CHAPTER 7 INCREMENTAL ANALYSIS INCREMENTAL ANALYSIS Managerial Accounting, Fourth Edition

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<ul><li><p>CHAPTER 7 INCREMENTAL ANALYSISManagerial Accounting, Fourth Edition</p></li><li><p> Incremental AnalysisOccurs when there is more than one alternative choice of action.Alternative OneAlternative Two</p></li><li><p>Important DefinitionsRelevant Cost. Costs and revenues that do not differ between alternatives. These can be ignored in incremental analysisOpportunity Cost. The benefit given up when one alternative is chosen over another.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.</p></li><li><p>Types of Incremental AnalysisAccept an order at a special price</p><p>Make or buy components or finished products</p><p>Sell products or process further</p><p>Retain or replace equipment</p><p>Eliminate an unprofitable business segment</p><p>Allocate limited resourcesLO 2: Describe the concept of incremental analysis.</p></li><li><p>McDermotts CriteriaWhen can you sell a product at less than full cost and still make a profit? When . . .You can segregate the marketYou can identify fixed and variable costsYou have a positive contribution marginYou have excess capacity or can charge for opportunity costThe minimum price you can charge under these conditions is:Variable costs of the new order plus opportunity cost</p></li><li><p>Variable Cost of the New OrderVariable costs of the new order include:Direct laborDirect materialsVariable overheadVariable marketing and administrative costsAny 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.</p></li><li><p>Opportunity CostThe 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)</p></li><li><p>Example ProblemMcDermott Manufacturing makes computer monitors.Revenue and cost data for the company are shown below:Price $60Direct labor $10Direct materials $5Variable overhead $12Fixed overhead $100,000Variable marketing $6Fixed marketing and administration $50,000</p></li><li><p>Example ProblemA Japanese retailer wants to purchase 5,000 monitors.Assume that the purchase needs the criteria listed earlier by Professor McDermott.</p></li><li><p>Additional InformationThe 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 costsIt will cost $3 to ship the monitors to the purchasers San Francisco warehouse.What is the minimum price for which the company would be willing to sell this special order?</p></li><li><p>Calculation of Variable CostsRemember: we delete any savings on the special order. In this case we save marketing costs (sales commissions).</p><p>CategoryAmountDirect labor$10Direct materials$5Variable overhead$12Variable marketing$0Additional shipping$3Total variable costs$30</p></li><li><p>Calculation of Variable CostsAlso remember: We add any additional costs of this special order, in this case shipping the product to San Francisco.</p><p>CategoryAmountDirect labor$10Direct materials$5Variable overhead$12Variable marketing$0Additional shipping$3Total variable costs$30</p></li><li><p>Calculation of Opportunity CostThe 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.</p></li><li><p>Calculation of Opportunity CostThe 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</p></li><li><p>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?</p></li><li><p>Minimum Price Special OrderThe 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 = $4000Bottom line: variable revenues and costs are relevant, fixed costs are not relevant in short-term special pricing decisions.</p></li><li><p>Another example the authorsExampleMexico 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 unitsCurrent fixed manufacturing costs = $400,000 or $4 per unitVariable manufacturing cost = $8 per unitNormal selling price = $20 per unitBased strictly on total cost of $12 per unit ($8 + $4), reject offer as cost exceeds selling price of $11</p><p>LO 3: Identify the relevant costs in accepting an order at a special price.</p></li><li><p>Accept an Order at a Special PriceWithin existing capacity, no change in fixed costs - they are not relevant for this decisionTotal variable costs change they are relevant </p><p>Revenue increases $22,000; variable costs increase $16,000Income increases by $6,000Accept the Special OrderLO 3: Identify the relevant costs in accepting an order at a special price.</p></li><li><p>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.Lets ReviewLO 3: Identify the relevant costs in accepting an order at a special price.</p></li><li><p>Make or BuyManagement 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</p><p>LO 4: Identify the relevant costs in a make-or-buy decision.</p></li><li><p>Make or Buy Example ContinuedSwitches 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 unitBuying the switches eliminates all variable costs, but only $10,000 of fixed costsHowever, $50,000 of fixed costs remain even if the switches are purchased</p><p>LO 4: Identify the relevant costs in a make-or-buy decision.</p></li><li><p>Make or Buy Example ContinuedSwitches 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 unitBuying the switches eliminates all variable costs, but only $10,000 of fixed costsHowever, $50,000 of fixed costs remain even if the switches are purchased!!!!!</p><p>LO 4: Identify the relevant costs in a make-or-buy decision.</p></li><li><p>Make or Buy Example ContinuedThe relevant costs for incremental analysis are:</p><p>Baron Company will incur $25,000 additional cost if switches are purchasedContinue to make switchesLO 4: Identify the relevant costs in a make-or-buy decision.</p></li><li><p>Make or BuyOpportunity CostsDefinition: 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.</p><p>LO 4: Identify the relevant costs in a make-or-buy decision.</p></li><li><p>Make or Buy Opportunity Cost ExampleLO 4: Identify the relevant costs in a make-or-buy decision.This opportunity cost, the lost income, is added to the Make column as an additional cost for comparative purposes</p><p>It is now advantageous to buy the switches: Baron Company will be $3,000 better off</p></li><li><p>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. Lets ReviewLO 4: Identify the relevant costs in a make-or-buy decision.