chapter 7 incremental analysis incremental analysis managerial accounting, fourth edition

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CHAPTER CHAPTER 7 7 INCREMENTAL INCREMENTAL ANALYSIS ANALYSIS Managerial Accounting, Fourth Edition

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Page 1: CHAPTER 7 INCREMENTAL ANALYSIS INCREMENTAL ANALYSIS Managerial Accounting, Fourth Edition

CHAPTER CHAPTER 77

INCREMENTAL INCREMENTAL ANALYSISANALYSIS

Managerial Accounting, Fourth Edition

Page 2: CHAPTER 7 INCREMENTAL ANALYSIS INCREMENTAL ANALYSIS Managerial Accounting, Fourth Edition

Incremental AnalysisIncremental Analysis

Occurs when there is more than one alternative Occurs when there is more than one alternative choice of action.choice of action.

Alternative One Alternative Two

Page 3: CHAPTER 7 INCREMENTAL ANALYSIS INCREMENTAL ANALYSIS Managerial Accounting, Fourth Edition

Important DefinitionsImportant Definitions

Relevant CostRelevant Cost. Costs and revenues that do not . Costs and revenues that do not differ between alternatives. differ between alternatives. These can be ignored in incremental analysisThese can be ignored in incremental analysis

Opportunity CostOpportunity Cost. The benefit given up when . The benefit given up when one alternative is chosen over another.one alternative is chosen over another. Opportunity costs are never found in the general Opportunity costs are never found in the general

ledger.ledger.

Sunk CostSunk Cost. A cost that has already been . A cost that has already been incurred and will not be changed or avoided by incurred and will not be changed or avoided by any future decision.any future decision. Sunk costs are not relevant costs.Sunk costs are not relevant costs.

Page 4: CHAPTER 7 INCREMENTAL ANALYSIS INCREMENTAL ANALYSIS Managerial Accounting, Fourth Edition

Types of Incremental AnalysisTypes of Incremental AnalysisTypes of Incremental AnalysisTypes of Incremental Analysis

Accept an order at a special priceAccept an order at a special price

Make or buy components or Make or buy components or finished productsfinished products

Sell products or process furtherSell products or process further

Retain or replace equipmentRetain or replace equipment

Eliminate an unprofitable Eliminate an unprofitable business segmentbusiness segment

Allocate limited resourcesAllocate limited resources

LO 2: Describe the concept of incremental analysis.LO 2: Describe the concept of incremental analysis.

Page 5: CHAPTER 7 INCREMENTAL ANALYSIS INCREMENTAL ANALYSIS Managerial Accounting, Fourth Edition

McDermott’s CriteriaMcDermott’s Criteria

When can you sell a product at less than full When can you sell a product at less than full cost and still make a profit? When . . .cost and still make a profit? When . . . You can segregate the marketYou can segregate the market You can identify fixed and variable costsYou can identify fixed and variable costs You have a positive contribution marginYou have a positive contribution margin You have excess capacity or can charge for You have excess capacity or can charge for

opportunity costopportunity cost

The minimum price you can charge under these The minimum price you can charge under these conditions is:conditions is: Variable costs of the new order plus opportunity costVariable costs of the new order plus opportunity cost

Page 6: CHAPTER 7 INCREMENTAL ANALYSIS INCREMENTAL ANALYSIS Managerial Accounting, Fourth Edition

Variable Cost of the New OrderVariable Cost of the New Order

Variable costs of the new order include:Variable costs of the new order include: Direct laborDirect labor Direct materialsDirect materials Variable overheadVariable overhead Variable marketing and administrative costsVariable marketing and administrative costs Any other costs will be incurred to fulfill the new order Any other costs will be incurred to fulfill the new order

(freight, special handling, and so on).(freight, special handling, and so on).

Any normal costs that disappear should be Any normal costs that disappear should be subtracted from variable costs in this formula.subtracted from variable costs in this formula.

Page 7: CHAPTER 7 INCREMENTAL ANALYSIS INCREMENTAL ANALYSIS Managerial Accounting, Fourth Edition

Opportunity CostOpportunity Cost

The opportunity cost is the contribution margin The opportunity cost is the contribution margin of any sales given up.of any sales given up. The formula is (contribution margin per unit ) × (units The formula is (contribution margin per unit ) × (units

of sales to existing customers given up)of sales to existing customers given up)

Page 8: CHAPTER 7 INCREMENTAL ANALYSIS INCREMENTAL ANALYSIS Managerial Accounting, Fourth Edition

Example ProblemExample Problem

McDermott Manufacturing makes computer McDermott Manufacturing makes computer monitors.monitors.

Revenue and cost data for the company are Revenue and cost data for the company are shown below:shown below: Price $60Price $60 Direct labor $10Direct labor $10 Direct materials $5Direct materials $5 Variable overhead $12Variable overhead $12 Fixed overhead $100,000Fixed overhead $100,000 Variable marketing $6Variable marketing $6 Fixed marketing and administration $50,000Fixed marketing and administration $50,000

Page 9: CHAPTER 7 INCREMENTAL ANALYSIS INCREMENTAL ANALYSIS Managerial Accounting, Fourth Edition

Example ProblemExample Problem

A Japanese retailer wants to purchase 5,000 A Japanese retailer wants to purchase 5,000 monitors.monitors.

Assume that the purchase needs the criteria Assume that the purchase needs the criteria listed earlier by Professor McDermott.listed earlier by Professor McDermott.

Page 10: CHAPTER 7 INCREMENTAL ANALYSIS INCREMENTAL ANALYSIS Managerial Accounting, Fourth Edition

Additional InformationAdditional Information

The company has the capacity to manufacture The company has the capacity to manufacture 10,000 units per year.10,000 units per year.

Currently the company is manufacturing and Currently the company is manufacturing and selling 8,000 units per year.selling 8,000 units per year.

