Accounting Principles

Thirteenth Edition
Weygandt ● Kimmel ● Kieso

Chapter 23

Incremental Analysis
This slide deck contains animations. Please disable animations if they cause issues with your device.
Chapter Outline
Learning Objectives
LO 1 Describe management’s decision-making process and incremental
analysis.
LO 2 Analyze the relevant costs in accepting an order at a special price.
LO 3 Analyze the relevant costs in a make-or-buy decision.
LO 4 Analyze the relevant costs and revenues in determining whether to
sell or process materials further.
LO 5 Analyze the relevant costs to be considered in repairing, retaining,
or replacing equipment.
LO 6 Analyze the relevant costs in deciding whether to eliminate an
unprofitable segment or product.

Copyright ©2018 John Wiley & Sons, Inc. 2

Decision-Making
Making decisions is an important management function.
• Does not always follow a set pattern
• Decisions vary in scope, urgency, and importance
• Steps usually involved in process include:
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

Copyright ©2018 John Wiley & Sons, Inc. 3

Decision-Making Process
In making business decisions,
• Considers financial and non-financial information
• Financial information
o Revenues and costs, and
o Effect on overall profitability
• Nonfinancial information
o Effect on employee turnover
o The environment
o Overall company image

Copyright ©2018 John Wiley & Sons, Inc. 4

Incremental Analysis Approach
• Decisions involve a choice among alternative actions
• Process used to identify the financial data that change
under alternative courses of action
o Both costs and revenues may vary or
o Only revenues may vary or
o Only costs may vary

Copyright ©2018 John Wiley & Sons, Inc. 5

How Incremental Analysis Works (1 of 3)
Net Income
Increase
Alternative A Alternative B (Decrease)
Revenues $125,000 $110,000 $(15,000)
Costs 100,000 80,000 20,000
Net income $25,000 $30,000 $ 5,000

• Incremental revenue is $15,000 less under Alternative B

• Incremental cost savings of $20,000 is realized
• Alternative B produces $5,000 more net income

Copyright ©2018 John Wiley & Sons, Inc. 6

How Incremental Analysis Works (2 of 3)
Important concepts used in incremental analysis:
• Relevant cost and revenues
• Opportunity cost
• Sunk cost

Copyright ©2018 John Wiley & Sons, Inc. 7

How Incremental Analysis Works (3 of 3)
• Sometimes involves changes that seem contrary to
intuition
• Variable costs sometimes do not change under
alternatives
• Fixed costs sometimes change between alternatives

Copyright ©2018 John Wiley & Sons, Inc. 8

Types of Incremental Analysis
Common types of decisions involving incremental
analysis:
1. Accept an order at a special price
2. Make or buy component parts or finished products
3. Sell or process further them further
4. Repair, retain, or replace equipment
5. Eliminate an unprofitable business segment or product

Copyright ©2018 John Wiley & Sons, Inc. 9

DO IT! 1: Incremental Analysis (1 of 2)
Owen T Corporation is comparing two different options. The
company currently operates under Option 1, with revenues of
$80,000 per year, maintenance expenses of $5,000 per year, and
operating expenses of $38,000 per year. Option 2 provides
revenues of $80,000 per year, maintenance expenses of $12,000
per year, and operating expenses of $32,000 per year. Option 1
employs a piece of equipment that was upgraded 2 years ago at a
cost of $22,000. If Option 2 is chosen, it will free up resources that
will increase revenues by $3,000.
Complete the following table to show the change in income from
choosing Option 2 versus Option 1. Designate any sunk costs with
an “S.”

