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Managerial Accounting

Eighth Edition

Weygandt Kimmel Kieso

Chapter 7
Incremental Analysis

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Chapter Outline
Learning Objectives
LO 1 Describe management’s decision-making process and incremental
analysis.
LO 2 Analyze the relevant costs in accepting an order at a special price.
LO 3 Analyze the relevant costs in a make-or-buy decision.
LO 4 Analyze the relevant costs and revenues in determining whether to
sell or process materials further.
LO 5 Analyze the relevant costs to be considered in repairing, retaining,
or replacing equipment.
LO 6 Analyze the relevant costs in deciding whether to eliminate an
unprofitable segment or product.

Copyright ©2018 John Wiley & Sons, Inc. 2


Decision-Making

LEARNING OBJECTIVE 1
Describe management’s decision-making process and
incremental analysis.
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:
1. Identify the problem and assign responsibility
2. Determine and evaluate possible courses of action
3. Make a decision
4. Review results of the decision

LO 1 Copyright ©2018 John Wiley & Sons, Inc. 3


Decision-Making Process
In making business decisions,
• Considers financial and non-financial information
• Financial information
o Revenues and costs, and
o Effect on overall profitability
• Nonfinancial information
o Effect on employee turnover
o The environment
o Overall company image

LO 1 Copyright ©2018 John Wiley & Sons, Inc. 4


Incremental Analysis Approach
• Decisions involve a choice among alternative actions
• Process used to identify the financial data that change
under alternative courses of action
o Both costs and revenues may vary or
o Only revenues may vary or
o Only costs may vary

LO 1 Copyright ©2018 John Wiley & Sons, Inc. 5


How Incremental Analysis Works (1 of 3)
Net Income Increase
Alternative A Alternative B
(Decrease)
Revenues $125,000 $110,000 $(15,000)
Costs 100,000 80,000 20,000
Net income $25,000 $30,000 $5,000

• 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

LO 1 Copyright ©2018 John Wiley & Sons, Inc. 6


How Incremental Analysis Works (2 of 3)
Important concepts used in incremental analysis:
• Relevant cost
• Opportunity cost
• Sunk cost

LO 1 Copyright ©2018 John Wiley & Sons, Inc. 7


How Incremental Analysis Works (3 of 3)
• Sometimes involves changes that seem contrary to
intuition
• Variable costs sometimes do not change under
alternatives
• Fixed costs sometimes change between alternatives

LO 1 Copyright ©2018 John Wiley & Sons, Inc. 8


Types of Incremental Analysis
Common types of decisions involving incremental
analysis:
1. Accept an order at a special price
2. Make or buy component parts or finished products
3. Sell or process further them further
4. Repair, retain, or replace equipment
5. Eliminate an unprofitable business segment or product

LO 1 Copyright ©2018 John Wiley & Sons, Inc. 9


Do It! 1: Incremental Analysis (1 of 2)
Using the contribution margin technique, compute the break-even
point in Owen T Corporation is comparing two different options.
The company currently operates under Option 1, with revenues of
$80,000 per year, maintenance expenses of $5,000 per year, and
operating expenses of $38,000 per year. Option 2 provides revenues
of $80,000 per year, maintenance expenses of $12,000 per year, and
operating expenses of $32,000 per year. Option 1 employs a piece
of equipment that was upgraded 2 years ago at a cost of $22,000. If
Option 2 is chosen, it will free up resources that will increase
revenues by $3,000.
Complete the following table to show the change in income from
choosing Option 2 versus Option 1. Designate any sunk costs with
an “S.”
LO 1 Copyright ©2018 John Wiley & Sons, Inc. 10
Do It! 1: Incremental Analysis (2 of 2)
Complete the following table to show the change in income from
choosing Option 2 versus Option 1. Designate any sunk costs with
an “S.”
Net Income
Option 1 Option 2 Increase Sunk (S)
(Decrease)
Revenues $80,000 $80,000 $ 0
Maintenance expenses 5,000 12,000 (7,000)
Operating expenses 38,000 32,000 6,000
Equipment upgrade 22,000 0 0 S
Opportunity cost 3,000 0 3,000
$2,000
$ 2,000 double underline

LO 1 Copyright ©2018 John Wiley & Sons, Inc. 11


Special Orders

LEARNING OBJECTIVE 2
Analyze the relevant costs in accepting an order at a
special price.
• To 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

LO 2 Copyright ©2018 John Wiley & Sons, Inc. 12


Special Orders (1 of 2)
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 Smoothie 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?

