© the mcgraw-hill companies, inc., 2005 mcgraw-hill/irwin 21-1 incremental analysis chapter 21

© The McGraw-Hill Companies, Inc., 2005McGraw-Hill/Irwin

21-1

INCREMENTAL ANALYSIS

Chapter

21


21-2

Specialorder

decisions

Productmix

decisions

Makeor buy

decisions

Jointproduct

decisions

Product markets can change quickly due to competitor pricecuts, changing customer preferences, and introduction ofnew products by competitors.

Managers must make short-run decisions, with a fixed setof resources, to react to the changing market place.

The Challenge ofChanging MarketsThe Challenge ofChanging Markets


21-3

Will you drive or fly to Florida for spring break?

You have gathered the following information to help you with the decision. Motel cost is $80 per night. Meal cost is $20 per day. Your car insurance is $100 per month. Kennel cost for your dog is $5 per day. Round-trip cost of gasoline for your car is $200. Round-trip airfare and rental car for a week is $500.

Driving requires two days, with an overnight stay, cutting your time in Florida by two days.

Will you drive or fly to Florida for spring break?

You have gathered the following information to help you with the decision. Motel cost is $80 per night. Meal cost is $20 per day. Your car insurance is $100 per month. Kennel cost for your dog is $5 per day. Round-trip cost of gasoline for your car is $200. Round-trip airfare and rental car for a week is $500.

Driving requires two days, with an overnight stay, cutting your time in Florida by two days.

The Concept ofRelevant Cost Information



21-4

Florida Spring BreakDrive/Fly Analysis

Cost Drive FlyMotel 640$ 640$Eating out costs 160 160 Kennel cost 40 40 Car insurance 100 100 Gasoline 200 - Airfare/rental car - 500

8 days @ $80

8 days @ $20

8 days @ $5




21-5



Costs do not differ,so they are not

relevant to decision.

Also, car insuranceis not relevant tothe decision as it

is a past cost.




21-6

Transportationcosts differ betweenthe two alternatives,so they are relevant

to your decision

Are the extra twodays in Floridaworth the $300

extra cost to fly?

Are the extra twodays in Floridaworth the $300

extra cost to fly?






21-7

Decision making involves five steps:

Define the problem. Identify the alternatives. Collect information on alternatives. Eliminate irrelevant information. Make a decision with the

remaining relevant information.

Decision MakingDecision Making


21-8

Information that varies among the possible courses of action being considered.

— Incremental costs and revenues —

Important cost concepts forbusiness decisions.

Opportunity costs. Sunk costs. Out-of-pocket costs.

1

2

Relevant Informationin Business DecisionsRelevant Informationin Business Decisions


21-9

The benefit that could have been attained by pursuing an alternative course of action.

Opportunity CostOpportunity Cost

Example: If you were not attending college, you could be earning $20,000 per year. Your opportunity cost of attending college for one year includes the $20,000.

Opportunity costs are not recorded in the accounting records, but are relevant to decisions because they are

a real sacrifice.


21-10

All costs incurred in the past that cannot be changed by any decision made now or in the future.

Sunk costs should not be considered in decisions.

Example: You bought an automobile that cost $10,000 two years ago. The $10,000 cost is sunk because whether you drive it, park it, trade it, or sell it, you cannot change the $10,000 cost.

All costs incurred in the past that cannot be changed by any decision made now or in the future.

Sunk costs should not be considered in decisions.

Example: You bought an automobile that cost $10,000 two years ago. The $10,000 cost is sunk because whether you drive it, park it, trade it, or sell it, you cannot change the $10,000 cost.

Sunk Costs VersusOut-of-Pocket CostsSunk Costs Versus

Out-of-Pocket Costs


21-11

Cost = $10,000two years ago

Cost = $25,000today

The dealer will trade for $20,000 plus your car.What amount is relevant to your decision, the $10,000 sunk cost of your car or the$20,000 out-of-pocket cash differential?

The dealer will trade for $20,000 plus your car.What amount is relevant to your decision, the $10,000 sunk cost of your car or the$20,000 out-of-pocket cash differential?