The special order will have no marketing costsThe special order will have no marketing costs It will cost $3 to ship the monitors to the It will cost $3 to ship the monitors to the

purchaser’s San Francisco warehouse.purchaser’s San Francisco warehouse. What is the minimum price for which the What is the minimum price for which the

company would be willing to sell this special company would be willing to sell this special order?order?

Page 11: CHAPTER 7 INCREMENTAL ANALYSIS INCREMENTAL ANALYSIS Managerial Accounting, Fourth Edition

Calculation of Variable CostsCalculation of Variable Costs

Category Amount

Direct labor $10

Direct materials $5

Variable overhead $12

Variable marketing $0

Additional shipping $3

Total variable costs $30

Remember: we delete any savings on the special order. In this case we save marketing costs (sales commissions).

Page 12: CHAPTER 7 INCREMENTAL ANALYSIS INCREMENTAL ANALYSIS Managerial Accounting, Fourth Edition

Calculation of Variable CostsCalculation of Variable Costs

Category Amount

Direct labor $10

Direct materials $5

Variable overhead $12

Variable marketing $0

Additional shipping $3

Total variable costs $30

Also remember: We add any additional costs of this special order, in this case shipping the product to San Francisco.

Page 13: CHAPTER 7 INCREMENTAL ANALYSIS INCREMENTAL ANALYSIS Managerial Accounting, Fourth Edition

Calculation of Opportunity CostCalculation of Opportunity Cost

The company has an excess capacity of 2,000 The company has an excess capacity of 2,000 units (10,000 manufacturing capacity – 8,000 units (10,000 manufacturing capacity – 8,000 units presently manufactured and sold).units presently manufactured and sold).

However the customer wishes to purchase 5,000 However the customer wishes to purchase 5,000 monitors.monitors.

The opportunity cost in units, therefore, is 5,000 The opportunity cost in units, therefore, is 5,000 units of demand - 2,000 units of excess capacity = units of demand - 2,000 units of excess capacity = 3,000 units.3,000 units.

The opportunity cost in dollars is the contribution The opportunity cost in dollars is the contribution margin per unit times the opportunity cost in units.margin per unit times the opportunity cost in units.

Page 14: CHAPTER 7 INCREMENTAL ANALYSIS INCREMENTAL ANALYSIS Managerial Accounting, Fourth Edition

Calculation of Opportunity CostCalculation of Opportunity Cost

The contribution margin (for existing customers) The contribution margin (for existing customers) is:is:

$60 price - $10 direct labor - $5 direct materials $60 price - $10 direct labor - $5 direct materials - $12 variable overhead - $6 variable marketing - $12 variable overhead - $6 variable marketing = $27.= $27.

The total contribution margin lost is, therefore, The total contribution margin lost is, therefore, $27 × 3000 units = $81,000.$27 × 3000 units = $81,000.

The opportunity cost per unit sold to the The opportunity cost per unit sold to the Japanese is $81,000/5000 units = $16.20 per Japanese is $81,000/5000 units = $16.20 per unitunit

Page 15: CHAPTER 7 INCREMENTAL ANALYSIS INCREMENTAL ANALYSIS Managerial Accounting, Fourth Edition

Minimum Price Special OrderMinimum Price Special Order

$30 variable costs of special order + $16.20 $30 variable costs of special order + $16.20 opportunity cost = $46.20.opportunity cost = $46.20.

Note: the full cost of the product including fixed Note: the full cost of the product including fixed costs is $48.costs is $48.

What if the customer is willing to pay $47.50 per What if the customer is willing to pay $47.50 per unit?unit? This is less than the full (absorption) cost of the This is less than the full (absorption) cost of the

product.product. Should they accept the special order?Should they accept the special order?

Page 16: CHAPTER 7 INCREMENTAL ANALYSIS INCREMENTAL ANALYSIS Managerial Accounting, Fourth Edition

Minimum Price Special OrderMinimum Price Special Order

The contribution margin is $47 - $30 variable The contribution margin is $47 - $30 variable costs of special order = $17 contribution margin.costs of special order = $17 contribution margin.

This $17 will cover the opportunity cost of This $17 will cover the opportunity cost of $16.20 per unit, allowing $.80 per unit to flow to $16.20 per unit, allowing $.80 per unit to flow to the bottom line.the bottom line.

The net impact on the bottom line will be $.80 x The net impact on the bottom line will be $.80 x 5000 units = $40005000 units = $4000

Bottom line: Bottom line: variable revenues and costs are variable revenues and costs are relevant, fixed costs are not relevant in short-relevant, fixed costs are not relevant in short-term special pricing decisions.term special pricing decisions.

Page 17: CHAPTER 7 INCREMENTAL ANALYSIS INCREMENTAL ANALYSIS Managerial Accounting, Fourth Edition

Another example – the authorsAnother example – the authorsAnother example – the authorsAnother example – the authors

ExampleExample

Mexico 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 units

Current fixed manufacturing costs = $400,000 or $4 per unit

Variable manufacturing cost = $8 per unit

Normal selling price = $20 per unit

Based strictly on total cost of $12 per unit ($8 + $4), reject offer as cost exceeds selling price of $11

LO 3: Identify the relevant costs in accepting an order at a special price.LO 3: Identify the relevant costs in accepting an order at a special price.

Page 18: CHAPTER 7 INCREMENTAL ANALYSIS INCREMENTAL ANALYSIS Managerial Accounting, Fourth Edition

Accept an Order at a Special PriceAccept an Order at a Special PriceAccept an Order at a Special PriceAccept an Order at a Special Price

Within existing capacity, no change in fixed costs - they are not relevant for this decisionTotal variable costs change – they are relevant

Revenue increases $22,000; variable costs increase $16,000

Income increases by $6,000Accept the Special Order

LO 3: Identify the relevant costs in accepting an order at a special price.LO 3: Identify the relevant costs in accepting an order at a special price.