LO 2 Copyright ©2018 John Wiley & Sons, Inc. 13


Special Orders (2 of 2)
Net Income
Reject Order Accept Order Increase
(Decrease)
Revenues $0 $22,000 $22,000
Costs 0 16,000 (16,000)
Net income $0 $6,000 $6,000

• 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

LO 2 Copyright ©2018 John Wiley & Sons, Inc. 14


Do It! 2: Special Orders
Cobb Company incurs costs of $28 per unit ($18 variable and $10
fixed) to make a product that normally sells for $42. A foreign
wholesaler offers to buy 5,000 units at $25 each. The special order
results in additional shipping costs of $1 per unit. Compute the
increase or decrease in net income Cobb realizes by accepting the
special order, assuming Cobb has excess operating capacity.
Should Cobb Company accept the special order?
Net Income
Reject Order Accept Order Increase
(Decrease)
Revenues $0 $125,000 $125,000
Costs 0 95,000 (95,000)
Net income $0 $30,000 $30,000

LO 2 Copyright ©2018 John Wiley & Sons, Inc. 15


Make or Buy

LEARNING OBJECTIVE 3
Analyze the relevant costs in a make-or-buy decision.

Illustration: Baron Company incurs the following annual costs in


producing 25,000 ignition switches for motor scooters.

Direct materials $50,000


Direct labor 75,000
Variable manufacturing overhead 40,000
Fixed manufacturing overhead 60,000
$225,000 double
Total manufacturing costs $225,000
underline

Total cost per unit ($225,000 ÷ 25,000) $9.00 double


$9.00
underline

Instead of making switches, Baron might purchase ignition switches


at a price of $8 per unit. What should Baron do?
LO 3 Copyright ©2018 John Wiley & Sons, Inc. 16
Make or Buy
Net Income
Make Buy Increase
(Decrease)
Direct materials $50,000 $0 $50,000
Direct labor 75,000 0 75,000
Variable manufacturing costs 40,000 0 40,000
Fixed manufacturing costs 60,000 50,000 10,000
Purchase price (25,000 × $8) 0 200,000 (200,000)
$225,000 double $250,000 double $(25,000) double
Total annual cost $225,000
underline
$250,000
underline $(25,000)
underline

• Manufacturing cost is $1 higher per unit than purchase price


• Must absorb at least $50,000 of fixed costs under either
option
LO 3 Copyright ©2018 John Wiley & Sons, Inc. 17
Opportunity Cost (1 of 2)
The lost potential benefit that could have been obtained
from following an alternative course of action.
In the make-or-buy decision, it is important for
management to take into account the social impact of its
choice.

LO 3 Copyright ©2018 John Wiley & Sons, Inc. 18


Opportunity Cost (2 of 2)
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.

Net income
Make Buy Increase
(Decrease)
Total annual cost $225,000 $250,000 $(25,000)
Opportunity cost 38,000 0 38,000
$263,000 double $250,000 double underline $13,000 double underline
Total cost $263, 000
underline $250, 000 $13, 000

LO 3 Copyright ©2018 John Wiley & Sons, Inc. 19


Do It! 3: Make or Buy (1 of 3)
Juanita Company must decide whether to make or buy some of its
components for the appliances it produces. The costs of producing
166,000 electrical cords for its appliances are as follows.

Direct materials $90,000 Variable overhead $32,000


Direct labor 20,000 Fixed overhead 24,000

Instead of making the electrical cords at an average cost per unit of


$1.00 ($166,000 ÷ 166,000), the company has an opportunity to buy
the cords at $0.90 per unit. If the company purchases the cords, all
variable costs and one-fourth of the fixed costs will be eliminated.

LO 3 Copyright ©2018 John Wiley & Sons, Inc. 20


Do It! 3: Make or Buy (2 of 3)
a. Prepare an incremental analysis showing whether the
company should make or buy the electrical cords.
Net Income
Make Buy
Increase (Decrease)
Direct materials $ 90,000 $ –0– $90,000
Direct labor 20,000 –0– 20,000
Variable manufacturing costs 32,000 –0– 32,000
Fixed manufacturing costs 24,000 18,0001 6,000
Purchase price –0– 149,4002 (149,400)
Total cost $166,000 $167,400 $ (1,400)
1$24,000 × .75 = $18,000 remain, $6,000 avoided
2166,000 × $0.90 = $149,400 purchase price

LO 3 Copyright ©2018 John Wiley & Sons, Inc. 21


Do It! 3: Make or Buy (3 of 3)
b. Will your answer be different if the released productive
capacity will generate additional income of $5,000?
Net Income
Make Buy
Increase (Decrease)
Total cost $166,000 $167,400 $(1,400)
Opportunity cost 5,000 0 5,000
Opportunity cost $171,000 $167,400 $3,600

Yes, net income will be increased by $3,600 if Juanita


Company purchases the electrical cords rather than making
them.

