Managerial Accounting Weygandt, Kieso, & Kimmel Prepared by Karleen Nordquist. . The College of St. Benedict. . . and St. John’s University. . . with contributions by Marianne Bradford. . The University of Tennessee. . . Gregory K. Lowry…. Macon Technical Institute…. . John Wiley & Sons, Inc.
Chapter 9 § Incremental Analysis
Chapter 9 Incremental Analysis After studying this chapter, you should be able to: 1 Identify the steps in management’s decision-making process. 2 Describe the concept of incremental analysis. 3 Identify the relevant costs in accepting an order at a special price. 4 Indicate the relevant costs in a make-or-buy decision. 5 Give the decision rule in deciding whether to sell or process materials further.
Chapter 9 Incremental Analysis After studying this chapter, you should be able to: 6 Identify the factors to be considered in retaining or replacing equipment. 7 Explain the factors that are relevant in deciding whether to eliminate an unprofitable segment. 8 Explain the term “sales mix” and its effects in determining break-even sales. 9 Determine sales mix when a company has limited resources.
Preview of Chapter 9 Decision-Making Process • Incremental Analysis Approach • How Incremental Analysis Works INCREMENTAL ANALYSIS Types of Incremental Analysis • Accept an Order at a Special Price • Make or Buy • Sell or Process Further • Retain or Replace Equipment • Eliminate an Unprofitable Segment
Preview of Chapter 9 Sales Mix • Break-even Sales • Limited Resources INCREMENTAL ANALYSIS Other Considerations • Qualitative Factors • Incremental Analysis and ABC
Study Objective 1 Identify the steps in management’s decision-making process.
Management’s Decision. Making Process Management’s decision-making process frequently involves the following steps: 1 Identify the problem and assign responsibility. 2 Determine and evaluate possible courses of action. 3 Make a decision. 4 Review results of the decision.
Management’s Decision. Making Process § In making decisions, management ordinarily considers both financial and nonfinancial information. § Although nonfinancial information can be as important as, and in some cases more important than, financial information, the following discussion will primarily be limited to financial information that is relevant to decisions since that is the kind of information accounting usually provides (primarily in steps 2 and 4).
Study Objective 2 Describe the concept of incremental analysis.
Incremental Analysis § Business decisions involve a choice among alternative courses of action. § The process used to identify the financial data that change under alternative courses of action is called incremental analysis. § In some cases, both costs and revenues will change under alternative choices. In other cases only costs or revenues will vary. § It is important to recognize that – variable costs may not change under the alternatives, and – fixed costs may change.
Incremental Analysis § Incremental analysis involves not only identifying relevant revenues and costs, but also determining the probable effects of decisions on future earnings. § Data for incremental analysis often involves estimates and uncertainty. § Gathering data may involve market analysts, engineers, and accountants.
How Incremental Analysis Works The basic approach in incremental analysis is illustrated in the following illustration: Revenues Costs Net income Alternative A $125, 000 100, 000 $ 25, 000 Alternative B $110, 000 80, 000 $ 30, 000 Net Income Increase (Decrease) $(15, 000) 20, 000 $ 5, 000 Illustration 9 -2 In this illustration, alternative B is being compared with alternative A. The net income column shows the differences between the alternatives. Alternative B will produce $5, 000 more net income than alternative A.
Key Cost Concepts in Incremental Analysis Three important cost concepts used in incremental analysis follow: § In incremental analysis, the only factors to be considered are those costs and revenues that differ across alternatives. Those factors are called relevant. Costs and revenues that do not differ across alternatives can be ignored when trying to chose between alternatives.
Key Cost Concepts in Incremental Analysis § Often in choosing one course of action, the company must give up the opportunity to benefit from some other course of action. This lost benefit is referred to as opportunity cost. § Costs that have already been incurred and will not be changed or avoided by any future decision are referred to as sunk costs. Sunk costs are not relevant costs.
Types of Incremental Analysis A number of different types of decisions involve incremental analysis. The more common types of decisions are whether to: § Accept an order at a special price. § Make or buy component parts or finished products. § Sell products or process them further. § Retain or replace equipment. § Eliminate an unprofitable business segment.
Study Objective 3 Identify the relevant costs in accepting an order at a special price.
Accept an Order at a Special Price § Sometimes a company may have an opportunity to obtain additional business if it is willing to make major price concessions to a specific customer. § An order at a special price should be accepted when the incremental revenue from the order exceeds the incremental costs. § It is assumed that sales in other markets will not be affected by the special order. If other sales were affected, the lost sales would have to be considered in making the decision. § If the units can be produced within existing plant capacity, generally only variable costs will be affected.
