one alternative is
selected over another.
At capacity, adding
additional work
requires giving up a
portion of the existing
work. The benefit of the
existing work given up
is an opportunity cost.
With idle capacity,
additional work may be
added without
sacrificing existing
work. There is no
opportunity cost to the
additional work.
7-7
Special-Order Decisions
A special order is a one-time
order that is not considered
part of the company’s normal
ongoing business.
When analyzing a special
order, only the incremental
costs and benefits are
relevant.
7-8
Special-Order Decisions
A major university has asked Mattel to make a
special University Barbie, dressed in a sporty
outfit with the school’s logo and colors. The
university bookstore has offered to buy 25,000 of
these dolls at a price of $7.00 each. Mattel has
the capacity to fill the order without affecting
production of other Barbie products, which are
normally sold to toy stores and discount chains
for $9.00 each.
More Information
7-9
Special-Order Decisions
Mattel estimates that its unit cost to produce the
University Barbie will be:
Direct materials
Direct labor
Variable manufacturing overhead
Fixed manufacturing overhead
Total manufacturing cost
Unit Cost
$ 3.50
1.00
0.50
2.50
$ 7.50
Should Mattel accept the special order?
7-10
Incremental Analysis (with Excess
Capacity)
Incremental Analysis of the Special Order
for 25,000 University Barbie Dolls
Incremental Revenue
Less Incremental Costs:
Direct materials
Direct labor
Variable Overhead
Fixed Overhead
Total Incremental Cost
Incremental Profit
Per Unit
$
7.00
Total
$ 175,000
3.50
1.00
0.50
5.00
2.00
87,500
25,000
12,500
125,000
$ 50,000
$
7-11
Qualitative Analysis
Mattel should assure themselves the
special-order price of $7.00 would not lead
other customers, purchasing through regular
channels, to expect a price reduction from
$9.00 to $7.00.
Mattel would not want to use this type of
analysis to make long-run pricing decisions,
because in the long run, prices must cover all
costs, including fixed costs, if the company is
to be profitable.
7-12
Incremental Analysis (without Excess
Capacity)
Direct materials
Direct labor
Variable MFG Overhead
Fixed MFG Overhead
Total Manufacturing Cost
The opportunity cost
is the contribution
margin lost on
regular sales.
Unit Cost
$ 3.50
1.00
0.50
2.50
$ 7.50
Regular sales price
Variable cost
Contribution margin
Variable
cost = $5.00
Per Unit
$ 9.00
5.00
$ 4.00
7-13
Incremental Analysis (without Excess
Capacity)
Incremental Analysis of the Special Order
for 25,000 University Barbie Dolls
Incremental Revenue
Per Unit
$ 7.00
Less Incremental Costs:
Direct materials
Direct labor
Variable Overhead
Fixed Overhead
Opportunity cost of lost sales
Total Incremental Cost
Incremental Profit
$
3.50
1.00
0.50
4.00
9.00
(2.00)
Total
$ 175,000
87,500
25,000
12,500
100,000
225,000
$ (50,000)
7-14
Make-or-Buy Decisions
A decision to make a part or provide a service
internally rather than to buy externally from a
supplier is called a “make-or-buy” decision.
Make-or-buy decisions are also called
insourcing versus outsourcing decisions.
7-15
Make-or-Buy Decisions
Mattel is trying to decide whether to continue packaging the
American Girl doll “in-house” or outsource the packaging process to
an external supplier. Mattel’s packaging costs for the dolls are:
Internal Cost of Packaging
200,000 American Girl Dolls
Packaging Materials
Packaging Direct Labor
Indirect Materials
Packaging Supervision
Other Fixed MFG Overhead
Total Packaging Cost
Annual
Cost
$ 300,000
90,000
60,000
50,000
200,000
$ 700,000
Unit
Cost
$
1.50
0.45
0.30
0.25
1.00
$
3.50
The outside supplier bid $3.00 per doll for the packaging work.
Should Mattel outsource the packaging?
7-16
Make-or-Buy Decisions
• The agreement with the outside supplier includes a 3-year contract
for a minimum of 200,000 units per year.
• All costs directly related to the packaging activities, including all
direct and indirect materials, labor, and supervision, would be
avoided if the packaging is outsourced.
• Other total fixed manufacturing overhead costs would remain
unchanged.
• The factory space that is now used for packaging could be used
to expand production of a popular product line. The expansion
would generate an additional $150,000 in profit per year.