Copyright ©2018 John Wiley & Sons, Inc. 10

DO IT! 1: Incremental Analysis (2 of 2)
Complete the following table to show the change in income from
choosing Option 2 versus Option 1. Designate any sunk costs with
an “S.”
Net Income
Increase
Option 1 Option 2 (Decrease) Sunk (S)
Revenues $80,000 $80,000 $0
Maintenance expenses 5,000 12,000 (7,000)
Operating expenses 38,000 32,000 6,000
Equipment upgrade 22,000 0 0 S
Opportunity cost 3,000 0 3,000
$ 2,000

Copyright ©2018 John Wiley & Sons, Inc. 11

Special Orders (1 of 3)
• To obtain additional business by making a major price
concession to a specific customer
• Assumes that sales of products in other markets are not
affected by special order
• Assumes that company is not operating at full capacity

Copyright ©2018 John Wiley & Sons, Inc. 12

Special Orders (2 of 3)
Sunbelt Company produces 100,000 Smoothie blenders per
month, which is 80% of plant capacity. Variable manufacturing
costs are $8 per unit. Fixed manufacturing costs are $400,000,
or $4 per unit. The Smoothie blenders are normally sold
directly to retailers at $20 each. Sunbelt has an offer from
Kensington Co. (a foreign wholesaler) to purchase an
additional 2,000 blenders at $11 per unit. Acceptance of the
offer would not affect normal sales of the product, and the
additional units can be manufactured without increasing plant
capacity. What should management do?

Copyright ©2018 John Wiley & Sons, Inc. 13

Special Orders (3 of 3)
Net Income
Increase
Reject Order Accept Order (Decrease)
Revenues $0 $22,000 $22,000
Costs 0 16,000 (16,000)
Net income $0 $6,000 $6,000

• Fixed costs do not change since within existing capacity – thus

fixed costs are not relevant
• Variable manufacturing costs and expected revenues change –
thus both are relevant to the decision

Copyright ©2018 John Wiley & Sons, Inc. 14

DO IT! 2: Special Orders
Cobb Company incurs costs of $28 per unit ($18 variable and $10 fixed) to
make a product that normally sells for $42. A foreign wholesaler offers to
buy 5,000 units at $25 each. The special order results in additional
shipping costs of $1 per unit. Compute the increase or decrease in net
income Cobb realizes by accepting the special order, assuming Cobb has
excess operating capacity.
Should Cobb Company accept the special order?

Accept Net Income

Reject Order Order Increase (Decrease)
Revenues $0 $125,000 $125,000
Costs 0 95,000 (95,000)
Net income $0 $ 30,000 $ 30,000
Copyright ©2018 John Wiley & Sons, Inc. 15
Make or Buy (1 of 2)
Illustration: Baron Company incurs the following annual costs
in producing 25,000 ignition switches for motor scooters.
Direct materials $ 50,000
Direct labor 75,000
Variable manufacturing overhead 4,000
Fixed manufacturing overhead 60,000
Total manufacturing costs $225,000
Total cost per unit ($225,000 ÷ 25,000) $9.00

Instead of making switches, Baron might purchase ignition

switches at a price of $8 per unit. What should Baron do?
Copyright ©2018 John Wiley & Sons, Inc. 16
Make or Buy (2 of 2)
Net Income
Increase
Make Buy (Decrease)
Direct materials $50,000 $0 $50,000
Direct labor 75,000 0 75,000
Variable manufacturing costs 40,000 0 40,000
Fixed manufacturing costs 60,000 50,000 10,000
Purchase price (25,000 × $8) 0 200,000 (200,000)
Total annual cost $225,000 $250,000 $(25,000)

• Manufacturing cost is $1 higher per unit than purchase price

• Must absorb at least $50,000 of fixed costs under either option

Copyright ©2018 John Wiley & Sons, Inc. 17

Opportunity Cost (1 of 2)
The lost potential benefit that could have been obtained
from following an alternative course of action.
In the make-or-buy decision, it is important for
management to take into account the social impact of its
choice e.g. closure of a manufacturing plant and laying off
many good workers.

