Chapter Three

Incremental Analysis
• Decision making involves a choice between at least
two alternatives.
• Marginal analysis (also known as incremental or
differential analysis) is a method of analysing short-
term decisions.
• The short-term is defined as the lesser of the time
frame over which capacity is fixed, or one year.
 Chapter Three
Incremental Analysis
Lecture 7
Cost classification for decision making:
• Costs are an important feature of many business decisions. In making decisions, it is essential to have a firm
grasp of the concepts differential cost, opportunity cost, and sunk cost.

Cost classification
for decision making

Differential cost Opportunity cost Sunk cost

Differential cost and revenue:
• Decisions involve choosing between alternatives. In business decisions, each alternative will have costs and
benefits that must be compared to the costs and benefits of the other available alternatives. A difference in
costs between any two alternatives is known as a differential cost . A difference in revenues between any two
alternatives is known as differential revenue .
• A differential cost is also known as an incremental cost , although technically an incremental cost should
refer only to an increase in cost from one alternative to another; decreases in cost should be referred to as
decremental costs. Differential cost is a broader term, encompassing both cost increases (incremental costs)
and cost decreases (decremental costs) between alternatives.
• The accountant’s differential cost concept can be compared to the economist’s marginal cost concept. In
speaking of changes in cost and revenue, the economist uses the terms marginal cost and marginal revenue.
The revenue that can be obtained from selling one more unit of product is called marginal revenue, and the
cost involved in producing one more unit of product is called marginal cost. The economist’s marginal
concept is basically the same as the accountant’s differential concept applied to a single unit of output.
Opportunity cost:
Opportunity cost is the potential benefit that is given up when one alternative is selected over another. To
illustrate this important concept, consider the following example:

Example
Steve is employed by a company that pays him a salary of $38,000 per year. He is thinking about leaving the
company and returning to school. Because returning to school would require that he give up his $38,000 salary,
the forgone salary would be an opportunity cost of seeking further education. Opportunity costs are not usually
found in accounting records, but they are costs that must be explicitly considered in every decision a manager
makes. Virtually every alternative involves an opportunity cost.
Sunk cost:
• A sunk cost is a cost that has already been incurred and that cannot be changed by any decision made now or in the
future. Because sunk costs cannot be changed by any decision, they are not differential costs. And because only
differential costs are relevant in a decision, sunk costs can and should be ignored.
• A sunk cost is a cost that has been incurred and cannot be recovered. The money is spent. In accounting, a
sunk cost is a type of irrelevant cost. When facing a potential project or investment, a manager must only consider
relevant costs and ignore all irrelevant cost.
• When a manager is considering a particular decision, relevant costs are the costs that are incurred if the decision is
made and irrelevant costs are the costs that are incurred whether or not the decision is made. A sunk cost is not a
relevant cost for decision making.
• Whether a cost is relevant or irrelevant depends on the decision at hand. A cost may be relevant to one decision and
that same cost may be irrelevant to another decision. A sunk cost, however, is always an irrelevant cost.
• To illustrate a sunk cost, assume that a restaurant owner is considering expanding his restaurant into a chain. He
spends $10,000 on market research, and using that research determine that opening a new location in a specific area
isn't likely to be profitable. He doesn't move forward with the expansion, and that $10,000 is a sunk cost.
• Decision making involves a choice between at least
two alternatives.
• Marginal analysis (also known as incremental or
differential analysis) is a method of analysing short-
term decisions.
• The short-term is defined as the lesser of the time
frame over which capacity is fixed, or one year.
 • Sell or further process
• Make or buy
It is generally
applied to these
• Keep or drop a product line
types of decisions: • Special orders.
• The key factor in applying marginal analysis is deciding
which information is relevant to the decision. Relevant
costs and relevant revenues are those that differ
among options and are future oriented.
• Costs and revenues that already have been incurred or
committed are sunk and are irrelevant in decision
making.
1. Sell or process further:
Sell or process further concerns the decision to sell a product or service
before an intermediate processing step or to add further processing and
then sell the product or service for a higher price. Common examples of sell
or process further include decisions to:
- Add features to a product to enhance its functionality.
- Improve the flexibility or quality of a service.
- Repair defective products so they can be sold in the usual manner.
A key point in this type of decisions is that the joint costs are irrelevant costs.
Joint Costs are the costs incurred up to the split-off point.
The split off point is the point in the production process at which the joint
products can be recognized as separate products.
Joint products or joint services involve situations in which two or more
products or services are produced from a single common input. For example,
gasoline, diesel fuel and heating oil are three joint products that are
prepared from crude oil.
Steps for solving this case:
1. Compute the incremental revenue: which is the selling price of the
product after further processing minus the selling price of the product
at split-off point.
2. Compute the incremental cost: which is the cost of further
processing.
3. Compute the net benefit/ net loss = incremental revenue –
incremental costs.
Case 1 (Sell or process further)
• The unit production cost of X product is $4,200.
• The unit selling price of X is $5,000
• The X product can be further processed to be Y product, and the
further processing cost per unit is $1,500
• The selling price for Y product is $5,800

Required:
Is it profitable to process further this product?
Solution:
• The incremental revenue per unit = $5,800 - $5,000 = $800
• The incremental costs per unit = $1,500
• The incremental loss = $800 - $1,500 = ($700)

Decision: The product should be sold as is and not processed further.

N.B. The unit production cost of X is irrelevant to the decision, because
in both cases (sell as is or further process) it will be incurred.
Case 2 (Sell or process further)
• A company processes raw material A into joint products B and C.
• Each 100 units of raw material A yield 60 units of B and 40 units of C.
• Raw material A costs $5/ unit.
• Processing 100 units of raw material A into joint products B and C
costs $100.
• Product C can be sold immediately for $5/unit, or it can be processed
further and sold for $15/unit. The Additional processing costs are
$4/unit.

Would you recommend selling C as it is or further process it?

Solution:
1. The incremental revenue per unit = $15 - $5 = $10
2. The incremental cost for processing further = $4
3. The incremental profit (net profit) = $10 - $4 = $6
Decision: Process further.
N.B. The raw material A cost which is $5 and the $100 incurred to
process raw material A into products B and C are joint costs incurred to
the split-off point, they are irrelevant costs.