Download - Chapter 7-1 Welcome to Seminar #5 Chapter 7. Chapter 7-2 CHAPTER 7 INCREMENTAL ANALYSIS INCREMENTAL ANALYSIS Managerial Accounting, Fifth Edition

Chapter 7-1

Welcome to Seminar #5Welcome to Seminar #5

Chapter 7Chapter 7

Chapter 7-2

CHAPTER CHAPTER 77

INCREMENTAL INCREMENTAL ANALYSISANALYSIS

Managerial Accounting, Fifth Edition

Chapter 7-3

Study ObjectivesStudy ObjectivesStudy ObjectivesStudy Objectives

1. Identify the steps in management’s decision-making process.

2. Describe the concept of incremental analysis.

3.3. Identify the relevant Identify the relevant costs in accepting an costs in accepting an order at a special price.order at a special price.

4.4. Identify the relevant Identify the relevant costs in a make-or-buy costs in a make-or-buy decision.decision.

Chapter 7-4

Study ObjectivesStudy ObjectivesStudy ObjectivesStudy Objectives

5. Identify the relevant costs in determining whether to sell or process materials further.

6.6. Identify the relevant Identify the relevant costs to be considered in costs to be considered in retaining or replacing retaining or replacing equipment.equipment.

7.7. Identify the relevant Identify the relevant costs in deciding whether costs in deciding whether to eliminate an to eliminate an unprofitable segment.unprofitable segment.

Chapter 7-5

Preview of ChapterPreview of ChapterPreview of ChapterPreview of Chapter

An important purpose of management An important purpose of management accounting is to provide managers with accounting is to provide managers with relevant information for decision making.relevant information for decision making.

All companies must make product decisions – All companies must make product decisions – to cut prices to increase market share, to to cut prices to increase market share, to produce a higher priced product, to change produce a higher priced product, to change their product mix, etc.their product mix, etc.

Management frequently uses a decision-Management frequently uses a decision-making process called making process called incremental analysis.incremental analysis.

Chapter 7-6

Incremental AnalysisIncremental AnalysisIncremental AnalysisIncremental Analysis

Management’s Management’s

Decision-Making Decision-Making

ProcessProcess

Management’s Management’s

Decision-Making Decision-Making

ProcessProcess

Other Other

ConsiderationsConsiderations

Other Other

ConsiderationsConsiderations

Incremental analysis Incremental analysis approachapproach

How incremental How incremental analysis worksanalysis works

Qualitative factorsQualitative factors

Incremental analysis Incremental analysis and ABCand ABC

Types of Types of

Incremental Incremental

AnalysisAnalysis

Types of Types of

Incremental Incremental

AnalysisAnalysis

Accept an order at a Accept an order at a special pricespecial price

Make or buyMake or buy

Sell or process furtherSell or process further

Retain or replace Retain or replace equipmentequipment

Eliminate an Eliminate an unprofitable segmentunprofitable segment

Chapter 7-7

Management’s Decision-Making Management’s Decision-Making ProcessProcess

Management’s Decision-Making Management’s Decision-Making ProcessProcess

Decision-making is an important management function that does not always follow a set pattern.Steps in management’s decision-making process:Steps in management’s decision-making process:

Accounting helps management in making decisions by evaluating possible courses of action (step 2) and reviewing results (step 4).

SO 1: Identify the steps in management’s decision-making process.SO 1: Identify the steps in management’s decision-making process.

Illustration 7-1

Chapter 7-8

Management’s Decision-making ProcessManagement’s Decision-making ProcessManagement’s Decision-making ProcessManagement’s Decision-making Process

Both financial and nonfinancial information are considered in decision-making.

Decisions vary in scope, urgency and importance.

Financial information includes revenues and costs as well as their effect on profitability.

Nonfinancial information relates to factors such as: the effect of the decision on employee

turnover, the environment, or company image.

SO 1: Identify the steps in management’s decision-making process.SO 1: Identify the steps in management’s decision-making process.

Chapter 7-9

Incremental Analysis ApproachIncremental Analysis ApproachIncremental Analysis ApproachIncremental Analysis Approach

Decisions involve a choice among alternative courses of action.

Financial data relevant to a decision are the data that vary in the future among alternatives.

Both costs and revenues may vary,orOnly revenues may vary,

orOnly costs may vary.

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

Chapter 7-10

Incremental Analysis Incremental Analysis Incremental Analysis Incremental Analysis

Process used to identify the financial data that change under alternative courses of action.

Identifies the probable effects of decisions on future earnings.

Involves estimates and uncertainty.

Incremental analysis is also called differential analysis because it focuses on differences.


Chapter 7-11

GATHERING DATA MAY INVOLVE:MARKET ANALYSTSENGINEERSACCOUNTANTS

NEED TO PRODUCE THE MOST RELIABLE INFORMATION AVAILABLE AT THE TIME THE DECISION MUST BE MADE.

Incremental Analysis Incremental Analysis Incremental Analysis Incremental Analysis

Chapter 7-12

How Incremental Analysis WorksHow Incremental Analysis WorksHow Incremental Analysis WorksHow Incremental Analysis Works


Illustration 7-2

Comparing alternative B to A, the net income differences between the two are $15,000 with less net income under alternative B. However, a $20,000 incremental cost saving will be realized with alternative B. Thus, alternative B will produce $5,000 more net income than A.