LO 3 Copyright ©2018 John Wiley & Sons, Inc. 22


Sell or Process Further

LEARNING OBJECTIVE 4
Analyze the relevant costs and revenues in determining whether to
sell or process materials 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

LO 4 Copyright ©2018 John Wiley & Sons, Inc. 23


Single-Product Case (1 of 2)
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.

Direct materials $15


Direct labor 10
Variable manufacturing overhead 6
Fixed manufacturing overhead 4
Manufacturing cost per unit $35

LO 4 Copyright ©2018 John Wiley & Sons, Inc. 24


Single-Product Case (2 of 2)
Sell Process Net Income
Unfinished Further Increase
(Decrease)
Sales price per unit $50.00 $60.00 $10.00
Cost per unit
Direct materials 15.00 17.00 (2.00)
Direct labor 10.00 14.00 (4.00)
Variable manufacturing overhead 6.00 8.40 (2.40)
Fixed manufacturing overhead 4.00 4.00 0.00
Total 35.00 43.40 (8.40)
Net income per unit $15.00 double
$15.00
underline
$16.60 double
$16.60
underline
$1.60
$1.60 double underline

Should Woodmasters sell or process further?


begin underline End underline

LO 4 Copyright ©2018 John Wiley & Sons, Inc. 25


Multiple-Product Case (1 of 5)
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.

LO 4 Copyright ©2018 John Wiley & Sons, Inc. 26


Multiple-Product Case (2 of 5)
Cost and revenue date per day for cream.
Costs (per day)
Joint cost allocated to cream $9,000
Cost to process cream into cottage cheese 10,000
Revenues from Products (per day)
Cream $19,000
Cottage cheese 27,000

Determine whether the company should simply sell the


cream or process it further into cottage cheese.
LO 4 Copyright ©2018 John Wiley & Sons, Inc. 27
Multiple-Product Case (3 of 5)
Net Income
Process
Sell Increase
Further
(Decrease)
Sales per day $19,000 $27,000 $8,000
Cost per day to process
cream into cottage cheese 0 10,000 (10,000)
$19,000 double $17,000 double
Net income per day $19,000
underline $17, 000
underline
$(2,000)
$(2,000) double underline

Marais should or should not process the cream further?


begin underline end underline

LO 4 Copyright ©2018 John Wiley & Sons, Inc. 28


Multiple-Product Case (4 of 5)
Cost and revenue date per day for cream.
Costs (per day)
Joint cost allocated to skim milk $5,000
Cost to process skim into condensed milk 8,000
Revenues from Products (per day)
Skim milk $11,000
Condensed milk 26,000

Determine whether the company should sell the skim milk


or process further into condensed milk.
LO 4 Copyright ©2018 John Wiley & Sons, Inc. 29
Multiple-Product Case (5 of 5)
Net Income
Process
Sell Increase
Further
(Decrease)
Sales per day $11,000 $26,000 $15,000
Cost per day to process skim
milk into condensed milk 0 8,000 (8,000)
$11,000 double $18,000 double
Net income per day $11,000
underline $18, 000
underline $7,000
$7,000 double underline

Marais should or should not process the cream further?


begin underline end underline

LO 4 Copyright ©2018 John Wiley & Sons, Inc. 30


Sell or Process Further (1 of 2)
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 4 Copyright ©2018 John Wiley & Sons, Inc. 31


Sell or Process Further (2 of 2)
Process further as long as the incremental revenue from
processing exceeds:
a. Answer: Incremental processing costs
b. Variable processing costs
c. Fixed processing costs
d. No correct answer is given

LO 4 Copyright ©2018 John Wiley & Sons, Inc. 32


Do It! 4: Sell or Process Further (1 of 2)
Easy Does It manufactures unpainted furniture for the
do-it-yourself (DIY) market. It currently sells a child’s
rocking chair for $25. Production costs per unit are $12
variable and $8 fixed. Easy Does It is considering
painting the rocking chair and selling it for $35.
Variable costs to paint each chair are expected to be $9,
and fixed costs are expected to be $2. Prepare an
analysis showing whether Easy Does It should sell
unpainted or painted chairs.