Page 19: CHAPTER 7 INCREMENTAL ANALYSIS INCREMENTAL ANALYSIS Managerial Accounting, Fourth Edition

It costs a company $14 of variable costs and $6 of It costs a company $14 of variable costs and $6 of fixed costs to produce product Z200 that sells for fixed costs to produce product Z200 that sells for $30. A foreign buyer offers to purchase 3,000 units $30. A foreign buyer offers to purchase 3,000 units at $18 each. If the special offer is accepted and at $18 each. If the special offer is accepted and produced with unused capacity, net income will:produced with unused capacity, net income will:

a.a. Decrease $6,000Decrease $6,000.

b. Increase $6,000.

c. Increase $12,000.

d. Increase $9,000.

Let’s ReviewLet’s ReviewLet’s ReviewLet’s Review

LO 3: Identify the relevant costs in accepting an order at a special LO 3: Identify the relevant costs in accepting an order at a special price.price.

Page 20: CHAPTER 7 INCREMENTAL ANALYSIS INCREMENTAL ANALYSIS Managerial Accounting, Fourth Edition

Make or BuyMake or BuyMake or BuyMake or Buy

Management 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

LO 4: Identify the relevant costs in a make-or-buy decision.LO 4: Identify the relevant costs in a make-or-buy decision.

Page 21: CHAPTER 7 INCREMENTAL ANALYSIS INCREMENTAL ANALYSIS Managerial Accounting, Fourth Edition

Make or Buy – Example ContinuedMake or Buy – Example ContinuedMake or Buy – Example ContinuedMake or Buy – Example Continued

Switches 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 unit

Buying the switches eliminates all variable costs, but only $10,000 of fixed costs

However, $50,000 of fixed costs remain even if the switches are purchased

LO 4: Identify the relevant costs in a make-or-buy decision.LO 4: Identify the relevant costs in a make-or-buy decision.

Page 22: CHAPTER 7 INCREMENTAL ANALYSIS INCREMENTAL ANALYSIS Managerial Accounting, Fourth Edition

Make or Buy – Example ContinuedMake or Buy – Example ContinuedMake or Buy – Example ContinuedMake or Buy – Example Continued

Switches 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 unit

Buying the switches eliminates all variable costs, but only $10,000 of fixed costs

However, $50,000 of fixed costs remain even if the switches are purchased!!!!!

LO 4: Identify the relevant costs in a make-or-buy decision.LO 4: Identify the relevant costs in a make-or-buy decision.

Page 23: CHAPTER 7 INCREMENTAL ANALYSIS INCREMENTAL ANALYSIS Managerial Accounting, Fourth Edition

Make or Buy – Example ContinuedMake or Buy – Example ContinuedMake or Buy – Example ContinuedMake or Buy – Example Continued

The relevant costs for incremental analysis are:

Baron Company will incur $25,000 additional cost if switches are purchased

Continue to make switches

LO 4: Identify the relevant costs in a make-or-buy decision.LO 4: Identify the relevant costs in a make-or-buy decision.

Page 24: CHAPTER 7 INCREMENTAL ANALYSIS INCREMENTAL ANALYSIS Managerial Accounting, Fourth Edition

Make or BuyMake or BuyMake or BuyMake or Buy

Opportunity CostsOpportunity Costs

Definition: 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.

LO 4: Identify the relevant costs in a make-or-buy decision.LO 4: Identify the relevant costs in a make-or-buy decision.

Page 25: CHAPTER 7 INCREMENTAL ANALYSIS INCREMENTAL ANALYSIS Managerial Accounting, Fourth Edition

Make or Buy – Opportunity Cost Make or Buy – Opportunity Cost ExampleExample

Make or Buy – Opportunity Cost Make or Buy – Opportunity Cost ExampleExample

LO 4: Identify the relevant costs in a make-or-buy decision.LO 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

It is now advantageous to buy the switches: Baron Company will be $3,000 better off

Page 26: CHAPTER 7 INCREMENTAL ANALYSIS INCREMENTAL ANALYSIS Managerial Accounting, Fourth Edition

In a make-or-buy decision, relevant costs are:In a make-or-buy decision, relevant costs are:

a.a. Manufacturing costs that will be savedManufacturing costs that will be saved.

b. The purchase price of the units.

c. Opportunity costs.

d. All of the above.

Let’s ReviewLet’s ReviewLet’s ReviewLet’s Review

LO 4: Identify the relevant costs in a make-or-buy LO 4: Identify the relevant costs in a make-or-buy decision.decision.

Page 27: CHAPTER 7 INCREMENTAL ANALYSIS INCREMENTAL ANALYSIS Managerial Accounting, Fourth Edition

Sell or Process FurtherSell or Process FurtherSell or Process FurtherSell or Process Further

Many 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

Decision Rule:

Process further as long as the incremental revenue fromsuch processing exceeds theincremental processing costs

LO 5: Identify the relevant costs in determining whetherLO 5: Identify the relevant costs in determining whetherto sell or process materials further.to sell or process materials further.

Page 28: CHAPTER 7 INCREMENTAL ANALYSIS INCREMENTAL ANALYSIS Managerial Accounting, Fourth Edition

Sell or Process Further - ExampleSell or Process Further - ExampleSell or Process Further - ExampleSell or Process Further - Example

Single-Product Case

Cost to manufacture one unfinished table:

Selling price of unfinished unit is $50; unused capacity can be used to finish the tables to sell for $60

Relevant unit costs of finishing tables:Direct materials increase $2; Direct labor increases $4

Variable 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 whetherLO 5: Identify the relevant costs in determining whether

to sell or process materials further.to sell or process materials further.

