ACT23
LESSON INCREMENTAL
12 ANALYSIS
Ralph Angelo A. Hipolito, CPA | Institute of Business and Accountancy | Dalubhasaang Politekniko ng Lungsod ng Baliwag
Making decisions is an
important management
function.
• Does not always follow
a set pattern.
• Decisions vary in
scope, urgency, and
importance.
• Steps usually involved
in process include:
2
In making business decisions,
• Considers both financial and non-
financial information.
• Financial information
• Revenues and costs, and
• Effect on overall profitability.
3
In making business decisions,
• Considers both financial and non-
financial information.
• Non-financial information
• Effect on employee turnover
• The environment
• Overall company image.
4
FR
Incremental
Analysis Approach
• Decisions involve a choice among
alternative actions.
• Process used to identify the financial
data that change under alternative
courses of action.
• Both costs and revenues may vary
or
• Only revenues may vary or
• Only costs may vary 5
FR
• Incremental revenue is $15,000 less under
Alternative B.
• Incremental cost savings of $20,000 is
realized.
• Alternative B produces $5,000 more net
income.
6
FR
Important concepts used in incremental
analysis:
• Relevant cost.
• Opportunity cost.
• Sunk cost.
7
DO
IT!
FR
• Sometimes involves changes that
seem contrary to intuition.
• Variable costs sometimes do not
change under alternatives.
• Fixed costs sometimes change
between alternatives.
• Incremental analysis is not the same
as CVP analysis.
9
FR
Types of Incremental Analysis
1. Accept an order at a special price.
2. Make or buy component parts or
finished products.
3. Sell or process them further
4. Repair, retain, or replace
equipment.
5. Eliminate an unprofitable business
segment or product.
10
FR
• Obtain additional business by making
a major price concession to a specific
customer.
• Assumes that sales of products in
other markets are not affected by
special order.
• Assumes that company is not
operating at full capacity.
11
Accept an Order at a Special Price
Illustration:
Sunbelt Company produces 100,000 Smoothie blenders per month,
which is 80% of plant capacity. Variable manufacturing costs are $8
per unit. Fixed manufacturing costs are $400,000, or $4 per unit.
The blenders are normally sold directly to retailers at $20 each.
Sunbelt has an offer from Kensington Co. (a foreign wholesaler) to
purchase an additional 2,000 blenders at $11 per unit. Acceptance
of the offer would not affect normal sales of the product, and the
additional units can be manufactured without increasing plant
capacity. What should management do?
FR
• Fixed costs do not change since within
existing capacity – thus fixed costs are not
relevant.
• Variable manufacturing costs and expected
revenues change – thus both are relevant to
the decision.
13
Make or Buy
Illustration:
Baron Co. incurs the following annual costs in producing 25,000 ignition switches for
motor scooters.
Instead of making its own switches, Baron Co. might purchase the ignition switches at
a price of $8/unit. However, a review of operations indicates that if the ignition switches
are purchased from Ignition, Inc., all of Baron’s variable costs but only $10,000 of its
fixed manufacturing costs will be eliminated. “What should management do?”
FR
Make or Buy
• Total manufacturing cost is $1 higher per
unit than purchase price.
• Must absorb at least $50,000 of fixed costs
under either option.
16
FR
Make or Buy –
Opportunity Cost
Illustration:
• Assume that through buying the
switches, Baron Company can use
the released productive capacity to
generate additional income of
$38,000 from producing a different
product. This lost income is an
additional cost of continuing to make
the switches in the make-or-buy
decision.
17
FR
Make or Buy –
Opportunity Cost
Illustration:
18
FR
Sell or
Process Further
• May have option to sell product at a
given point in production or to process
further and sell at a higher price.
• Decision Rule: Process further as
long as the incremental revenue from
such processing exceeds the
incremental processing costs.
22
Sell or Process Further
Illustration:
Woodmasters Inc. makes tables. The cost to manufacture an unfinished table is
$35. The selling price per unfinished unit is $50. Woodmasters has unused
capacity that can be used to finish the tables and sell them at $60 per unit. For
a finished table, direct materials will increase $2 and direct labor costs will
increase $4. Variable manufacturing overhead costs will increase by $2.40
(60% of direct labor). No increase is anticipated in fixed manufacturing
overhead.
Sell or Process Further
Illustration:
Woodmasters Inc. makes tables. The cost to manufacture an unfinished table is
$35. The selling price per unfinished unit is $50. Woodmasters has unused
capacity that can be used to finish the tables and sell them at $60 per unit. For
a finished table, direct materials will increase $2 and direct labor costs will
increase $4. Variable manufacturing overhead costs will increase by $2.40
(60% of direct labor). No increase is anticipated in fixed manufacturing
overhead.
FR
• Joint product situation for
Marais Creamery. Cream
and skim milk are
products that result from
the processing of raw
milk.
• Joint product costs are
sunk costs and thus not
relevant to the sell-or-
process further decision.
25
FR
• Cost and revenue data per day for cream.
• Determine whether the company should
simply sell the cream or process it further
into cottage cheese.
26
FR
• Analysis of whether to sell cream or process
into cottage cheese.
• Marais should or should not process the
cream further?
27
FR
• Cost and revenue data per day for skim milk.
• Determine whether the company should sell
the skim milk or process it further into
condensed milk.
28
FR
• Analysis of whether to sell skim milk or
process into condensed milk.
• Marais should or should not process the milk
further?
29
Repair, Retain, or Replace
Equipment
Illustration:
Jeffcoat Company is considering replacing a factory machine with a new
machine. Jeffcoat Company has a factory machine that originally cost
$110,000. It has a balance in Accumulated Depreciation of $70,000, so its
book value is $40,000. It has a remaining useful life of four years. The
company is considering replacing this machine with a new machine. A
new machine is available that costs $120,000. It is expected to have zero
salvage value at the end of its four-year useful life. If the new machine is
acquired, variable manufacturing costs are expected to decrease from
$160,000 to $125,000 and the old unit could be sold for $5,000. The
incremental analysis for the four-year period is as follows.
FR
• Prepare the incremental analysis for the
four-year period.
• Retain or Replace? 32
FR
Additional Considerations
• The book value of old machine does not affect
the decision.
• Book value is a sunk cost.
• Costs which cannot be changed by future
decisions (sunk cost) are not relevant in
incremental analysis.
• However, any trade-in allowance or cash
disposal value of the existing asset is relevant.
33
FR
• 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 contribution
margin lost.
35
Eliminate an Unprofitable Segment
Illustration:
Venus Company manufactures three models of tennis rackets: Profitable
lines – Pro and Master; Unprofitable line – Champ. Should Champ be
eliminated?
Prepare income data after eliminating Champ product line. Assume fixed
costs are allocated 2/3 to Pro and 1/3 to Master.
Eliminate an Unprofitable Segment
Illustration:
Incremental analysis of Champ provided the same results:
Do Not Eliminate Champ.
Eliminate an Unprofitable Segment
Illustration:
Assume the same facts as above, except now assume that $22,000
of the fixed costs attributed to the Champ line can be eliminated if
the line is discontinued.
Relationship of Incremental Analysis
and Activity-Based Costing
• Many companies have shifted to
activity-based costing (ABC).
• The primary reason for using ABC is
that it results in a more accurate
allocation of overhead.
• ABC will result in better identification
of relevant costs and, therefore, better
incremental analysis. 40
Thank You.
RAAH Ralph Angelo A. Hipolito, CPA
+63 929 687 5411
[email protected] www.btech.edu.ph