LO 4 Copyright ©2018 John Wiley & Sons, Inc. 33


Do It! 4: Sell or Process Further (2 of 2)
Prepare an analysis showing whether Easy Does It should
sell unpainted or painted chairs.
Process Net Income Increase
Sell
Further (Decrease)
Revenues $25 $35 $10
Variable costs 12 21a (9)
Fixed costs 8 10b (2)
$5 double
Net income $5
underline $4
$4 double underline $ (1)
$(1) double underline

a$12 + $9 = $21
b$8 + $2 = $10

LO 4 Copyright ©2018 John Wiley & Sons, Inc. 34


Repair, Retain, or Replace Equipment

LEARNING OBJECTIVE 5
Analyze the relevant costs to be considered in repairing, retaining, or
replacing equipment.
Illustration: Jeffcoat Company has a factory machine that
originally cost $110,000. It has a balance in Accumulated
Depreciation of $70,000, so the machine’s 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 annually, and the old unit
could be sold for $5,000. Prepare the incremental analysis for the
four-year period.

LO 5 Copyright ©2018 John Wiley & Sons, Inc. 35


Repair, Retain, or Replace Equipment (1 of 2)

Prepare the incremental analysis for the four-year period.


Net Income
Retain Replace
Increase
Equipment Equipment
(Decrease)
Variable manufacturing costs $640,000a $500,000b $140,000
New machine cost 120,000 (120,000)
Sale of old machine (5,000) 5,000
Total $640,000 double
underline
$640,000 $615,000
$615,000 double
underline
$25, 000
$25,000 double underline

a $160,000 × 4 years = $640,000


b $125,000
Retain or Replace begin underline

× 4 years = $500,000
end underline

LO 5 Copyright ©2018 John Wiley & Sons, Inc. 36


Repair, Retain, or Replace Equipment (2 of 2)
Additional Considerations
• Book value of old machine does not affect the decision
o Book value is a sunk cost
o Costs which cannot be changed by future decisions (sunk
cost) are not relevant in incremental analysis
• Any trade-in allowance or cash disposal value of the
existing asset is relevant

LO 5 Copyright ©2018 John Wiley & Sons, Inc. 37


Do It! 5: Repair or Replace (1 of 2)
Rochester Roofing is faced with a decision. The company relies on
the use of its 60-foot extension lift for work on large homes and
commercial properties. Last year, the company spent $60,000
refurbishing the lift. Another $40,000 of repair work is required.
Alternatively, Rochester Roofing has found a newer used lift that is
for sale for $170,000. The company estimates that both the old and
new lifts would have useful lives of 6 years. However, the new lift
is more efficient and thus would reduce operating expenses by about
$20,000 per year. The company could also rent out the new lift for
about $2,000 per year. The old lift is not suitable for rental. The old
lift could currently be sold for $25,000 if the new lift is purchased.
Prepare an incremental analysis that shows whether the company
should repair or replace the equipment.

LO 5 Copyright ©2018 John Wiley & Sons, Inc. 38


Do It! 5: Repair or Replace (2 of 2)
Prepare an incremental analysis that shows whether the company
should repair or replace the equipment.
a $20,000 × 6 years = $120,000
b$2,000 × 6 years = $12,000
Net Income
Retain Replace
Increase
Equipment Equipment
(Decrease)
Operating expenses $120,000a $120,000
Repair costs 40,000 40,000
Rental revenue $(12,000)b 12,000
New machine cost 170,000 (170,000)
Sale of old machine (25,000) 25,000
$160,000 double $133,000 double underline $27,000 double underline
Total cost $160,000
underline
$133,000 $27,000

LO 5 Copyright ©2018 John Wiley & Sons, Inc. 39


Eliminate Unprofitable Segment or Product

LEARNING OBJECTIVE 6
Analyze the relevant costs in deciding whether to eliminate an
unprofitable segment or product.
• 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

LO 6 Copyright ©2018 John Wiley & Sons, Inc. 40


Eliminate Unprofitable Segment
Illustration: Venus Company manufactures three models of tennis
rackets:
• Profitable lines: Pro and Master Should Champ be
eliminated?
• Unprofitable line: Champ

