CHAPTER 7
INCREMENTAL
ANALYSIS
Managerial Accounting, Fourth Edition
Incremental Analysis

Occurs when there is more than one alternative
choice of action.
Alternative One
Alternative Two
Important Definitions

Relevant Cost. Costs and revenues that do not
differ between alternatives.


Opportunity Cost. The benefit given up when
one alternative is chosen over another.


These can be ignored in incremental analysis
Opportunity costs are never found in the general
ledger.
Sunk Cost. A cost that has already been
incurred and will not be changed or avoided by
any future decision.

Sunk costs are not relevant costs.
Types of Incremental Analysis
Accept an order at a special price
Make or buy components or finished
products
Sell products or process further
Retain or replace equipment
Eliminate an unprofitable business
segment
Allocate limited resources
LO 2: Describe the concept of incremental analysis.
McDermott’s Criteria

When can you sell a product at less than full
cost and still make a profit? When . . .





You can segregate the market
You can identify fixed and variable costs
You have a positive contribution margin
You have excess capacity or can charge for
opportunity cost
The minimum price you can charge under these
conditions is:

Variable costs of the new order plus opportunity cost
Variable Cost of the New Order

Variable costs of the new order include:






Direct labor
Direct materials
Variable overhead
Variable marketing and administrative costs
Any other costs will be incurred to fulfill the new order
(freight, special handling, and so on).
Any normal costs that disappear should be
subtracted from variable costs in this formula.
Opportunity Cost

The opportunity cost is the contribution margin
of any sales given up.

The formula is (contribution margin per unit ) × (units
of sales to existing customers given up)
Example Problem


McDermott Manufacturing makes computer
monitors.
Revenue and cost data for the company are
shown below:







Price $60
Direct labor $10
Direct materials $5
Variable overhead $12
Fixed overhead $100,000
Variable marketing $6
Fixed marketing and administration $50,000
Example Problem


A Japanese retailer wants to purchase 5,000
monitors.
Assume that the purchase needs the criteria
listed earlier by Professor McDermott.
Additional Information





The company has the capacity to manufacture
10,000 units per year.
Currently the company is manufacturing and
selling 8,000 units per year.
The special order will have no marketing costs
It will cost $3 to ship the monitors to the
purchaser’s San Francisco warehouse.
What is the minimum price for which the
company would be willing to sell this special
order?
Calculation of Variable Costs
Category
Direct labor
Direct materials
Amount
$10
$5
Variable overhead
$12
Variable marketing
$0
Additional shipping
$3
Total variable costs
$30
Remember: we delete any savings on the
special order. In this case we save
marketing costs (sales commissions).
Calculation of Variable Costs
Category
Direct labor
Direct materials
Amount
$10
$5
Variable overhead
$12
Variable marketing
$0
Additional shipping
$3
Total variable costs
$30
Also remember: We add any additional costs of
this special order, in this case shipping the
product to San Francisco.
Calculation of Opportunity Cost




The company has an excess capacity of 2,000
units (10,000 manufacturing capacity – 8,000
units presently manufactured and sold).
However the customer wishes to purchase
5,000 monitors.
The opportunity cost in units, therefore, is 5,000
units of demand - 2,000 units of excess capacity
= 3,000 units.
The opportunity cost in dollars is the contribution
margin per unit times the opportunity cost in
units.
Calculation of Opportunity Cost




The contribution margin (for existing customers)
is:
$60 price - $10 direct labor - $5 direct materials
- $12 variable overhead - $6 variable marketing
= $27.
The total contribution margin lost is, therefore,
$27 × 3000 units = $81,000.
The opportunity cost per unit sold to the
Japanese is $81,000/5000 units = $16.20 per
unit
Minimum Price Special Order



$30 variable costs of special order + $16.20
opportunity cost = $46.20.
Note: the full cost of the product including fixed
costs is $48.
What if the customer is willing to pay $47.50 per
unit?