Page 29: CHAPTER 7 INCREMENTAL ANALYSIS INCREMENTAL ANALYSIS Managerial Accounting, Fourth Edition

Sell or Process FurtherSell or Process FurtherSell or Process FurtherSell or Process Further

Incremental revenues ($10) exceed incremental costs ($8.40); Income increases $1.60 per unit

Process furtherProcess further

LO 5: Identify the relevant costs in determining whetherLO 5: Identify the relevant costs in determining whetherto sell or process materials further .to sell or process materials further .

Page 30: CHAPTER 7 INCREMENTAL ANALYSIS INCREMENTAL ANALYSIS Managerial Accounting, Fourth Edition

Sell or Process FurtherSell or Process FurtherSell or Process FurtherSell or Process Further

Multiple-Product Case

In many industries, a number of end-products are produced from a single raw material and a common production process

Multiple end-products are commonly called joint productsPetroleum – gasoline, lubricating oil, kerosene

Meat Packing – meat, hides, bones

LO 5: Identify the relevant costs in determining whetherLO 5: Identify the relevant costs in determining whetherto sell or process materials further.to sell or process materials further.

Page 31: CHAPTER 7 INCREMENTAL ANALYSIS INCREMENTAL ANALYSIS Managerial Accounting, Fourth Edition

Sell or Process FurtherSell or Process FurtherSell or Process FurtherSell or Process Further

Multiple-Product Case

All costs incurred prior to the point at which the products are separately identifiable (the split-off point) are called joint costs

Joint costs are (for purposes of determining product cost) allocated to individual products on the basis of relative sales value

Joint costs are not relevant for any sell-or-process-further decisions

Joint product costs are sunk costs.They have already been incurred and cannot be changed

LO 5: Identify the relevant costs in determining whetherLO 5: Identify the relevant costs in determining whetherto sell or process materials further.to sell or process materials further.

Page 32: CHAPTER 7 INCREMENTAL ANALYSIS INCREMENTAL ANALYSIS Managerial Accounting, Fourth Edition

Sell or Process Further - ExampleSell or Process Further - ExampleSell or Process Further - ExampleSell or Process Further - Example

Multiple-Product Case

Marais Creamery must decide whether to:

Sell cream and skim milk nowor

Process each further before selling

LO 5: Identify the relevant costs in determining whetherLO 5: Identify the relevant costs in determining whetherto sell or process materials further.to sell or process materials further.

Page 33: CHAPTER 7 INCREMENTAL ANALYSIS INCREMENTAL ANALYSIS Managerial Accounting, Fourth Edition

Sell or Process Further – Example Sell or Process Further – Example ContinuedContinued

Sell or Process Further – Example Sell or Process Further – Example ContinuedContinued

The daily cost and revenue data for Marais Creamery are:

LO 5: Identify the relevant costs in determining whetherLO 5: Identify the relevant costs in determining whetherto sell or process materials further.to sell or process materials further.

Page 34: CHAPTER 7 INCREMENTAL ANALYSIS INCREMENTAL ANALYSIS Managerial Accounting, Fourth Edition

Sell or Process Further – Example Sell or Process Further – Example ContinuedContinued

Sell or Process Further – Example Sell or Process Further – Example ContinuedContinued

Sell cream or process further into cottage cheese?

Do not process cream further:To do so will incur an incremental loss of $2,000

LO 5: Identify the relevant costs in determining whetherLO 5: Identify the relevant costs in determining whetherto sell or process materials further.to sell or process materials further.

Page 35: CHAPTER 7 INCREMENTAL ANALYSIS INCREMENTAL ANALYSIS Managerial Accounting, Fourth Edition

Sell or Process FurtherSell or Process FurtherSell or Process FurtherSell or Process Further

Sell skim milk or process further into condensed milk?

Marais should process the skim milk:To do so will increase net income by $7,000

LO 5: Identify the relevant costs in determining whetherLO 5: Identify the relevant costs in determining whetherto sell or process materials further.to sell or process materials further.

Page 36: CHAPTER 7 INCREMENTAL ANALYSIS INCREMENTAL ANALYSIS Managerial Accounting, Fourth Edition

The decision rule in a sell-or-process-further The decision rule in a sell-or-process-further decision is:decision is:

process further as long as the incremental process further as long as the incremental revenue from processing revenue from processing exceeds:exceeds:

a.a. Incremental processing costsIncremental processing costs.

b. Variable processing costs.

c. Fixed processing costs.

d. No correct answer is given.

Let’s ReviewLet’s ReviewLet’s ReviewLet’s Review

LO 5: Identify the relevant costs in determining whetherLO 5: Identify the relevant costs in determining whetherto sell or process materials further.to sell or process materials further.

Page 37: CHAPTER 7 INCREMENTAL ANALYSIS INCREMENTAL ANALYSIS Managerial Accounting, Fourth Edition

Retain or Replace EquipmentRetain or Replace EquipmentRetain or Replace EquipmentRetain or Replace Equipment

Management must decide whether a company should continue to use an asset or replace itExample: Assessment of replacement of a factory

machine:

Variable costs: Decrease from $160,000to $125,000 annually

LO 6: Identify the relevant costs to be considered inLO 6: Identify the relevant costs to be considered inretaining or replacing equipment.retaining or replacing equipment.

Old Machine New Machine Book value $40,000 Cost $120,000Remaining useful life four years four yearsScrap value - 0 - - 0 -

Page 38: CHAPTER 7 INCREMENTAL ANALYSIS INCREMENTAL ANALYSIS Managerial Accounting, Fourth Edition

Retain or Replace Equipment - ExampleRetain or Replace Equipment - ExampleRetain or Replace Equipment - ExampleRetain or Replace Equipment - Example

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 relevant

LO 6: Identify the relevant costs to be considered inLO 6: Identify the relevant costs to be considered inretaining or replacing equipment.retaining or replacing equipment.

