lesson fa-20-060-01 incremental analysis accept or...

File: FA-20-060-01-Workbook.pdf

Title: Managerial Acctng – Incremental Analysis – Part 1 – Accept or Reject a Special Order

_____________________________________________________________________________________________ Copyright 2011 by Rocky Spears Enterprises LLC, All Rights Reserved of 14 videos for this lesson are available at evideolearner.com Revised: 2011-05-24

Lesson FA-20-060-01

Incremental Analysis

Part 1 – Accept or Reject a Special Order

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Copyright 2011 by Rocky Spears Enterprises LLC, All Rights Reserved of 14 videos for this lesson are available at evideolearner.com Revised: 2011-05-24

Incremental Analysis – Part 1 – Accept or Reject a Special

Order

[Clip 01] Incremental Analysis Concepts

Pre-Requisites

Before watching this video, you should understand the concepts covered in video

lesson FA-20-010-xx on Managerial Cost Concepts, and video lesson FA-20-050-xx

on Cost Volume Profit Analysis

In particular you should understand the manufacturing cost classifications of

direct materials, direct labor, and manufacturing overhead, and the cost behavior

classifications of variable and fixed costs.

Objectives

The primary objectives of this lesson are:

Understand concepts related to short term, or incremental, decisions.

Illustrate common situations in which short term decision principles may be applied.




Incremental Analysis

Incremental Analysis is a general term usually applied to the process of

determining relevant revenue and cost information for making short term

decisions

The basic approach involves:

o identifying the revenue and cost factors associated with two or more

choices for a decision

o selecting from these revenue and cost factors those that are relevant

to the decision given the time frame for the decision

o evaluating the relevant revenue and cost factors to determine the

relative impact of each choice on net income and/or total costs

o choosing the alternative that gives the highest net income or the

lowest total cost as appropriate

Incremental Analysis Scenarios

We usually find it helpful to think about incremental analysis in terms of

“scenarios”

There are five common scenarios in which we can apply incremental analysis

principles:

o Accept or Reject a Special Order Decision

o Make or Buy Decision (Insource or Outsource)

o Continue or Discontinue a Business Segment Decision

o Sell now or Process Further (and Sell later) Decision

o Retain or Replace Decision

We will discuss each of these scenarios and the important considerations

with regard to incremental revenue and incremental cost

Before discussing the scenarios, let’s establish the basic cost concepts that

will apply to these scenarios.




Incremental Analysis Cost Factors

Relevant revenue or cost – is one which differs among the decision

alternatives and has characteristics that make it relevant

Opportunity cost – is the implied cost associated with passing up a benefit of

one decision alternative by making an alternate decision

Sunk cost – is a cost which has been incurred in the past and is not relevant

to a future decision

Direct fixed cost – is a cost which can be directly associated with a product,

service, or activity

o Direct fixed costs are usually relevant unless they are sunk costs

Indirect fixed cost – is a fixed cost which cannot be directly associated

with a product, service, or activity, and thus is allocated using a set of rules

or assumptions

o Are usually not relevant to a short-term decision

As we discuss each scenario for incremental analysis, keep in mind the three cost

concepts here.

In particular, keep in mind that fixed costs are fixed in total in the short run, and

thus are often not relevant to a short term decision.

In cases where a fixed cost is relevant to a short-term decision, sometimes we

have to differentiate between direct and indirect fixed costs since indirect fixed

costs are usually not relevant, but direct fixed costs may be relevant.




Accept or Reject an Order at a Special Price

The first scenario we want to study is the “accept an order at a special

price” decision.

The basic scenario is one in which a buyer approaches our company and asks

for a special price lower than our normal price.

The question then is whether it is worthwhile to take the special order and

grant the special price.

In this scenario, we will want to consider the incremental revenue from

making the sale at the special price versus the revenue from not making the

sale; and the incremental costs from making the sale versus not making the

sale.