This is less than the full (absorption) cost of the
product.
Should they accept the special order?
Minimum Price Special Order




The contribution margin is $47 - $30 variable
costs of special order = $17 contribution margin.
This $17 will cover the opportunity cost of
$16.20 per unit, allowing $.80 per unit to flow to
the bottom line.
The net impact on the bottom line will be $.80 x
5000 units = $4000
Bottom line: variable revenues and costs are
relevant, fixed costs are not relevant in shortterm special pricing decisions.
Another example – the authors
Example
Mexico Co. offers to buy a special order of 2,000
blenders at $11 per unit from Sunbelt.
No effect on normal sales; sufficient plant capacity
Operating at 80 percent capacity = 100,000 units
Current fixed manufacturing costs = $400,000 or $4 per unit
Variable manufacturing cost = $8 per unit
Normal selling price = $20 per unit
Based strictly on total cost of $12 per unit ($8 + $4),
reject offer as cost exceeds selling price of $11
LO 3: Identify the relevant costs in accepting an order at a special price.
Accept an Order at a Special Price
Within existing capacity, no change in fixed costs they are not relevant for this decision
Total variable costs change – they are relevant
Revenue increases $22,000; variable costs increase
$16,000
Income increases by $6,000
Accept the Special Order
LO 3: Identify the relevant costs in accepting an order at a special price.
Let’s Review
It costs a company $14 of variable costs and $6 of
fixed costs to produce product Z200 that sells for
$30. A foreign buyer offers to purchase 3,000 units
at $18 each. If the special offer is accepted and
produced with unused capacity, net income will:
a.
Decrease $6,000.
b. Increase $6,000.
c.
Increase $12,000.
d. Increase $9,000.
LO 3: Identify the relevant costs in accepting an order at a special price.
Make or Buy
Management must decide whether to make or buy
components.
The decision to buy parts or services rather than
making them is called outsourcing.
Example: Costs to produce 25,000 switches
LO 4: Identify the relevant costs in a make-or-buy decision.
Make or Buy – Example Continued
Switches can be purchased for $8 per switch
(25,000 x $8 = $200,000)
At first look, the switches should be purchased;
thus saving $1 per unit
Buying the switches eliminates all variable costs,
but only $10,000 of fixed costs
However, $50,000 of fixed costs remain even if
the switches are purchased
LO 4: Identify the relevant costs in a make-or-buy decision.
Make or Buy – Example Continued
Switches can be purchased for $8 per switch
(25,000 x $8 = $200,000)
At first look, the switches should be purchased;
thus saving $1 per unit
Buying the switches eliminates all variable costs,
but only $10,000 of fixed costs
However, $50,000 of fixed costs remain even if
the switches are purchased!!!!!
LO 4: Identify the relevant costs in a make-or-buy decision.
Make or Buy – Example Continued
The relevant costs for incremental analysis are:
Baron Company will incur $25,000 additional cost if
switches are purchased
Continue to make switches
LO 4: Identify the relevant costs in a make-or-buy decision.
Make or Buy
Opportunity Costs
Definition: The potential benefits that may be
obtained from following an alternative course of
action.
New assumption:
Now assume Baron Company can use the newly available
productive capacity from buying the switches to
generate additional income of $28,000 by making
another product.
If Baron makes the switches, this possible income
is lost.
LO 4: Identify the relevant costs in a make-or-buy decision.
Make or Buy – Opportunity Cost Example
This opportunity cost, the lost income, is
added to the “Make” column as an additional
“cost” for comparative purposes
It is now advantageous to buy the switches:
Baron Company will be $3,000 better off
LO 4: Identify the relevant costs in a make-or-buy decision.
Let’s Review
In a make-or-buy decision, relevant costs are:
a.
Manufacturing costs that will be saved.
b. The purchase price of the units.
c.
Opportunity costs.
d. All of the above.
LO 4: Identify the relevant costs in a make-or-buy decision.
Sell or Process Further
Many manufacturers have the option of selling a
product now or continuing to process the product
hoping to sell the refined product at a higher price
Decision Rule:
Process further as long as
the incremental revenue from
such processing exceeds the
incremental processing costs
LO 5: Identify the relevant costs in determining whether
to sell or process materials further.
Sell or Process Further - Example
Single-Product Case
Cost to manufacture one unfinished table:
Selling price of unfinished unit is $50; unused capacity
can be used to finish the tables to sell for $60
Relevant unit costs of finishing tables:
Direct materials increase $2; Direct labor increases $4
Variable manufacturing overhead costs increase by $2.40 (60
percent of direct labor increase)
Fixed manufacturing costs will not increase
LO 5: Identify the relevant costs in determining whether
to sell or process materials further.
Sell or Process Further
Incremental revenues ($10) exceed incremental costs
($8.40); Income increases $1.60 per unit
Process further
LO 5: Identify the relevant costs in determining whether
to sell or process materials further .
Sell or Process Further
Multiple-Product Case
In many industries, a number of end-products are
produced from a single raw material and a common
production process
Multiple end-products are commonly called joint
products
Petroleum – gasoline, lubricating oil, kerosene
Meat Packing – meat, hides, bones
LO 5: Identify the relevant costs in determining whether
to sell or process materials further.
Sell or Process Further
Multiple-Product Case
All costs incurred prior to the point at which the products are
separately identifiable (the split-off point) are called joint costs
Joint costs are (for purposes of determining product cost)
allocated to individual products on the basis of relative sales
value
Joint costs are not relevant for any sell-or-process-further
decisions
Joint product costs are sunk costs.
They have already been incurred and cannot be changed
LO 5: Identify the relevant costs in determining whether
to sell or process materials further.
Sell or Process Further - Example
Multiple-Product Case
Marais Creamery must decide whether to:
Sell cream and skim milk now
or
Process each further before selling