Page 39: CHAPTER 7 INCREMENTAL ANALYSIS INCREMENTAL ANALYSIS Managerial Accounting, Fourth Edition

In a decision to retain or replace equipment, the In a decision to retain or replace equipment, the book value of the old equipment is a(an):book value of the old equipment is a(an):

a.a. Opportunity costOpportunity cost.

b. Sunk cost.

c. Incremental cost.

d. Marginal cost.

Let’s ReviewLet’s ReviewLet’s ReviewLet’s Review

LO 6: Identify the relevant costs to be considered inLO 6: Identify the relevant costs to be considered inretaining or replacing equipment.retaining or replacing equipment.

Page 40: CHAPTER 7 INCREMENTAL ANALYSIS INCREMENTAL ANALYSIS Managerial Accounting, Fourth Edition

Eliminate an Unprofitable SegmentEliminate an Unprofitable SegmentEliminate an Unprofitable SegmentEliminate an Unprofitable Segment

Should the company eliminate an unprofitable segment?

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 the contribution margin lostLO 7: Identify the relevant costs in deciding whetherLO 7: Identify the relevant costs in deciding whether

to eliminate an unprofitable segment.to eliminate an unprofitable segment.

Page 41: CHAPTER 7 INCREMENTAL ANALYSIS INCREMENTAL ANALYSIS Managerial Accounting, Fourth Edition

Eliminate an Unprofitable Segment - Eliminate an Unprofitable Segment - ExampleExample

Eliminate an Unprofitable Segment - Eliminate an Unprofitable Segment - ExampleExample

Martina Company manufactures three models of tennis racquets: Profitable lines: Pro and Master Unprofitable line: Champ

Condensed Income Statement data:

Should the Champ line be eliminated?

LO 7: Identify the relevant costs in deciding whetherLO 7: Identify the relevant costs in deciding whetherto eliminate an unprofitable segment.to eliminate an unprofitable segment.

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Eliminate an Unprofitable Segment - Eliminate an Unprofitable Segment - ExampleExample

Eliminate an Unprofitable Segment - Eliminate an Unprofitable Segment - ExampleExample

If Champ is eliminated, must allocate its $30,000 share of fixed costs: 2/3 to Pro and 1/3 to Master

Revised Income Statement data:

Total income has decreased by $10,000 ($220,000 - $210,000)

LO 7: Identify the relevant costs in deciding whetherLO 7: Identify the relevant costs in deciding whetherto eliminate an unprofitable segment.to eliminate an unprofitable segment.

Page 43: CHAPTER 7 INCREMENTAL ANALYSIS INCREMENTAL ANALYSIS Managerial Accounting, Fourth Edition

Eliminate an Unprofitable Segment - Eliminate an Unprofitable Segment - ExampleExample

Eliminate an Unprofitable Segment - Eliminate an Unprofitable Segment - ExampleExample

Incremental analysis of Champ provides the same results:

Decision: Do not eliminate Champ

LO 7: Identify the relevant costs in deciding whetherLO 7: Identify the relevant costs in deciding whetherto eliminate an unprofitable segment.to eliminate an unprofitable segment.

Page 44: CHAPTER 7 INCREMENTAL ANALYSIS INCREMENTAL ANALYSIS Managerial Accounting, Fourth Edition

If an unprofitable segment is eliminated:If an unprofitable segment is eliminated:

a.a. Net income will always increaseNet 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.

Let’s ReviewLet’s ReviewLet’s ReviewLet’s Review

LO 7: Identify the relevant costs in deciding whetherLO 7: Identify the relevant costs in deciding whetherto eliminate an unprofitable segment .to eliminate an unprofitable segment .

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Other Considerations in Decision MakingOther Considerations in Decision MakingOther Considerations in Decision MakingOther Considerations in Decision Making

Many 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 is completely consistent with activity-based costing (ABC)

ABC often results in better identification of relevant costs and, thus, better incremental analysis

Page 46: CHAPTER 7 INCREMENTAL ANALYSIS INCREMENTAL ANALYSIS Managerial Accounting, Fourth Edition

AllAll About YouAbout YouAllAll About YouAbout You

What is a Degree Worth?

Over a life time of work, college graduates earn an average of $500,000 more than associate degree holders and $900,000 more than high-school graduates.

Tuition costs about $8,655 a year to attend a public four-year college and about $1,359 for a public two year institution.

About 600,000 students drop out of four-year colleges each year.

Page 47: CHAPTER 7 INCREMENTAL ANALYSIS INCREMENTAL ANALYSIS Managerial Accounting, Fourth Edition

AllAll About YouAbout YouAllAll About YouAbout You

What is a Degree What is a Degree Worth?Worth?

You are working two jobs, your grades are suffering, you feel depressed: Should you drop out of school?

Is it better to stay in school even if you only take one class each semester?

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Chapter Review - Exercise 7-1 Chapter Review - Exercise 7-1 Chapter Review - Exercise 7-1 Chapter Review - Exercise 7-1

1. The first step in management’s decision-making process is “Determine and evaluate possible courses of action.”

2. The final step in management’s decision-making process is to actually make the decision.

3. Accounting’s contribution to management’s decision-making process occurs primarily in evaluating possible courses of action and in reviewing the results.

4. In making business decisions, management ordinarily considers only financial information because it is

objectively determined.

Identify each of the following statements as true or false.

False

False

True

False

Page 49: CHAPTER 7 INCREMENTAL ANALYSIS INCREMENTAL ANALYSIS Managerial Accounting, Fourth Edition

Chapter Review - Exercise 7-1 Chapter Review - Exercise 7-1 ContinuedContinued

Chapter Review - Exercise 7-1 Chapter Review - Exercise 7-1 ContinuedContinued

5. Decisions involve a choice among alternative courses of action.

6. The process used to identify the financial data that change under alternative courses of action is called incremental analysis.

7. Costs that are the same under all alternative courses of action sometimes affect the decision.

8. When using incremental analysis, some costs will always change under alternative courses of action, but revenues will not.

9. Variable costs will change under alternative courses of action, but fixed costs will not.

Identify each of the following statements as true or false.