7-17
Incremental Analysis
Relevant Costs of Packaging 200,000 Units per Year
Supplier's Price ($3.00 per unit)
Packaging Materials ($1.50 per unit)
Packaging Direct Labor ($0.45 per unit)
Indirect Materials ($0.30 per unit)
Packaging Supervisor
Profit from Expanding Another Product Line
Total cost
Internal
Costs
$
300,000
90,000
60,000
50,000
$
500,000
Outsourced
Costs
$
600,000
$
(150,000)
450,000
7-18
Qualitative Analysis
• What is the supplier’s level of quality and reliability?
• What happens if demand for the product drops below 200,000
units or rises significantly higher than 200,000? Does the
supplier have the capacity to meet the increased demand? Will
the price be higher or lower for any additional or fewer units?
• What happens in three years? Will the price of packaging
increase significantly? Returning to internal packaging will be
difficult after the space is converted to another use.
• What if the predicted profit to be generated by expanding the
other product line has been substantially over- or
underestimated?
• Does outsourcing the packaging create any additional risks,
such as loss of sensitive information to the supplier that could
result in a competitive disadvantage for Mattel?
7-19
Decisions to Eliminate Unprofitable
Segments
One of the most important decisions
managers make is whether to
continue or eliminate a business
segment, such as a product or a
store.
A segment is a candidate for
elimination if its revenues are less than
its relevant (avoidable) expenses.
7-20
Decisions to Eliminate Unprofitable
Segments
Mattel has three versions of its Power-Wheels batterypowered vehicles. The company is considering
eliminating the Barbie Mustang product, because
it has shown a loss for the past few years.
Considerations before eliminating the Barbie Mustang:
• What costs (and revenues) will be affected by the
decision?
• Will the costs (and revenues) of other product lines be
affected by the decision?
• Are there any opportunity costs to consider, such as
alternative use of facilities?
7-21
Decisions to Eliminate Unprofitable
Segments
Segmented Income Statement for the Power-Wheels Product Lines
Jeep
Wrangler
4X4
Sales Revenue
$ 500,000
Variable Costs
200,000
Contribution Margin
300,000
Direct Fixed Costs
50,000
Segment Margin
250,000
Common Fixed Costs*
100,000
Profit Margin
$ 150,000
Barbie
Mustang
$ 150,000
100,000
50,000
40,000
10,000
30,000
$ (20,000)
Dora the
Explorer
Jeep
$ 350,000
140,000
210,000
30,000
180,000
70,000
$ 110,000
$
$
Total
1,000,000
440,000
560,000
120,000
440,000
200,000
240,000
* Common fixed costs are allocated based on a percentage of total sales revenue.
Should Mattel drop the Barbie Mustang?
7-22
Decisions to Eliminate Unprofitable
Segments
• Elimination of the Barbie Mustang will eliminate the revenues,
variable costs, and direct fixed costs for the Barbie Mustang product.
• Elimination of the Barbie Mustang will increase sales of the
Dora the Explorer Jeep by 10%, with no effect on the Jeep 4X4.
• Total variable costs of the Dora the Explorer Jeep will also increase
by 10 % as a result of the increased sales.
• Total common fixed costs will not be affected by the elimination
of the Barbie Mustang. They will be reallocated to the remaining
products based on total sales dollars.
7-23
Incremental Analysis
Segmented Income Statement for the Power Wheel
Product Lines After Elimination of the Barbie Mustang
Jeep
Wrangler
4X4
Sales Revenue
$ 500,000
Variable Costs
200,000
Contribution margin
300,000
Direct Fixed Costs
50,000
Segment Margin
250,000
Common Fixed Costs*
113,000
Profit Margin
$ 137,000
Dora the
Explorer
Jeep
$ 385,000
154,000
231,000
30,000
201,000
87,000
$ 114,000
Total
$ 885,000
354,000
531,000
80,000
451,000
200,000
$ 251,000
* Allocated based on a percentage of total sales revenue.
7-24
Incremental Analysis
Let’s look at an approach that focuses on
only the relevant items for the decision.