LO 5: Identify the relevant costs in determining whether
to sell or process materials further.
Sell or Process Further – Example Continued
The daily cost and revenue data for Marais Creamery are:
LO 5: Identify the relevant costs in determining whether
to sell or process materials further.
Sell or Process Further – Example Continued
Sell cream or process further into cottage cheese?
Do not process cream further:
To do so will incur an incremental loss of $2,000
LO 5: Identify the relevant costs in determining whether
to sell or process materials further.
Sell or Process Further
Sell skim milk or process further into condensed milk?
Marais should process the skim milk:
To do so will increase net income by $7,000
LO 5: Identify the relevant costs in determining whether
to sell or process materials further.
Let’s Review
The decision rule in a sell-or-process-further decision
is:
process further as long as the incremental
revenue from processing exceeds:
a.
Incremental processing costs.
b. Variable processing costs.
c.
Fixed processing costs.
d. No correct answer is given.
LO 5: Identify the relevant costs in determining whether
to sell or process materials further.
Retain or Replace Equipment
Management must decide whether a company should
continue to use an asset or replace it
Example: Assessment of replacement of a factory
machine:
Book value
Cost
Remaining useful life
Scrap value
Old Machine
$40,000
four years
-0-
New Machine
$120,000
four years
-0-
Variable costs:
Decrease from $160,000
to $125,000 annually
LO 6: Identify the relevant costs to be considered in
retaining or replacing equipment.
Retain or Replace Equipment - Example
Replace the equipment - Lower variable manufacturing costs
more than offset cost of new equipment.
The book value of the old machine does not affect the
decision – it is a sunk cost.
However, any trade-in allowance or cash disposal value of
the old asset is relevant
LO 6: Identify the relevant costs to be considered in
retaining or replacing equipment.
Let’s Review
In a decision to retain or replace equipment, the book
value of the old equipment is a(an):
a.
Opportunity cost.
b. Sunk cost.
c.
Incremental cost.
d. Marginal cost.
LO 6: Identify the relevant costs to be considered in
retaining or replacing equipment.
Eliminate an Unprofitable Segment
Should the company eliminate an unprofitable
segment?
Key: Focus on relevant costs
Consider effect on related product lines
Fixed costs allocated to the unprofitable segment
must be absorbed by the other segments
Net income may decrease when an unprofitable
segment is eliminated
Decision Rule:
Retain the segment unless fixed costs eliminated
exceed the contribution margin lost
LO 7: Identify the relevant costs in deciding whether
to eliminate an unprofitable segment.
Eliminate an Unprofitable Segment - Example
Martina Company manufactures three models of tennis
racquets:
Profitable lines:
Pro and Master
Unprofitable line:
Champ
Condensed Income Statement data:
Should the Champ line be eliminated?
LO 7: Identify the relevant costs in deciding whether
to eliminate an unprofitable segment.
Eliminate an Unprofitable Segment - Example
If Champ is eliminated, must allocate its $30,000
share of fixed costs: 2/3 to Pro and 1/3 to Master
Revised Income Statement data:
Total income has decreased by $10,000 ($220,000 $210,000)
LO 7: Identify the relevant costs in deciding whether
to eliminate an unprofitable segment.
Eliminate an Unprofitable Segment - Example
Incremental analysis of Champ provides the same
results:
Decision: Do not eliminate Champ
LO 7: Identify the relevant costs in deciding whether
to eliminate an unprofitable segment.
Let’s Review
If an unprofitable segment is eliminated:
a.
Net income will always increase.
b. Variable expenses of the eliminated segment will
have to be absorbed by other segments.
c.
Fixed expenses allocated to the eliminated
segment will have to be absorbed by other
segments.
d. Net income will always decrease.
LO 7: Identify the relevant costs in deciding whether
to eliminate an unprofitable segment .
Other Considerations in Decision Making
Many decisions involving incremental analysis have
important qualitative features that must be
considered in addition to the quantitative factors.
Example – cost of lost morale due to outsourcing or
eliminating a plant
Incremental analysis is completely consistent with
activity-based costing (ABC)
ABC often results in better identification of relevant
costs and, thus, better incremental analysis
All About You
What is a Degree Worth?
Over a life time of work, college graduates earn an
average of $500,000 more than associate degree
holders and $900,000 more than high-school
graduates.
Tuition costs about $8,655 a year to attend a public
four-year college and about $1,359 for a public two
year institution.
About 600,000 students drop out
of four-year colleges each year.
All About You
What is a Degree Worth?
You are working two jobs,
your grades are suffering,
you feel depressed: Should
you drop out of school?
Is it better to stay in school
even if you only take one class
each semester?
Chapter Review - Exercise 7-1
Identify each of the following statements as true or false.
1. The first step in management’s decision-making process is
“Determine and evaluate possible courses of action.”
False
2. The final step in management’s decision-making process is
to actually make the decision.
False
3. Accounting’s contribution to management’s decisionmaking process occurs primarily in evaluating possible
courses of action and in reviewing the results.
True
4. In making business decisions, management ordinarily
considers only financial information because it is
objectively determined.
False
Chapter Review - Exercise 7-1 Continued
Identify each of the following statements as true or false.
5. Decisions involve a choice among alternative courses of
action.
True
6. The process used to identify the financial data that
change under alternative courses of action is called
incremental analysis.
True
7. Costs that are the same under all alternative courses of
action sometimes affect the decision.
False
8. When using incremental analysis, some costs will always
change under alternative courses of action, but revenues
will not.
False
9. Variable costs will change under alternative courses of
action, but fixed costs will not.
False
Problems Come Next!
Brief Exercise One