Accept an Order at a Special Price To illustrate, assume that Sunbelt Company produces 100, 000 automatic blenders per month, which is 80% of plant capacity. Variable manufacturing costs are $8 per unit, and fixed manufacturing costs are $400, 000, or $4 per unit. The blenders are normally sold to retailers at $20 each. Question: Sunbelt has an offer from Mexico Co. to purchase an additional 2, 000 blenders at $11 per unit. Acceptance of this offer would not affect normal sales of the product, and the additional units can be manufactured without increasing plant capacity.
Accept an Order at a Special Price: Incremental Analysis If management makes its decision on the basis of total cost per unit of $12 ($8 + $4), the order would be rejected, because costs ($12) would exceed revenues ($11) by $1 per unit. However, since the units can be produced within existing plant capacity, the special order will not increase fixed costs. The relevant data for the decision, therefore, are the variable manufacturing costs per unit of $8 and the expected revenue of $11 per unit. Revenues Costs Net income Reject Order $ -0 -0$ -0 - Accept Order $22, 000 16, 000 $ 6, 000 Net Income Increase (Decrease) $ 22, 000 (16, 000) $ 6, 000 Illustration 9 -4 Decision: Sunbelt will increase its net income by $6, 000 when accepting this special order.
Study Objective 4 Indicate the relevant costs in a make -or-buy decision.
Make or Buy § When a manufacturer assembles component parts in producing a finished product, management must decide whether to make or buy the components. § This is often referred to as an outsourcing decision. § If there is an opportunity to use the productive capacity for another purpose, opportunity costs should be considered. § The decision to make or buy components should be made on the basis of incremental analysis.
Make or Buy Assume that Baron Co. incurs the following annual costs in producing 25, 000 ignition switches for motor scooters. Direct materials Direct labor Variable manufacturing overhead Fixed manufacturing overhead Total manufacturing costs Total cost per unit ($225, 000 25, 000) $ 50, 000 75, 000 40, 000 60, 000 $225, 000 $9. 00 Alternatively, Baron may purchase the ignition switches from Ignition, Inc. , at a price of $8 per unit. Question: Should Baron make or buy the ignition switches?
Make or Buy: Incremental Analysis At first glance, it appears that management should buy the switches for $8 instead of make for $9. However, a review of operations indicates that if the switches are purchased all of Baron’s variable costs, but only $10, 000 of its fixed manufacturing costs, will be eliminated. Thus, $50, 000 of fixed costs will remain. The incremental costs are: Illustration 9 -6 Direct materials Direct labor Variable manufacturing costs Fixed manufacturing costs Purchase price Total annual cost Make Buy $ 50, 000 $ - 0 75, 000 -040, 000 -060, 000 50, 000 -0200, 000 $225, 000 $250, 000 Net Income Increase (Decrease) $ 50, 000 75, 000 40, 000 10, 000 (200, 000) $ (25, 000) Decision: Barton Company will incur $25, 000 of additional costs by buying the switches. Therefore, Barton should continue to make the switches.
Make or Buy with Opportunity Cost: Incremental Analysis Assume that through buying the switches, Baron Co. can use the released productive capacity to generate additional income of $28, 000. This lost income is an additional cost of continuing to make the switches in the make-or-buy decision. This opportunity cost is added to the “Make” column, for comparison. Illustration 9 -7 Total annual cost Opportunity cost Total cost Make Buy $225, 000 $250, 000 28, 000 -0$225, 000 $250, 000 Net Income Increase (Decrease) $(25, 000) 28, 000 $ 3, 000 Decision: It is now advantageous to buy the switches. Barton will save $3, 000 worth of costs with this alternative.
Study Objective 5 Give the decision rule in deciding whether to sell or process materials further.
Sell or Process Further § Many manufacturers have the option of selling products at a given point in the production cycle or continuing to process with the expectation of selling them at a higher price. § The sell-or-process further decision should be made on the basis of incremental analysis. § The basic decision rule in a sell or process further decision is: Process further as long as the incremental revenue from such processing exceeds the incremental processing costs.
Sell or Process Further Assume that Woodmasters, Inc. makes tables. The cost to manufacture an unfinished table is $35, computed as follows: Direct materials Direct labor Variable manufacturing overhead Fixed manufacturing overhead Total manufacturing costs $ 15 10 6 4 $35 The selling price per unfinished unit is $50. Woodmasters currently has unused productive capacity that is expected to continue indefinitely and can be used to finish the tables and sell them for $60 each. For a finished table direct materials and direct labor costs will increase $2 and $4, respectively. Variable overhead will increase by $2. 40 (60% of direct labor). There will be no increase in fixed overhead. Question: Should Woodmasters sell the unfinished tables or process them further?