Chapter 7-13

How Incremental Analysis WorksHow Incremental Analysis WorksHow Incremental Analysis WorksHow Incremental Analysis Works

Uses Three Important Cost Concepts:


Illustration 7-3

Chapter 7-14

Incremental analysis is the process of identifying Incremental analysis is the process of identifying the financial data that:the financial data that:

a.a. Do not change under alternative courses of Do not change under alternative courses of actionaction.

b. Change under alternative courses of action.

c. Are mixed under alternative courses of action.

d. No correct answer is given.

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


Chapter 7-15

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

Accept an order at a special price.Accept an order at a special price.

Make or buy components or Make or buy components or finished products.finished products.

Sell products or process further.Sell products or process further.

Retain or replace equipment.Retain or replace equipment.

Eliminate an unprofitable Eliminate an unprofitable business segment.business segment.

Allocate limited resources.Allocate limited resources.


Chapter 7-16

Obtain additional business Obtain additional business by making price concessions by making price concessions to a specific customer.to a specific customer.

Assumes sales of the Assumes sales of the product in other markets product in other markets would not be affected by this would not be affected by this special order.special order.

Assumes company is Assumes company is notnot operating at full capacity.operating at full capacity.

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

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

Chapter 7-17


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.


Chapter 7-18


Within existing capacity, thus no change in fixed costs, so they are not relevant for this decision.Total variable costs change – thus they are relevant.

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

Income increases by $6,000.Accept the Special Order.


Illustration 7-4

Chapter 7-19

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.


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

$18 - $14= $4$4 × 3,000 units =

$12,000

Chapter 7-20

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.

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

Illustration 7-5

Chapter 7-21

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

Switches can be purchased for $8 per switch (25,000 × $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 $10,000 of fixed costs ($ 60,000 -10,000) = $50,000 of fixed cost will remain.


Illustration 7-5

Chapter 7-22

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

The relevant costs for incremental analysis are:

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

Continue to make switches.


Illustration 7-6

Chapter 7-23

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.

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 income is lost.


Chapter 7-24

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

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


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.

Illustration 7-7

Chapter 7-25

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.


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

Chapter 7-26

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 hoping to sell at a higher price.

Decision Rule:

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

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

Chapter 7-27

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 increase.SO 5: Identify the relevant costs in determining whetherSO 5: Identify the relevant costs in determining whether

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

Illustration 7-8

Chapter 7-28


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

Process further.Process further.

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

Illustration 7-9

Chapter 7-29


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 products:

Petroleum – gasoline, lubricating oil, kerosene.

Meat Packing – meat, hides, bones.


Chapter 7-30



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.


Chapter 7-31

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


Marais Creamery must decide whether to:

Sell cream and skim milk now,or

Process each further before selling.


Illustration 7-10

Chapter 7-32

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


The daily cost and revenue data for Marais Creamery are:


Illustration 7-11

Chapter 7-33



Sell cream or process further into cottage cheese?

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


Illustration 7-12

Chapter 7-34


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.


Illustration 7-13

Chapter 7-35

The decision rule in a sell-or-process-further The decision rule in a sell-or-process-further decision is process further as long as the decision is process further as long as the incremental revenue from processing exceeds:incremental revenue from processing exceeds:

a.a. Incremental processing costsIncremental processing costs.

b. Variable processing costs.

c. Fixed processing costs.

d. No correct answer is given.



Chapter 7-36

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 it.Example: Assessment of replacement of a factory

machine:

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

SO 6: Identify the relevant costs to be considered inSO 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 -

Chapter 7-37

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.


Illustration 7-14

Chapter 7-38

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.



Chapter 7-39

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 lost.SO 7: Identify the relevant costs in deciding whetherSO 7: Identify the relevant costs in deciding whether

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

Chapter 7-40

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?

SO 7: Identify the relevant costs in deciding whetherSO 7: Identify the relevant costs in deciding whetherto eliminate an unprofitable segment.to eliminate an unprofitable segment.

Illustration 7-15

Chapter 7-41



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).


Illustration 7-16

Chapter 7-42



Incremental analysis of Champ provides the same results:

Decision: Do not eliminate Champ.


Illustration 7-17

Chapter 7-43

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.


SO 7: Identify the relevant costs in deciding whetherSO 7: Identify the relevant costs in deciding whetherto eliminate an unprofitable segment .to eliminate an unprofitable segment .

Chapter 7-44

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.

Chapter 7-45

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 outof four-year colleges each year.

Chapter 7-46

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?

Chapter 7-47

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

Chapter 7-48

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

Chapter 7-49

QUESTIONS?QUESTIONS?QUESTIONS?QUESTIONS?

Chapter 7-50

Homework Assignment Homework Assignment

Wiley PlusWiley Plus

Be sure to complete the practice Be sure to complete the practice quiz first and then do the quiz first and then do the

homework as this has really helped homework as this has really helped students gain a much better students gain a much better

understanding.understanding.

5 attempts on the homework - FYI5 attempts on the homework - FYI

Download - Chapter 7-1 Welcome to Seminar #5 Chapter 7. Chapter 7-2 CHAPTER 7 INCREMENTAL ANALYSIS INCREMENTAL ANALYSIS Managerial Accounting, Fifth Edition

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