The steps in management decision-making
process are listed in random order below.
Indicate the order in which the step should be
executed.





Identify the problem and assign responsibility.
Determine and evaluate possible courses of action.
Make a decision.
Review results of the decision.
Exercise One


Given the following list of statements about
decision making and incremental analysis,
determine which are true and which are false.
If false, correct the statement.
Statements

The first step in management ‘s decision-making
process is: Determine and evaluate possible
courses of action.


False. The first step in management decision making
process is identified the problem and assign
responsibility
The final step in management’s decision-making
process is to actually make the decision.

False. The final step in management’s decisionmaking process is to review the results of the
decision.
Statements

Accounting’s contribution to management’s
decision-making process occurs primarily in
evaluating possible courses of action and in
reviewing the results.


True
In making business decisions, management
ordinarily considers only financial information
because it is objectively determined.
 False. In making business decisions,
management ordinarily considers both
financial and nonfinancial information.
Statements

Decisions involve a choice among alternative
courses of action.


The process used to identify the financial data
that changes under alternative courses of action
is called incremental analysis.


True
True
Costs that are the same under all alternative
courses of action sometimes affect the decision.

False. Costs that are the same are not relevant.
Statements

When using incremental analysis, some costs
will always change under alternative courses of
actions, but revenues will not.
 False. When using incremental analysis,
either costs or revenues or both will change
under alternative courses of action.

Variable costs will change under variable
courses of action, but fixed costs will not.

False. Sometimes variable costs will not
change under alternative courses of action,
but fixed costs will.
Exercise 7-2


A company produces golf discs which normally
sellto retailers for seven dollars each.
The cost of manufacturing 20,000 golf discs is.