Trade ?

Sunk Costs VersusOut-of-Pocket CostsSunk Costs Versus

Out-of-Pocket Costs


21-12

The decision to accept additional business should be based on incremental

costs and incremental revenues.

Incremental amounts are those that occur only if the company decides to accept

the new business.

Special Order DecisionsSpecial Order Decisions


21-13

View Co. currently sells 100,000 units of its product. The company has revenue and costs

as shown below: Per Unit Total

Sales 10.00$ 1,000,000$ Direct materials 3.50 350,000 Direct labor 2.20 220,000 Factory overhead 1.10 110,000 Selling expenses 1.40 140,000 Administrative expenses 0.80 80,000 Total expenses 9.00$ 900,000$ Operating income 1.00$ 100,000$



21-14

View Co. is approached by an overseascompany that offers to purchase

10,000 units at $8.50 per unit.

If View Co. accepts the offer, total factory overhead will increase by $5,000; total selling expenses will

increase by $2,000; and total administrative expenses will increaseby $1,000.

Should View Co.accept the offer?



21-15

First let’s look at incorrect reasoningthat leads to an incorrect decision.

First let’s look at incorrect reasoningthat leads to an incorrect decision.

Our cost is $9.00per unit. I can’t sell for $8.50 per unit.



21-16

Current Business

Additional Business Combined

Sales 1,000,000$ 85,000$ 1,085,000$ Direct materials 350,000$ 35,000$ 385,000$ Direct labor 220,000 22,000 242,000 Factory overhead 110,000 5,000 115,000 Selling expenses 140,000 2,000 142,000 Admin. expenses 80,000 1,000 81,000 Total expenses 900,000$ 65,000$ 965,000$ Operating income 100,000$ 20,000$ 120,000$

This analysis leads to the correct decision.This analysis leads to the correct decision.



21-17

Current Business



10,000 new units × $8.50 selling price = $85,000



21-18

Current Business



10,000 new units × $3.50 = $35,000



21-19

Current Business



10,000 new units × $2.20 = $22,000



21-20

Current Business



Even though the $8.50 selling price is less than thenormal $10 selling price, View Co. should accept theoffer because net income will increase by $20,000.



21-21

We can also look at this decisionusing contribution margin.

Per Unit Total Special order revenue 8.50$ 85,000$ Direct materials 3.50 35,000 Direct labor 2.20 22,000 Contribution margin 2.80$ 28,000$

Increase in fixed costs: Factory overhead 5,000$ Selling expenses 2,000 Administrative expenses 1,000 Special order profit 20,000$



21-22

Managers often face the problem of deciding how scarce resources are going to be utilized.

Usually, fixed costs are not affected by this particular decision, so management can focus

on maximizing total contribution margin.

Let’s look at the Kaiser Company example.

Production Constraint DecisionsProduction Constraint Decisions


21-23

Kaiser Company produces two products and selected data is shown below:

Products1 2

Selling price per unit $ 60 $ 50 Less: variable expenses per unit 36 35 Contribution margin per unit 24$ 15$

Current demand per week (units) 2,000 2,200 Contribution margin ratio 40% 30%Processing time required on machine A1 per unit 1.00 min. 0.50 min.



21-24

Machine A1 is the scarce resource because there is excess capacity on other machines. Machine

A1 is being used at 100% of its capacity.

Machine A1 capacity is 2,400 minutes per week.

Should Kaiser focus its efforts on Product 1 or 2?



21-25

Let’s calculate the contribution margin per unit of the scarce resource, machine A1.

Products1 2

Contribution margin per unit $ 24 $ 15 Time required to produce one unit ÷ 1.00 min. ÷ ? min.Contribution margin per minute 24$ ?



21-26

Product 2 should be emphasized. It is the more valuable use of the scarce resource, machine A1, yielding a contribution margin of $30 per minute as

opposed to $24 for Product 1.