</p></li><li><p>Sell or Process FurtherMany 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</p><p>Decision Rule:Process further as long as the incremental revenue fromsuch processing exceeds theincremental processing costsLO 5: Identify the relevant costs in determining whetherto sell or process materials further.</p></li><li><p>Sell or Process Further - ExampleSingle-Product CaseCost to manufacture one unfinished table:</p><p>Selling price of unfinished unit is $50; unused capacity can be used to finish the tables to sell for $60Relevant unit costs of finishing tables:Direct materials increase $2; Direct labor increases $4Variable manufacturing overhead costs increase by $2.40 (60 percent of direct labor increase)Fixed manufacturing costs will not increaseLO 5: Identify the relevant costs in determining whetherto sell or process materials further.</p></li><li><p>Sell or Process Further</p><p>Incremental revenues ($10) exceed incremental costs ($8.40); Income increases $1.60 per unitProcess furtherLO 5: Identify the relevant costs in determining whetherto sell or process materials further .</p></li><li><p>Sell or Process FurtherMultiple-Product Case</p><p>In many industries, a number of end-products are produced from a single raw material and a common production process</p><p>Multiple end-products are commonly called joint productsPetroleum gasoline, lubricating oil, keroseneMeat Packing meat, hides, bonesLO 5: Identify the relevant costs in determining whetherto sell or process materials further.</p></li><li><p>Sell or Process FurtherMultiple-Product Case</p><p>All costs incurred prior to the point at which the products are separately identifiable (the split-off point) are called joint costs </p><p>Joint costs are (for purposes of determining product cost) allocated to individual products on the basis of relative sales value</p><p>Joint costs are not relevant for any sell-or-process-further decisions</p><p>Joint product costs are sunk costs.They have already been incurred and cannot be changedLO 5: Identify the relevant costs in determining whetherto sell or process materials further.</p></li><li><p>Sell or Process Further - ExampleMultiple-Product Case </p><p>Marais Creamery must decide whether to:Sell cream and skim milk noworProcess each further before sellingLO 5: Identify the relevant costs in determining whetherto sell or process materials further.</p></li><li><p>Sell or Process Further Example ContinuedThe daily cost and revenue data for Marais Creamery are:LO 5: Identify the relevant costs in determining whetherto sell or process materials further.</p></li><li><p>Sell or Process Further Example ContinuedSell cream or process further into cottage cheese?</p><p>Do not process cream further:To do so will incur an incremental loss of $2,000LO 5: Identify the relevant costs in determining whetherto sell or process materials further.</p></li><li><p>Sell or Process FurtherSell skim milk or process further into condensed milk?</p><p>Marais should process the skim milk:To do so will increase net income by $7,000LO 5: Identify the relevant costs in determining whetherto sell or process materials further.</p></li><li><p>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.Lets ReviewLO 5: Identify the relevant costs in determining whetherto sell or process materials further.</p></li><li><p>Retain or Replace EquipmentManagement must decide whether a company should continue to use an asset or replace itExample: Assessment of replacement of a factory machine:</p><p>Variable costs: Decrease from $160,000to $125,000 annuallyLO 6: Identify the relevant costs to be considered inretaining or replacing equipment. Old Machine New Machine Book value $40,000 Cost $120,000Remaining useful life four years four yearsScrap value - 0 - - 0 -</p></li><li><p>Retain or Replace Equipment - Example</p><p>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 relevantLO 6: Identify the relevant costs to be considered inretaining or replacing equipment.</p></li><li><p>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.Lets ReviewLO 6: Identify the relevant costs to be considered inretaining or replacing equipment.</p></li><li><p>Eliminate an Unprofitable SegmentShould the company eliminate an unprofitable segment? Key: Focus on relevant costsConsider effect on related product lines Fixed costs allocated to the unprofitable segment must be absorbed by the other segmentsNet income may decrease when an unprofitable segment is eliminatedDecision Rule:Retain the segment unless fixed costs eliminated exceed the contribution margin lostLO 7: Identify the relevant costs in deciding whetherto eliminate an unprofitable segment.</p></li><li><p>Eliminate an Unprofitable Segment - ExampleMartina Company manufactures three models of tennis racquets: Profitable lines: Pro and Master Unprofitable line: ChampCondensed Income Statement data:</p><p>Should the Champ line be eliminated?LO 7: Identify the relevant costs in deciding whetherto eliminate an unprofitable segment.</p></li><li><p>Eliminate an Unprofitable Segment - ExampleIf Champ is eliminated, must allocate its $30,000 share of fixed costs: 2/3 to Pro and 1/3 to MasterRevised Income Statement data:</p><p>Total income has decreased by $10,000 ($220,000 - $210,000)</p><p>LO 7: Identify the relevant costs in deciding whetherto eliminate an unprofitable segment.</p></li><li><p>Eliminate an Unprofitable Segment - ExampleIncremental analysis of Champ provides the same results:</p><p>Decision: Do not eliminate ChampLO 7: Identify the relevant costs in deciding whetherto eliminate an unprofitable segment.</p></li><li><p>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.Lets ReviewLO 7: Identify the relevant costs in deciding whetherto eliminate an unprofitable segment .</p></li><li><p>Other Considerations in Decision MakingMany 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 i...</p></li></ul>