Materials $10,000
Labor $30,000
Variable overhead $20,000
Fixed overhead $40,000
Total cost $100,000
The company incurs a 5% sales commission
($0.35) on each disc sold.
Exercise 7-2




An outside firm offers $4.75 per disc for 5,000
discs.
This company would sell the discs under its own
brand in foreign markets yet not served.
If the manufacturer accepts the offer, it’s fixed
overhead will increase from $40,000 to $45,000
due to the purchase of a new printing machine.
No sales commissions will result from the
special order.
Exercise 7-2

Prepare an incremental analysis for the special
order.
(a)
Reject
Order
Accept
Order
$23,750
(2,500)
(7,500)
Net Income
Effect
$23,750
(2,500)
(7,500)
-0-0-
(5,000)
(5,000)
-0-
(5,000)
(5,000)
-0-
$ -0-
$ 3,750
$ 3,750
Revenues
Materials ($0.50)
Labor ($1.50)
Variable overhead
($1.00)
Fixed overhead
Sales commissions
$ -0-0-0-0-
Net income
Note that fixed costs sometimes are relevant. However only the portion that
varies one alternative to the next ($5,000) is relevant. The other $47,000
is not relevant
Exercise 7-2



Should the company except the special order?
Why or why not?
As shown in the incremental analysis, Innova
should accept the special order because
incremental revenue exceeds incremental
expenses by $3,750.
Exercise 7-2


What assumptions underlie the decision made in
part b?
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.
Exercise 7-5



XYZ Company has been manufacturing his own
shades for table lamps.
The company is currently operating at 100%
capacity, and variable overhead is charged
production at the rate of 70% of direct labor
costs.
The direct materials and direct labor cost per
unit to make lampshades are five and six dollars
respectively.
Exercise 7-5



Normal production is 30,000 tables per year.
A supplier offers to make the lampshades at a
price of $15.50 per unit.
If XYZ accepts the suppliers offer, all variable
costs will be eliminated, but the $45,000 of fixed
manufacturing overhead currently charge to
lampshades will have to be absorbed by other
products.
Exercise 7-5

Prepare the incremental analysis for the
decision to make her by the lampshades.
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
$150,000
180,000
126,000
45,000
0
$501,000
Buy
$
0
0
0
45,000
465,000
$510,000
Net Income
Increase
(Decrease)
$ 150,000
180,000
126,000
0
( (465,000)
($ (9,000)
In this case the fixed cost is not relevant since
it is not change one alternative to the next.
Exercise 7-5

Prepare the incremental analysis for the
decision to make her by the lampshades.
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
$150,000
180,000
126,000
45,000
0
$501,000
Buy
$
0
0
0
45,000
465,000
$510,000
Net Income
Increase
(Decrease)
$ 150,000
180,000
126,000
0
( (465,000)
($ (9,000)
They should not purchase the lampshades
Since doing so will decrease net income by $9,000.
Exercise 7-5

Prepare the incremental analysis for the
decision to make her by the lampshades.
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
$150,000
180,000
126,000
45,000
0
$501,000
Buy
$
0
0
0
45,000
465,000
$510,000
Net Income
Increase
(Decrease)
$ 150,000
180,000
126,000
0
( (465,000)
($ (9,000)
Would your answer be different if the productive capacity released by not making
the lampshades could be used to produce income of $35,000?
Of course, by purchasing the lampshades they would then save $26,000.
Exercise 7-6


XYZ has recently started to manufacture a
product.
The cost structure to manufacture 20,000 units
is as follows.






Direct materials ($40 per unit) $80,000
Direct labor ($30) $600,000
Variable labor ($6) hundred and $20,000
Allocated fixed overhead ($25) $500,000
Total costs $2,020,000
XYZ is approached by ABC which offers to
make the product for $90 per unit or $1,800,000.
Exercise 7-6

Using incremental analysis, determine rather
XYZ should accept the offer under each of the
following independent assumptions.
Exercise 7-6

Assume that $300,000 of the fixed overhead
costs can be reduced or avoided.
Direct materials
Make
$ 800,000
-0-
Net Income
Increase
(Decrease)
$ 800,000
Buy
$
Direct labor
600,000
-0-
600,000
Variable overhead
120,000
-0-
120,000
Fixed overhead
500,000
200,000
300,000
Purchase price
0
1,800,000
(1,800,000)
$2,020,000
$2,000,000
Total annual cost
Accept the order!
$
20,000
Exercise 7-6


Assume that none of the fixed overhead can be avoided.
However, if the products are purchased from ABC, XYZ can use the
release productive resources to generate additional income of
$300,000.
(2)
Direct materials
Direct labor
Variable overhead
Fixed overhead
Opportunity cost
Purchase price
Totals
Make
$ 800,000
600,000
120,000
500,000
300,000
0
$2,320,000
Buy
$
0
0
0
500,000
0
1,800,000
$2,300,000
Net Income
Increase
(Decrease)
$ 800,000
600,000
120,000
0
300,000
(1,800,000)
$
20,000
Here the author shows the revenue as a negative (opportunity) cost which is
the same as a revenue.
Exercise 7-6