Product 2 should be emphasized. It is the more valuable use of the scarce resource, machine A1, yielding a contribution margin of $30 per minute as

opposed to $24 for Product 1.

Products1 2

Contribution margin per unit $ 24 $ 15 Time required to produce one unit ÷ 1.00 min. ÷ 0.50 min.Contribution margin per minute 24$ 30$




21-27

If there are no other considerations, the best plan would be to produce to meet current demand for Product 2 and then use any capacity that remains to make Product 1.

If there are no other considerations, the best plan would be to produce to meet current demand for Product 2 and then use any capacity that remains to make Product 1.

Products1 2

Contribution margin per unit $ 24 $ 15 Time required to produce one unit ÷ 1.00 min. ÷ 0.50 min.Contribution margin per minute 24$ 30$




21-28

Allotting Our Scarce Resource (Machine A1)

Weekly demand for Product 2 2,200 unitsTime required per unit × 0.50 min.Total time required to make Product 2 1,100 min.

Let’s see how this plan would work.



21-29



Total time available 2,400 min.Time used to make Product 2 1,100 min.

1,300




21-30



Total time available 2,400 min.Time used to make Product 2 1,100 min.Time available for Product 1 1,300 min.Time required per unit ÷ 1.00 min.Production of Product 1 1,300 units




21-31

According to the plan, we will produce 2,200 units of Product 2 and 1,300 of Product 1. Our contribution

margin looks like this.

Product 1 Product 2Production and sales (units) 1,300 2,200 Contribution margin per unit 24$ 15.00$ Total contribution margin 31,200$ 33,000$

The total contribution margin for Kaiser is $64,200.The total contribution margin for Kaiser is $64,200.



21-32

Should Icontinue to make

the part, or shouldI buy it?

I suppose Ishould compare

the outside purchaseprice with the additional

costs to manufacturethe part.

What will I do with my

idle facilities ifI buy the part?

Make or Buy DecisionsMake or Buy Decisions


21-33

Incremental costs also are important in the decision to make a product or buy it from a supplier.

The cost to produce an item must include(1) direct materials, (2) direct labor and (3) incremental overhead.

We should not use the predetermined overhead rate to determine product cost.

Incremental costs also are important in the decision to make a product or buy it from a supplier.

The cost to produce an item must include(1) direct materials, (2) direct labor and (3) incremental overhead.

We should not use the predetermined overhead rate to determine product cost.



21-34

Excel makes computer chips used inone of its products. Unit costs, based on production of 20,000 chips per year, are:

Excel makes computer chips used inone of its products. Unit costs, based on production of 20,000 chips per year, are:

Unit Costs

Direct Material 9.00$

Direct Labor 5.00

Variable Overhead 1.00

Fixed Overhead 13.00

Total 28.00$



21-35

An outside supplier has offered to provide the 20,000 chips at a cost of $25 per chip. Fixed overhead costs will not be avoided if the chips are purchased.

Excel has no alternative use for the facilities.

Should Excel accept the offer?



21-36


Differential costs of making (costs avoided if bought from outside supplier)

Unit Cost

Direct Material 9.00$

Direct Labor 5.00

Variable Overhead 1.00

Total 15.00$

Excel should not pay $25 per unit to an outside supplier to avoid the $15 per unit differential cost of making the

part. Fixed costs are irrelevant to decision.

Excel should not pay $25 per unit to an outside supplier to avoid the $15 per unit differential cost of making the

part. Fixed costs are irrelevant to decision.


21-37

If Excel buys the chips from the outside supplier, the idle facilities could be leased to

another company for $250,000 per year.

Should Excel buy the chips andlease the facilities?



21-38


The real question to answer is, “What is the best use of Excel’s facilities?”

The real question to answer is, “What is the best use of Excel’s facilities?”

Disadvantage of buying 20,000 units × ($25 - $15) 200,000$

Opportunity cost of facilities: The lease revenue 250,000

Advantage of buying partand leasing facilities 50,000$

The opportunity cost of facilities changes the decision. The opportunity cost of facilities changes the decision.


