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Chapter 11
Incremental Analysis
Prepared by
Diane Tanner
University of North Florida
Incremental Analysis Components
Incremental Revenue
The additional revenue as a
result of selecting one
decision over another
Incremental Cost
The additional cost as a
result of selecting one
alternative over another
Incremental Savings
The reduction of cost as a
result of selecting one
alternative over another
Usually combined/netted
with incremental costs
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Terminology
Avoidable Cost: can be
avoided if a certain decision
is made
Sunk Cost: a cost that has
already been incurred and
irreversible
Opportunity Cost:
Represents the benefit
forgone by selecting one
alternative over another
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Why Do We Use Relevant Costs?
 Allows us to focus on only the few
things that matter
 Much quicker decision making
 Mingling irrelevant costs with
relevant costs may cause confusion
and distract attention from critical
matters
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Steps in Incremental Analysis
Step 1: Compare revenues under both alternatives
 ‘Change’ in revenues = relevant revenues
Step 2: Compare costs under both alternatives
 ‘Change’ in costs = relevant costs
Step 3: List and clearly label each incremental line
item as an 1) incremental revenue, 2) incremental
cost, or 3) incremental cost savings
 Include a ‘+’ sign if the incremental amount
increases profit (i.e., a benefit)
 Show the amount in ( ) parentheses if the amount
causes profit to decline
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Qualitative Issues
 Should be considered regardless if the
outcome points to accepting or rejecting
the decision
 Includes:
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Morale
Control over design, quality, timeliness, & reliability
Environmental effects and safety
Prestige
Future price increases
Contractual issues
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Types of Incremental Decisions
 Special order
 Outsourcing / Make-or-buy
 Keep or Drop
 A customer, product, segment, or subdivision
 Capacity constraints
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One-Time-Only Special Orders
 When there is idle capacity and the special
order has no long-run implications
 Decision rule: Does the special order generate
additional operating income?
 Yes—accept
 No—reject
 Compares relevant revenues and relevant costs
to determine profitability
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One-Time-Only Special Orders
 When there is no idle capacity and the special
order has no long-run implications
 Decision rule: Does the special order cover the
contribution margin that could be generated
from current customers that will no longer be
able to buy from our company plus all
incremental costs?
 Yes—accept
 No—reject
 Compares relevant revenues, relevant costs,
and opportunity costs to determine profitability
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Long-term Special Orders
 When there is idle capacity and the special
order has no long-run implications
 Decision rule: Does the special order generate
additional operating income and cover an
allocated share of fixed costs?
 Yes—accept
 No—reject
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Keep or Drop Products or Segments
 Decision rule: Does dropping a customer add
operating income to the firm?
 Yes—add or don’t drop
 No—drop or don’t add
 Caution
 Allocated fixed costs are not usually eliminated and
must be absorbed by other products
Cost Allocation Death Spiral
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Capacity Constraints
 Often called product mix decisions
 Exists when demand exceeds production that is
limited by a particular resource
 Labor hours
 Machine hours
 Space
 Materials
 Goal is to maximize the contribution margin per
unit of the constrained resource
The End
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