Sell-or Process Further: Incremental Analysis The incremental analysis on a per unit basis is as follows: Illustration 9 -9 Sales per unit Cost per unit Direct materials Direct labor Variable manufacturing overhead Fixed manufacturing overhead Total Net income per unit Sell $50. 00 Process Further $60. 00 Net Income Increase (Decrease) $10. 00 15. 00 10. 00 6. 00 4. 00 $35. 00 $15. 00 17. 00 14. 00 8. 40 4. 00 $43. 40 $16. 60 (2. 00) (4. 00) (2. 40) -0$(8. 40) $ 1. 60 Decision: It would be advantageous for Woodmasters to process the tables further. In this case, the per unit incremental revenue of $10. 00 from the additional processing is $1. 60 higher than the per unit incremental processing costs of $8. 40.
Study Objective 6 Identify the factors to be considered in retaining or replacing equipment.
Retain or Replace Equipment § Management often has to decide whether to continue using an asset or replace it. § In a decision to retain or replace equipment, management compares the costs which are affected by the two alternatives. Generally, these are variable manufacturing costs and the cost of the new equipment. § The book value of the old machine is a sunk cost which is a cost that cannot be changed by any present or future decision. Sunk costs are not relevant in incremental analysis. § Any trade-in allowance or cash disposal value of the existing asset is relevant, however.
Retain or Replace Equipment Assume that Jeffcoat Company has a factory machine with a book value of $40, 000 and a remaining useful life of four years. A new machine is available that costs $120, 000 and is expected to have zero salvage value at the end of its 4 -year useful life. If the new machine is acquired, variable manufacturing costs are expected to decrease from $160, 000 to $125, 000 annually and the old unit will be scrapped. Question: Should Jeffcoat Company retain or replace the machine?
Retain or Replace: Incremental Analysis The incremental analysis for the 4 -year period is as follows: Variable manufacturing costs New machine cost Total years x $160, 000) b(4 years x $125, 000) Retain $640, 000 a $640, 000 Replace $500, 000 b 120, 000 $620, 000 Net Income Increase (Decrease) $140, 000 (120, 000) $ 20, 000 a(4 Illustration 9 -10 Decision: In this case, it would be to the company’s advantage to replace the equipment. The lower variable manufacturing costs due to replacement more than offset the cost of the new equipment.
Study Objective 7 Explain the factors that are relevant in deciding whether to eliminate an unprofitable segment.
Eliminate an Unprofitable Segment § Management sometimes needs to decide whether to eliminate an unprofitable business segment. § Again, the key is to focus on the data that change under the alternative courses of action. § Often fixed costs allocated to the unprofitable segment must be absorbed by the other segments. It is possible, therefore, for net income to decrease when an unprofitable segment is eliminated. § In deciding whether to eliminate an unprofitable segment, management should choose the alternative which results in the highest net income for the company as a whole.
Eliminate an Unprofitable Segment Assume that Martina Company manufactures tennis racquets in three models: Pro, Master, and Champ. Pro and Master are profitable lines, whereas Champ operates at a loss. Condensed income statement data are: Sales Variable expenses Contribution margin Fixed expenses Net income Pro $800, 000 520, 000 280, 000 $200, 000 Master $300, 000 210, 000 90, 000 50, 000 $ 40, 000 Champ $100, 000 90, 000 10, 000 30, 000 $(20, 000) Total $1, 200, 000 820, 000 380, 000 160, 000 $ 220, 000 Question: Should the Champ segment be eliminated?
Eliminate an Unprofitable Segment Although it appears that income would increase if the Champ line was discontinued, it is possible for income to decrease if Champ was discontinued. The reason is that the fixed expense allocated to Champ will have to be absorbed by the other products. To illustrate, assume that the $30, 000 of fixed costs are allocated 2/3 to Pro and 1/3 to Master. The revised income statement data is: Sales Variable expenses Contribution margin Fixed expenses Net income Pro $800, 000 520, 000 280, 000 100, 000 $200, 000 Master Total $300, 000 $1, 100, 000 210, 000 730, 000 90, 000 370, 000 60, 000 160, 000 $ 40, 000 $ 210, 000 Decision: Total net income has decreased $10, 000 ($220, 000 – $210, 000).