True

True

False

False

False

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Problems Come Next!Problems Come Next!

Page 51: CHAPTER 7 INCREMENTAL ANALYSIS INCREMENTAL ANALYSIS Managerial Accounting, Fourth Edition

Brief Exercise OneBrief Exercise One

The steps in management decision-making The steps in management decision-making process are listed in random order below. process are listed in random order below. Indicate the order in which the step should be Indicate the order in which the step should be executed.executed. Identify the problem and assign responsibility.Identify the problem and assign responsibility. Determine and evaluate possible courses of action.Determine and evaluate possible courses of action. Make a decision.Make a decision. Review results of the decision.Review results of the decision.   

Page 52: CHAPTER 7 INCREMENTAL ANALYSIS INCREMENTAL ANALYSIS Managerial Accounting, Fourth Edition

Exercise OneExercise One

Given the following list of statements about Given the following list of statements about decision making and incremental analysis, decision making and incremental analysis, determine which are true and which are false.determine which are true and which are false.

If false, correct the statement.If false, correct the statement.

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StatementsStatements

The first step in management ‘s decision-making The first step in management ‘s decision-making process is: Determine and evaluate possible process is: Determine and evaluate possible courses of action.courses of action. False. The first step in management decision making False. The first step in management decision making

process is identified the problem and assign process is identified the problem and assign responsibilityresponsibility

The final step in management’s decision-making The final step in management’s decision-making process is to actually make the decision.process is to actually make the decision. False.False. The final step in management’s decision-The final step in management’s decision-

making process is to review the results of the making process is to review the results of the decision.decision.

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StatementsStatements

Accounting’s contribution to management’s Accounting’s contribution to management’s decision-making process occurs primarily in decision-making process occurs primarily in evaluating possible courses of action and in evaluating possible courses of action and in reviewing the results.reviewing the results. TrueTrue

In making business decisions, management In making business decisions, management ordinarily considers only financial information ordinarily considers only financial information because it is objectively determined.because it is objectively determined.False. In making business decisions, False. In making business decisions,

management ordinarily considers both management ordinarily considers both financial and nonfinancial information.financial and nonfinancial information.

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StatementsStatements

Decisions involve a choice among alternative Decisions involve a choice among alternative courses of action.courses of action. TrueTrue

The process used to identify the financial data The process used to identify the financial data that changes under alternative courses of action that changes under alternative courses of action is called incremental analysis.is called incremental analysis. TrueTrue

Costs that are the same under all alternative Costs that are the same under all alternative courses of action sometimes affect the decision.courses of action sometimes affect the decision. False. Costs that are the same are not relevant.False. Costs that are the same are not relevant.

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StatementsStatements

When using incremental analysis, some costs will When using incremental analysis, some costs will always change under alternative courses of always change under alternative courses of actions, but revenues will not.actions, but revenues will not.False. When using incremental analysis, either False. When using incremental analysis, either

costs or revenues or both will change under costs or revenues or both will change under alternative courses of action.alternative courses of action.

Variable costs will change under variable Variable costs will change under variable courses of action, but fixed costs will not.courses of action, but fixed costs will not.False. Sometimes variable costs will not change False. Sometimes variable costs will not change

under alternative courses of action, but fixed under alternative courses of action, but fixed costs will.costs will.

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Exercise 7-2Exercise 7-2

A company produces golf discs which normally A company produces golf discs which normally sellto retailers for seven dollars each. sellto retailers for seven dollars each.

The cost of manufacturing 20,000 golf discs is.The cost of manufacturing 20,000 golf discs is. Materials $10,000Materials $10,000 Labor $30,000Labor $30,000 Variable overhead $20,000Variable overhead $20,000 Fixed overhead $40,000Fixed overhead $40,000 Total cost $100,000Total cost $100,000

The company incurs a 5% sales commission The company incurs a 5% sales commission ($0.35) on each disc sold.($0.35) on each disc sold.

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Exercise 7-2Exercise 7-2

An outside firm offers $4.75 per disc for 5,000 An outside firm offers $4.75 per disc for 5,000 discs.discs.

This company would sell the discs under its own This company would sell the discs under its own brand in foreign markets yet not served.brand in foreign markets yet not served.

If the manufacturer accepts the offer, it’s fixed If the manufacturer accepts the offer, it’s fixed overhead will increase from $40,000 to $45,000 overhead will increase from $40,000 to $45,000 due to the purchase of a new printing machine.due to the purchase of a new printing machine.

No sales commissions will result from the No sales commissions will result from the special order.special order.

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Exercise 7-2Exercise 7-2

Prepare an incremental analysis for the special Prepare an incremental analysis for the special order.order.

(a) RejectOrder

AcceptOrder Net Income

EffectRevenuesMaterials ($0.50)Labor ($1.50)Variable overhead ($1.00)Fixed overheadSales commissions

Net income

$ -0- -0- -0- -0-

 -0-

  -0-

$ -0-

$23,750  (2,500)  (7,500)

  (5,000)

  (5,000)   -0-    

$ 3,750

$23,750 (2,500) (7,500)

(5,000)

(5,000)  -0-    

$ 3,750

Note that fixed costs sometimes are relevant. However only the portion thatvaries one alternative to the next ($5,000) is relevant. The other $47,000 is not relevant

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Exercise 7-2Exercise 7-2

Should the company except the special order?Should the company except the special order? Why or why not?Why or why not? As shown in the incremental analysis, Innova As shown in the incremental analysis, Innova

should accept the special order because should accept the special order because incremental revenue exceeds incremental incremental revenue exceeds incremental expenses by $3,750.expenses by $3,750.

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Exercise 7-2Exercise 7-2

What assumptions underlie the decision made in What assumptions underlie the decision made in part b?part b?