Relevant Cost and Revenue Approach
Elimination of Barbie Mustang
Lost Sales
Reduced Variable Costs
Reduced Direct Fixed Costs
Lost Segment Margin
$ (150,000)
100,000
40,000
Effect on Dorer Explorer (10% increase)
Increased Sales ($350,000 × 10%)
$ 35,000
Increased Variable Costs ($140,000 × 10%)
(14,000)
Increased Contribution Margin
Net Increase in Profits from Eliminating the Barbie Mustang
$ (10,000)
$
21,000
11,000
7-25
Qualitative Analysis
What if the expected increase in sales of the Dora the
Explorer Jeep has been overestimated or
underestimated?
• Will the elimination of the Barbie Mustang free up
resources (people, space, or machines) that could be
used in another way?
• Can the company introduce another product that will
yield more than $11,000 in incremental profit?
• Are there any other opportunity costs associated with
keeping the Barbie Musting?
7-26
Sell-or-Process Further Decisions
Businesses are often faced with the decision
to sell partially completed products or to process them
to completion and hopefully sell them at a higher price.
As a general rule, we
process further only if
incremental revenues
exceed incremental costs.
Costs of manufacturing the
product up to the sell-orprocess decision point are
sunk and therefore
irrelevant.
7-27
Sell-or-Process Further Decisions
Mattel has developed a new toy, spending a total of
$250,000 on R&D. Demand for the new toy is estimated
to be 100,000 units at a price of $15 per unit.
If the company spends an additional $100,000 on R&D
to enhance the toy, it could be sold for $18 per unit.
However, the enhanced toy would have a slightly
higher manufacturing cost.
The following table gives us the information we need to
decide between the current design and the enhanced
design.
7-28
Sell-or-Process Further Decisions
Estimated Demand
Estimated Sales Price (Per Unit)
Estimated Manufacturing Costs (Per Unit)
Direct Materials
Direct Labor
Variable Manufacturing Overhead
Fixed Manufacturing Overhead
Total Unit Manufacturing Costs
Research and Development Costs
Current
Design
100,000 units
$
15
Enhanced
Design
100,000 units
$
18
$
$
$
3.00
1.50
0.50
2.00
7.00
$
4.25
1.75
0.75
2.00
8.75
$
250,000
$
350,000
Should Mattel sell the product as it is currently designed,
or spend more money to create an enhanced design?
7-29
Sell-or-Process Further Decisions
Increased Sales Revenue
100,000 units × ($18 – $15)
Increased Manufacturing Costs
100,000 units × ($8.75 – $7.00)
Increased R & D Costs
Increased Profit
$
300,000
$
(175,000)
(100,000)
25,000
Mattel will make an additional $25,000
in profit by enhancing the product.
7-30
Prioritizing Products with Limited
Resources
When a limited resource restricts a company’s ability to
satisfy demand, the company is said to have a
constrained resource that is referred to as a bottleneck.
To maximize profits in the short run, a company with a
bottleneck must prioritize its products or services so as
to maximize contribution margin per unit of the
constrained resource.
The focus is on contribution margin instead of segment
margin because fixed costs will not change in the short
run, and are not relevant.
7-31
Prioritizing Products with Limited
Resources
One of Mattel’s factories produces three types of toy
cars, Match Box, Hot Wheels, and Remote Control with
the following financial and production information.
Unit Sales Price
Unit Variable Costs
Unit Contribution Margin
Match
Box
$ 5.00
2.00
$ 3.00
Hot
Wheels
$ 15.00
7.00
$ 8.00
Remote
Control
$ 25.00
10.00
$ 15.00
Machine time required
(minutes per unit)
6
minutes
10
minutes
20
minutes
10,000
10,000
10,000
60,000
minutes
100,000
minutes
200,000
minutes
Monthly demand (units)
Total Machine
Requirements
7-32
Prioritizing Products with Limited
Resources
Unit Contribution Margin
Machine time required
(minutes per unit)
Match
Box
$ 3.00
÷ 6
minutes
Hot
Wheels
$ 8.00
÷ 10
minutes
Remote
Control
$ 15.00
÷ 20
minutes
Contribution margin per
minute of machine time
$0.50 per
minute
$ 0.80 per
minute
$ 0.75 per
minute
7-33
Prioritizing Products with Limited
Resources
Priority
Production
Machine time required
(minutes per unit)
Total Machine
Requirements
Match
Box
3
5,000
units
Hot
Wheels
1
10,000
units
6
minutes
10
minutes
30,000
minutes
100,000
minutes
Remote
Control
2
10,000
units
20
minutes
200,000
minutes
End of Topic 7