Describes the qualitative factors that might
affect the decision to purchase the product from
an outside supplier.
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 7-11



XYZ Enterprises uses a computer to handle its
sales invoices.
Lately, businesses has been so good that it
takes an extra three hours per night, plus every
third Saturday, to keep up with the volume of
sales invoices.
Management is considering updating its
computer with a faster model that would
eliminate all of the overtime processing.
Exercise 7-11
Current Machine
New Machine
$15,000
$25,000
$6,000
$0
$24,000
$18,000
Five years
Five years
Original purchase cost
Accumulated depreciation
Estimated annual operating costs
Useful life
If sold now, the current machine would have a salvage value of $5,000. If
operated for the remainder of its useful life, the current machine would
have a zero salvage value. The new machine is expected to have zero
salvage value after five years.
Should the current machine be replaced?
Exercise 7-11
Retain
Machine
Operating costs
New machine cost
Salvage value (old)
Total
$120,000
0
0
$120,000
Net Income
Increase
(Decrease)
Replace
Machine
(1)
($ 90,000)
( 25,000)
( (5,000)
($110,000)
(2)
( $ 30,000
( (25,000)
(
5,000)
($ 10,000)
(1) $24,000 X 5.
(2) $18,000 X 5.
There are a number of formats one could use in doing this analysis, here the
author chooses to make the far right column show the impact the change
would have on operating income. He arbitrarily decides to make a positive
impact a positive number and a negative impact a negative number.
Exercise 7-11
Retain
Machine
Operating costs
New machine cost
Salvage value (old)
Total
$120,000
0
0
$120,000
Net Income
Increase
(Decrease)
Replace
Machine
(1)
($ 90,000)
( 25,000)
( (5,000)
($110,000)
(2)
( $ 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 the
net income for the five-year period will be $10,000 higher by replacing the
current machine.
Problem 5


Lewis Manufacturing Company has four
operating divisions.
During the first quarter of 2008, the company
reported aggregate income from operations of
$176,000 and the following divisional results.
Problem 5
Divisions
One
Two
Sales
$250,000
$200,000
$500,000
$400,000
COGS
200,000
189,000
300,000
250,000
65,000
60,000
60,000
50,000
-$15,000
-$49,000
$140,000
$100,000
S&A
Expense
Income (loss)
Three
Four
Analysis reveals the following percentages of variable costs in each division.
Divisions
One
Two
Three
Four
COGS
70%
90%
80%
75%
S&A Exp.
40%
70%
50%
60%
Problem 5



Discontinuance of any division would save 50%
of the fixed costs and expenses for that division.
Top management is very concerned about the
unprofitable divisions (one and two).
Consensus is that one or both of the division
should be discontinued.
Problem 5

Compute the contribution margin for divisions
one and two.
Sales
Variable costs
Cost of goods sold
Selling and administrative
Total variable expenses
Contribution margin
Division I
Division II
$250,000
140,000
26,000
166,000
($ 84,000)
$200,000
170,100
42,000
212,100
$ (12,100)
Contribution margin is what is available to pay fixed costs. Eliminating
Division II gives us a negative contribution margin.
However, if we can decrease fixed cost below $12,100, the elimination
would still be a good idea.
Problem 5

Prepare an incremental analysis concerning the
possible discontinuance of Division I and
Division II.
(1)
Division I
Contribution margin (above)
Fixed costs
Cost of goods sold
Selling and administrative
Total fixed expenses
Income (loss) from operations
Continue
Eliminate
Net Income
Increase
(Decrease)
$(84,000)
(60,000)
(39,000)
(99,000)
$(15,000)
$(
0)
(30,000)
(19,500)
(49,500)
$(49,500)
$(84,000)
30,000
19,500
49,500
$(34,500)
Eliminating Division One would reduce income by $34,500 – not a good
idea!
Problem 5
Division II
Contribution margin (above)
Fixed costs
Cost of goods sold
Selling and administrative
Total fixed expenses
Income (loss) from operations
Continue
Eliminate
Net Income
Increase
(Decrease)
$(12,100)
(18,900
( 18,000
( 36,900
$(49,000)
$(
0)
( 9,450)
( 9,000)
(18,450)
$(18,450)
$12,100
( 9,450
( 9,000
18,450
$30,550
Division II should be eliminated as income from operations would
increase by $30,500 by so doing.
The End