21-39

Costs incurred in manufacturing units of product that do not meet quality standards are sunk costs and cannot be recovered.

Sell, Scrap, or Rebuild DecisionsSell, Scrap, or Rebuild Decisions

As long as rebuild costs are recovered through sale of the product, and rebuilding does not interfere with normal production,

we should rebuild.


21-40

Servo has 10,000 defective units that cost $1.00 each to make. The units can be scrapped now for $.40 each or rebuilt at an additional cost of

$.80 per unit.If rebuilt, the units can be sold for the normal

selling price of $1.50 each. Rebuilding the 10,000 defective units will prevent the

production of 10,000 new units that would also sell for $1.50.

Should Servo scrap or rebuild?



21-41

Scrap Now Rebuild

Sale of defects 4,000$ 15,000$ Less rebuild costs - Less opportunity cost - Net return 4,000$

10,000 units × $1.50 per unit10,000 units × $1.50 per unit




21-42

Scrap Now Rebuild

Sale of defects 4,000$ 15,000$ Less rebuild costs - (8,000) Less opportunity cost - (5,000) Net return 4,000$ 2,000


10,000 units × ($1.50 - $1.00) per unit10,000 units × ($1.50 - $1.00) per unit



21-43

Scrap Now Rebuild

Sale of defects 4,000$ 15,000$ Less rebuild costs - (8,000) Less opportunity cost - (5,000) Net return 4,000$ 2,000

Servo should scrap the units now.Servo should scrap the units now.

If Servo fails to include the opportunity cost,the rework option would show a return of $7,000,

mistakenly making rebuild appear more favorable.

If Servo fails to include the opportunity cost,the rework option would show a return of $7,000,

mistakenly making rebuild appear more favorable.



21-44

Product 2Joint Costs

Product 1

Product 3

Two or more products produced from acommon input are called joint products.Two or more products produced from acommon input are called joint products.

The split-off point is the point in a process where joint products can be recognized as separate products.

The split-off point is the point in a process where joint products can be recognized as separate products.

Joint costs arethe costs of

processing prior to the split-off point.

Joint costs arethe costs of

processing prior to the split-off point.

Joint Product DecisionsJoint Product Decisions


21-45

Businesses are often faced with the decision to sell partially completed products at the split-off

point or to process them to completion.


General rule: Process further only if

incremental revenues > incremental costs.


21-46

Ames Co. produces two products, A and B, from this process.

Should the products besold at split-off or

processed further?

CommonProduction

Process

FinalSale

$120,000

Split-OffPoint

JointCost

$100,000

Revenue$70,000

AdditionalProcessing

$40,000

A

B

AdditionalProcessing

$20,000

FinalSale

$65,000

Revenue$50,000



21-47

Decision: Process product A, but sell product B at the split-off point. Note that the $100,000 joint cost is

irrelevant to the processing decision.

Decision: Process product A, but sell product B at the split-off point. Note that the $100,000 joint cost is

irrelevant to the processing decision.

Incremental IncrementalProduct Revenue Cost Difference

A 50,000$ 40,000$ 10,000$

B 15,000 20,000 (5,000)

Product A incremental revenue = $120,000 - $70,000 Product B incremental revenue = $65,000 - $50,000 Product A incremental revenue = $120,000 - $70,000 Product B incremental revenue = $65,000 - $50,000



21-48

Joint costs are really common costs incurred to simultaneously produce a variety of end products.

Joint costs are commonly allocated to end products on the basis of the relative sales value of each product or on some other basis.



21-49


Joint costs are not relevantin decisions regarding what to do with

a product after the split-off point.

As a general rule . . .

It is always profitable to continue processing a joint product after the split-off point so long as

the incremental revenue exceeds the incremental processing costs.


21-50

End of Chapter 21End of Chapter 21

© the mcgraw-hill companies, inc., 2005 mcgraw-hill/irwin 21-1 incremental analysis chapter 21

Documents

extra cost

motel cost

kennel cost

meal cost

mcgrawhill companies

past cost

roundtrip cost of gasoline

opportunity cost example