It is assumed that sales of the golf discs in other It is assumed that sales of the golf discs in other markets would not be affected by this special markets would not be affected by this special order. If other sales were affected. Innova would order. If other sales were affected. Innova would have to consider the lost sales in making the have to consider the lost sales in making the decision. Second, if Innova is operating at full decision. Second, if Innova is operating at full capacity, it is likely that the special order would capacity, it is likely that the special order would be rejected.be rejected.

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Exercise 7-5Exercise 7-5

XYZ Company has been manufacturing his own XYZ Company has been manufacturing his own shades for table lamps.shades for table lamps.

The company is currently operating at 100% The company is currently operating at 100% capacity, and variable overhead is charged capacity, and variable overhead is charged production at the rate of 70% of direct labor production at the rate of 70% of direct labor costs.costs.

The direct materials and direct labor cost per The direct materials and direct labor cost per unit to make lampshades are five and six dollars unit to make lampshades are five and six dollars respectively.respectively.

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Exercise 7-5Exercise 7-5

Normal production is 30,000 tables per year.Normal production is 30,000 tables per year. A supplier offers to make the lampshades at a A supplier offers to make the lampshades at a

price of $15.50 per unit.price of $15.50 per unit. If XYZ accepts the suppliers offer, all variable If XYZ accepts the suppliers offer, all variable

costs will be eliminated, but the $45,000 of fixed costs will be eliminated, but the $45,000 of fixed manufacturing overhead currently charge to manufacturing overhead currently charge to lampshades will have to be absorbed by other lampshades will have to be absorbed by other products.products.

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Exercise 7-5Exercise 7-5

Prepare the incremental analysis for the Prepare the incremental analysis for the decision to make her by the lampshades.decision to make her by the lampshades.

Make BuyNet Income

Increase(Decrease)

Direct materials (30,000 X $5.00)Direct labor (30,000 X $6.00)Variable manufacturing costs  ($180,000 X 70%)Fixed manufacturing costsPurchase price (30,000 X $15.50)

Total annual cost

$150,000 180,000 126,000  45,000       0$501,000

$      0       0       0  45,000 465,000$510,000

$ 150,000180,000126,000       0

( (465,000)($ (9,000)

In this case the fixed cost is not relevant sinceit is not change one alternative to the next.

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Exercise 7-5Exercise 7-5

Prepare the incremental analysis for the Prepare the incremental analysis for the decision to make her by the lampshades.decision to make her by the lampshades.

Make BuyNet Income

Increase(Decrease)

Direct materials (30,000 X $5.00)Direct labor (30,000 X $6.00)Variable manufacturing costs  ($180,000 X 70%)Fixed manufacturing costsPurchase price (30,000 X $15.50)

Total annual cost

$150,000 180,000 126,000  45,000       0$501,000

$      0       0       0  45,000 465,000$510,000

$ 150,000180,000126,000       0

( (465,000)($ (9,000)

They should not purchase the lampshadesSince doing so will decrease net income by $9,000.

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Exercise 7-5Exercise 7-5

Prepare the incremental analysis for the Prepare the incremental analysis for the decision to make her by the lampshades.decision to make her by the lampshades.

Make BuyNet Income

Increase(Decrease)

Direct materials (30,000 X $5.00)Direct labor (30,000 X $6.00)Variable manufacturing costs  ($180,000 X 70%)Fixed manufacturing costsPurchase price (30,000 X $15.50)

Total annual cost

$150,000 180,000 126,000  45,000       0$501,000

$      0       0       0  45,000 465,000$510,000

$ 150,000180,000126,000       0

( (465,000)($ (9,000)

Would your answer be different if the productive capacity released by not making the lampshades could be used to produce income of $35,000?

Of course, by purchasing the lampshades they would then save $26,000.

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Exercise 7-6Exercise 7-6

XYZ has recently started to manufacture a XYZ has recently started to manufacture a product.product.

The cost structure to manufacture 20,000 units is The cost structure to manufacture 20,000 units is as follows.as follows. Direct materials ($40 per unit) $80,000Direct materials ($40 per unit) $80,000 Direct labor ($30) $600,000Direct labor ($30) $600,000 Variable labor ($6) hundred and $20,000Variable labor ($6) hundred and $20,000 Allocated fixed overhead ($25) $500,000Allocated fixed overhead ($25) $500,000 Total costs $2,020,000Total costs $2,020,000

XYZ is approached by ABC which offers to make XYZ is approached by ABC which offers to make the product for $90 per unit or $1,800,000.the product for $90 per unit or $1,800,000.

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Exercise 7-6Exercise 7-6

Using incremental analysis, determine rather Using incremental analysis, determine rather XYZ should accept the offer under each of the XYZ should accept the offer under each of the following independent assumptions.following independent assumptions.

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Exercise 7-6Exercise 7-6

Assume that $300,000 of the fixed overhead Assume that $300,000 of the fixed overhead costs can be reduced or avoided.costs can be reduced or avoided.

     Make           Buy      

Net Income Increase

  (Decrease)  Direct materials $ 800,000 $ -0-  $ 800,000

Direct labor 600,000 -0-  600,000

Variable overhead 120,000 -0-  120,000

Fixed overhead 500,000 200,000 300,000

Purchase price 0 1,800,000 (1,800,000)

Total annual cost $2,020,000 $2,000,000 $ 20,000

Accept the order!

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Exercise 7-6Exercise 7-6

Assume that none of the fixed overhead can be avoided.Assume that none of the fixed overhead can be avoided. However, if the products are purchased from ABC, XYZ can use the However, if the products are purchased from ABC, XYZ can use the

release productive resources to generate additional income of release productive resources to generate additional income of $300,000.$300,000.

(2)

     Make          Buy     

Net Income Increase

 (Decrease) Direct materials $ 800,000 $ 0 $ 800,000Direct labor 600,000 0 600,000Variable overhead 120,000 0 120,000Fixed overhead 500,000 500,000 0Opportunity cost 300,000 0 300,000Purchase price 0 1,800,000 (1,800,000)

Totals $2,320,000 $2,300,000 $ 20,000

Here the author shows the revenue as a negative (opportunity) cost which isthe same as a revenue.