Unprofitable Segment: Incremental Analysis This result is also obtained in the following incremental analysis: Illustration 9 -13 Sales Variable expenses Contribution margin Fixed expenses Net income Continue $100, 000 90, 000 10, 000 30, 000 $(20, 000) Eliminate $ -0 -0 -030, 000 $ 30, 000) Net Income Increase (Decrease $(100, 000) 90, 000 (10, 000) -0$ (10, 000) Decision: Once again, total net income has decreased $10, 000 ($220, 000 – $210, 000). This corresponds to the Champ segment’s contribution margin. Thus, management should not discontinue the Champ segment unless other lines can recover some or all of the sales/contribution margin lost by the discontinued segment.
Study Objective 8 Explain the term “sales mix” and its effects in determining break-even sales.
Sales Mix § One of the assumptions of CVP analysis (discussed in Chapter 5) is that if more than one product is involved, the sales mix of the products remains constant. § Sales mix is the relative combination in which a company’s products are sold. § For example, if 4 chairs are sold with each table, the sales mix of chairs to tables is 4: 1.
Break-Even Sales Break-even sales can be computed for a mix of two or more products by determining the weighted average unit contribution margin of all the products. § To illustrate, assume that Vargo Video sells both VCRs and TVs at the following per unit data: Unit Data Selling price Variable costs Contribution margin Sales mix VCRs $500 300 $200 TVs $800 400 $400 3 1 Illustration 9 -14
Break-Even Sales § The total contribution margin for the sales mix of 3 VCRs to 1 TV is $1, 000, computed as follows: [($200 x 3) + ($400 x 1)] = $1, 000 § The weighted average unit contribution margin, which is total CM divided by the number of units in the sales mix is $250, computed as follows: $1, 000/4 units = $250
Break-Even Formula: Sales Mix Then use the weighted average unit contribution margin to compute break-even sales as follows: § Assume Vargo Video has $200, 000 of fixed costs. Fixed Costs $200, 000 Weighted Average Unit Contribution Margin = Break-even Point in Units $250 = 800 units
Break-Even Sales § Note that with a sales mix of 3: 1, ¾ of the units sold will be VCRs and ¼ will be TVs. Therefore, in order to break even, Vargo Video must sell 600 VCRs (¾ x 800) and 200 TVs (¼ x 800). This can be verified by the following: Product VCRs TVs Unit Sales 600 200 800 x x x Unit CM $200 400 = = = Total CM $120, 000 80, 000 $200, 000 Illustration 9 -16 Management should continually review the company’s sales mix. At any level of units sold, net income will be greater if more high CM units are sold than low CM units.
Study Objective 9 Determine sales mix when a company has limited resources.
Limited Resources § When a company has limited resources (floor space, raw materials, or machine hours), management must decide which products to make and sell in order to maximize net income. § In an allocation of limited resources decision, it is necessary to find the contribution margin per unit of limited resource. § This is obtained by dividing the contribution margin per unit of each product by the number of units of the limited resource required for each product. § Production should be geared to the product with the highest contribution margin per unit of limited resource.
Limited Resources Assume that Collins Co. manufactures deluxe and standard pen and pencil sets. The limited resource is machine capacity, which is 3, 600 hours per month. Relevant data consists of: Contribution margin per unit Machine hours required per unit Deluxe $8. 4 Standard $6. 2 Question: Should Collins Co. shift its sales mix toward deluxe or standard sets?
Limited Resources Based on the previous data, it might appear that deluxe is more profitable since they have a higher contribution margin. However, standard sets take fewer machine hours. Therefore, it is necessary to find the contribution margin per unit of limited resource, as shown below: Contribution margin per unit (a) Machine hours required per unit (b) Contribution margin per unit of limited resource (a b) Deluxe $8. 4 Standard $6. 2 $20 $30 Decision: Since the standard set has the higher contribution margin per unit of limited resource, sales mix should shift towards that product.
Limited Resources: Incremental Analysis This result is confirmed by the following incremental analysis: Illustration 9 -19 Machine hours (a) Contribution margin per unit of limited resource (b) Contribution margin (a x b) If Produce Deluxe Sets 600 $20 $12, 000 If Produce Standard Sets 600 $30 $18, 000 Decision: Once again, it is clear that standard sets produce more contribution margin. Thus, given adequate demand for standard sets, the sales mix should shift to that product in order to maximize Collins Company’s income.
Other Considerations in Decision Making § In this chapter, the focus was primarily on the quantitative (those attributes that can be easily expressed in terms of numbers) factors that affect a decision. § Many of the decisions involving incremental analysis have important qualitative features that, while not easily measured, should not be ignored.
Other Considerations in Decision Making § It was noted in Chapter 4 that many companies have shifted to activitybased costing (ABC) to allocate overhead costs to products. § The concepts presented in this chapter are completely consistent with the use of ABC. In fact, ABC will result in better identification of relevant costs, and therefore, better incremental analysis.
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Chapter 9 Incremental Analysis
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