Since we typically have both revenue and costs to consider, our interest is in

evaluating the incremental effect on net income of accepting the special

order.




[Clip 02] Example 1 - Accept a Special Order Decision - Rochester Travel

Products - Case 1

Example 1. Rochester Travel Products – Case 1

Rochester Travel Products produces and sells a flight bag designed to allow the

traveler to conveniently complete the inspection and boarding process and to fit

neatly under the seat in most aircraft. In the current year, the company expects

to incur $600,000 in fixed costs ($12.00 per flight bag) and $400,000 in variable

costs ($8.00 per flight bag) in producing 50,000 flight bags while operating at 80%

capacity.

The company currently has orders from retailers in the United States for their

total year’s planned production at a price $25 each. A retailer in Bulgaria

approaches the sales manager of Rochester Travel Products and offers to buy

10,000 flight bags, but is willing to pay only $15.00 each including shipping. The

special order will add $2.00 per flight bag in special shipping costs to Bulgaria.

Sale of the flight bags to the Bulgarian retailer is not expected to affect

Rochester’s normal sales.

Should the sales manager accept the special order?

(see Appendix 1 for the Solution)

Summary of the facts:

Operating at 80% capacity, the company plans to produce and sell 50,000

flight bags at $25 each costing:

o $600,000 in fixed costs ($12.00 per flight bag)

o $400,000 in variable costs ($8.00 per flight bag)

The special order of 10,000 flight bags will add $2.00 per flight bag in

shipping costs and will yield $15.00 per bag in revenue.







Special Order Decision Worksheet

Reject the

Special order

Accept the

Special Order

Change in

Revenue,

Costs, and Net

Income

Revenue

Costs:

Fixed Costs

Variable Costs

Special Shipping

Net Income



(alternate incremental approach)

Reject the

Special order

Accept the

Special Order

Change in

Revenue,

Costs, and Net

Income

Revenue

Costs:

Fixed Costs

Variable Costs

Special Shipping

Net Income


Products - Case 2





Suppose all of the assumptions are the same as described, but in addition:

Rochester Travel Products is operating at 100% capacity and accepting the special

order would require installing an additional machine in the factory which could be

leased for $5,000 for the length of time needed to produce the additional 10,000

flight bags.

In addition, workers would be needed at overtime pay adding $2.00 per flight bag

for the additional 10,000 flight bags.












Leasing of an additional machine to meet production of the special order will

cost $5000.

Employing workers at overtime pay will add $2.00 per flight bag for the

additional flight bags.






Reject the

Special order

Accept the

Special Order

Change in

Revenue,

Costs, and Net

Income

Revenue

Costs:

Fixed Costs

Variable Costs

Special Shipping

Net Income



(alternate incremental approach)

Reject the

Special order

Accept the

Special Order

Change in

Revenue,

Costs, and Net

Income

Revenue

Costs:

Fixed Costs

Variable Costs

Special Shipping

Net Income





Products - Case 3


Suppose all of the assumptions are the same as described in case 1 and case 2, but

in addition:

Suppose the Bulgarian retailer has an online store and there is a high

probability that 5,000 of the flight bags will be sold to retail customers in

the United States and that Rochester’s normal retailers will likely have to

cut back their orders by 5,000 flight bags



Hint: Use the approach where you cost out the total revenue and total costs for

each relevant item.








Leasing of an additional machine to meet production of the special order will

cost $5000.

Employing workers at overtime pay will add $2.00 per flight bag for the

additional flight bags.

The special order will likely reduce normal sales by 5,000 units.






Reject the

Special order

Accept the

Special Order

Change in

Revenue,

Costs, and Net

Income

Revenue

Costs:

Fixed Costs

Variable Costs

Special Shipping

Net Income




APPENDIX 1 – SOLUTIONS

Incremental Analysis – Part 1 – Accept or Reject a Special

Order

[Clip 02] Example 1 - Accept a Special Order Decision - Rochester Travel Products - Case 1

SOLUTION:





SOLUTION:

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