Pro Master Champ Total


Sales $800,000 $300,000 $100,000 $1,200,000
Variable costs 520,000 210,000 90,000 820,000
Contribution margin 280,000 90,000 10,000 380,000
Fixed costs 80,000 50,000 30,000 160,000
$200,000 double $40,000 double $(20,000) double $ 220,000 double
Net income $200,000
underline
$40,000
underline
$(20, 000)
underline $220,000
underline

LO 6 Copyright ©2018 John Wiley & Sons, Inc. 41


Eliminate Unprofitable Segment (2 of 4)
Prepare income data after eliminating Champ product line. Assume
2 1
fixed costs are allocated to Pro and to Master.
3 3
Pro Master Champ Total
Sales $800,000 $300,000 $1,100,000
Variable costs 520,000 210,000 730,000
Contribution margin 280,000 90,000 370,000
Fixed costs 100,000a 60,000b 160,000
$180,000 double $30,000 double $210,000 double
Net income $180,000
underline $30,000
underline $210, 000
underline

2 
a
$80, 000    $30, 000   $1000, 000
3 
b 1 
$50, 000    $30, 000   $60, 000
Total income is decreased by $10,000.
3 
LO 6 Copyright ©2018 John Wiley & Sons, Inc. 42
Eliminate Unprofitable Segment (3 of 4)
Incremental analysis of Champ provided the same results:

Do Not Eliminate Champ


Net Income
Continue Eliminate Increase
(Decrease)
Sales $100,000 $ 0 $(100,000)
Variable costs 90,000 0 90,000
Contribution margin 10,000 0 (10,000)
Fixed costs 30,000 30,000 0
Net income $(20,000) double
$(20,000)
underline
$(30,000) double
$(30,000)
underline
$(10,
$ (10,000) 000)
double underline

LO 6 Copyright ©2018 John Wiley & Sons, Inc. 43


Eliminate Unprofitable Segment (4 of 4)
Assume that $22,000 of the fixed costs attributed to the Champ line
can be eliminated if the line is discontinued.
Eliminate Champ
Net Income
Continue Eliminate Increase
(Decrease)
Sales $100,000 $ 0 $(100,000)
Variable costs 90,000 0 90,000
Contribution margin 10,000 0 (10,000)
Fixed costs 30,000 8,000 22,000
$(20,000) double $(8,000) double
Net income $(20,000)
underline
$(8,000)
underline $12,000
$(12,000) double underline

LO 6 Copyright ©2018 John Wiley & Sons, Inc.


$(12, 000) x 44
Incremental Analysis (3 of 4)
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 6 Copyright ©2018 John Wiley & Sons, Inc. 45


Incremental Analysis (4 of 4)
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. Answer: Fixed expenses allocated to the eliminated
segment will have to be absorbed by other segments.
d. Net income will always decrease.

LO 6 Copyright ©2018 John Wiley & Sons, Inc. 46


Do It! 6: Unprofitable Segments (1 of 2)
Lambert, Inc. manufactures several types of accessories.
For the year, the knit hats and scarves line had sales of
$400,000, variable expenses of $310,000, and fixed
expenses of $120,000. Therefore, the knit hats and scarves
line had a net loss of $30,000. If Lambert eliminates the
knit hats and scarves line, $20,000 of fixed costs will
remain.
Prepare an analysis showing whether the company should
eliminate the knit hats and scarves line.

LO 6 Copyright ©2018 John Wiley & Sons, Inc. 47


Do It! 6: Unprofitable Segments (2 of 2)
Prepare an analysis showing whether the company should eliminate
the knit hats and scarves line.
Should Eliminate
Net Income
Continue Eliminate Increase
(Decrease)
Sales $400,000 $ 0 $(400,000)
Variable costs 310,000 0 310,000
Contribution margin 90,000 0 (90,000)
Fixed costs 120,000 20,000 100,000
Net income $(30,000) double
$underline
(30,000) $(20,000) double
$ underline
(20,000) $ 10,
$10,000 double000
underline

LO 6 Copyright ©2018 John Wiley & Sons, Inc. 48


Copyright
Copyright © 2018 John Wiley & Sons, Inc.
All rights reserved. Reproduction or translation of this work beyond that permitted in
Section 117 of the 1976 United States Act without the express written permission of the
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from the use of the information contained herein.

Copyright ©2018 John Wiley & Sons, Inc. 49