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Exercise 7-6Exercise 7-6

Describes the qualitative factors that might Describes the qualitative factors that might affect the decision to purchase the product from affect the decision to purchase the product from an outside supplier.an outside supplier.

Qualitative factors include the possibility of Qualitative factors include the possibility of laying off those employees that produced the laying off those employees that produced the robot and the resulting poor morale of the robot and the resulting poor morale of the remaining employees, maintaining quality remaining employees, maintaining quality standards, and controlling the purchase price in standards, and controlling the purchase price in the future.the future.

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Exercise 7-11Exercise 7-11

XYZ Enterprises uses a computer to handle its XYZ Enterprises uses a computer to handle its sales invoices.sales invoices.

Lately, businesses has been so good that it Lately, businesses has been so good that it takes an extra three hours per night, plus every takes an extra three hours per night, plus every third Saturday, to keep up with the volume of third Saturday, to keep up with the volume of sales invoices.sales invoices.

Management is considering updating its Management is considering updating its computer with a faster model that would computer with a faster model that would eliminate all of the overtime processing.eliminate all of the overtime processing.

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Exercise 7-11Exercise 7-11

Current Machine New Machine

Original purchase cost $15,000 $25,000

Accumulated depreciation $6,000 $0

Estimated annual operating costs $24,000 $18,000

Useful life Five years Five years

If sold now, the current machine would have a salvage value of $5,000. If operated for the remainder of its useful life, the current machine would have a zero salvage value. The new machine is expected to have zero salvage value after five years.

Should the current machine be replaced?

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Exercise 7-11Exercise 7-11

RetainMachine

ReplaceMachine

Net IncomeIncrease

(Decrease)

Operating costsNew machine costSalvage value (old)

Total

$120,000       0       0

$120,000

 (1) ($ 90,000)(  25,000)(   (5,000)($110,000)

(2) ( $ 30,000( (25,000)(   5,000)($ 10,000)

(1) $24,000 X 5.(2) $18,000 X 5.

There are a number of formats one could use in doing this analysis, here the author chooses to make the far right column show the impact the change would have on operating income. He arbitrarily decides to make a positive impact a positive number and a negative impact a negative number.

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Exercise 7-11Exercise 7-11

RetainMachine

ReplaceMachine

Net IncomeIncrease

(Decrease)

Operating costsNew machine costSalvage value (old)

Total

$120,000       0       0

$120,000

 (1) ($ 90,000)(  25,000)(   (5,000)($110,000)

(2) ( $ 30,000( (25,000)(   5,000)($ 10,000)

(1) $24,000 X 5.(2) $18,000 X 5.

The current machine should be replaced. The incremental analysis shows the net income for the five-year period will be $10,000 higher by replacing the current machine.

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Problem 5Problem 5

Lewis Manufacturing Company has four Lewis Manufacturing Company has four operating divisions.operating divisions.

During the first quarter of 2008, the company During the first quarter of 2008, the company reported aggregate income from operations of reported aggregate income from operations of $176,000 and the following divisional results.$176,000 and the following divisional results.

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Problem 5Problem 5

Divisions

One Two Three Four

Sales $250,000 $200,000 $500,000 $400,000

COGS 200,000 189,000 300,000 250,000

S & A Expense

65,000 60,000 60,000 50,000

Income (loss) -$15,000 -$49,000 $140,000 $100,000

Analysis reveals the following percentages of variable costs in each division.

Divisions

One Two Three Four

COGS 70% 90% 80% 75%

S&A Exp. 40% 70% 50% 60%

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Problem 5Problem 5

Discontinuance of any division would save 50% Discontinuance of any division would save 50% of the fixed costs and expenses for that division.of the fixed costs and expenses for that division.

Top management is very concerned about the Top management is very concerned about the unprofitable divisions (one and two).unprofitable divisions (one and two).

Consensus is that one or both of the division Consensus is that one or both of the division should be discontinued. should be discontinued.

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Problem 5Problem 5

Compute the contribution margin for divisions Compute the contribution margin for divisions one and two.one and two.

Division I Division II

SalesVariable costs

Cost of goods soldSelling and administrative

Total variable expensesContribution margin

$250,000 140,000  26,000 166,000

($ 84,000)

$200,000 170,100  42,000 212,100$ (12,100)

Contribution margin is what is available to pay fixed costs. Eliminating Division II gives us a negative contribution margin.

However, if we can decrease fixed cost below $12,100, the elimination would still be a good idea.

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Problem 5Problem 5

Prepare an incremental analysis concerning the Prepare an incremental analysis concerning the possible discontinuance of Division I and possible discontinuance of Division I and Division II.Division II.

(1)

Division I Continue EliminateNet Income

Increase(Decrease)

Contribution margin (above)Fixed costs

Cost of goods soldSelling and administrative

Total fixed expensesIncome (loss) from operations

$(84,000) (60,000) (39,000) (99,000)$(15,000)

$(     0) (30,000) (19,500) (49,500)$(49,500)

$(84,000)  30,000  19,500  49,500

$(34,500)

Eliminating Division One would reduce income by $34,500 – not a good idea!

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Problem 5Problem 5

Division II Continue EliminateNet Income

Increase(Decrease)

Contribution margin (above)Fixed costs

Cost of goods soldSelling and administrative

Total fixed expensesIncome (loss) from operations

$(12,100)(18,900

(  18,000(  36,900

$(49,000)

$(     0) ( 9,450) ( 9,000) (18,450)$(18,450)

$12,100 ( 9,450 ( 9,000 18,450$30,550

Division II should be eliminated as income from operations would increase by $30,500 by so doing.

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The EndThe End