Copyright ©2018 John Wiley & Sons, Inc. 18

Opportunity Cost (2 of 2)
Illustration: Assume that through buying the switches, Baron Company
can use the released productive capacity to generate additional income
of $38,000 from producing a different product. This lost income is an
additional cost of continuing to make the switches in the make-or-buy
decision.
Net Income
Increase
Make Buy (Decrease)
Total annual cost $225,000 $250,000 $(25,000)
Opportunity cost 38,000 0 38,000
Total cost $263,000 $250,000 $13,000

Copyright ©2018 John Wiley & Sons, Inc. 19

DO IT! 3: Make or Buy (1 of 3)
Juanita Company must decide whether to make or buy some of its
components for the appliances it produces. The costs of producing
166,000 electrical cords for its appliances are as follows.
Direct materials $90,000 Variable overhead $32,000
Direct labor 20,000 Fixed overhead 24,000

Instead of making the electrical cords at an average cost per unit of

$1.00 ($166,000 ÷ 166,000), the company has an opportunity to
buy the cords at $0.90 per unit. If the company purchases the cords,
all variable costs and one-fourth of the fixed costs will be
eliminated.

Copyright ©2018 John Wiley & Sons, Inc. 20

DO IT! 3: Make or Buy (2 of 3)
a. Prepare an incremental analysis showing whether the company should make or buy the
electrical cords.
Net Income
Increase
Make Buy (Decrease)
Direct materials $ 90,000 $ –0– $90,000
Direct labor 20,000 –0– 20,000
Variable manufacturing costs 32,000 –0– 32,000
Fixed manufacturing costs 24,000 18,0001 6,000
Purchase price –0– 149,4002 (149,400)
Total cost $166,000 $167,400 $ (1,400)
1$24,000 × .75
2166,000 × $0.90

This analysis indicates that Juanita Company will incur $1,400 of additional costs if it buys
the electrical cords rather than making them.
Copyright ©2018 John Wiley & Sons, Inc. 21
DO IT! 3: Make or Buy (3 of 3)
b. Will your answer be different if the released productive capacity
will generate additional income of $5,000?
Net Income
Increase
Make Buy (Decrease)
Total cost $ 166,000 $ 167,400 $(1,400)
Opportunity cost 5,000 0 5,000
Total cost $171,000 $167,400 $ 3,600

Yes, net income will be increased by $3,600 if Juanita Company

purchases the electrical cords rather than making them.

Copyright ©2018 John Wiley & Sons, Inc. 22

Sell or Process Further (1 of 3)
May have option to sell product at a given point in
production or to process further and sell at a higher price.
Decision Rule:
• Process further as long as the incremental revenue
from such processing exceeds the incremental
processing costs

Copyright ©2018 John Wiley & Sons, Inc. 23

Single-Product Case (1 of 2)
Illustration: Woodmasters Inc. makes tables. The cost to manufacture an
unfinished table is $35. The selling price per unfinished unit is $50.
Woodmasters has unused capacity that can be used to finish the tables
and sell them at $60 per unit. For a finished table, direct materials will
increase $2 and direct labor costs will increase $4. Variable
manufacturing overhead costs will increase by $2.40 (60% of direct labor).
No increase is anticipated in fixed manufacturing overhead.
Direct materials $15
Direct labor 10
Variable manufacturing overhead 6
Fixed manufacturing overhead 4
Manufacturing cost per unit $35

Copyright ©2018 John Wiley & Sons, Inc. 24

Single-Product Case (2 of 2)
Net Income Increase
Sell Unfinished Process Further (Decrease)
Sales price per unit $50.00 $60.00 $10.00
Cost per unit
Direct materials 15.00 17.00 (2.00)
Direct labor 10.00 14.00 (4.00)
Variable manufacturing overhead 6.00 8.40 (2.40)
Fixed manufacturing overhead 4.00 4.00 0.00
Total 35.00 43.40 (8.40)
Net income per unit $15.00 $16.60 $1.60

Should Woodmasters sell or process further?

Yes, since incremental revenue is $1.60 higher than the incremental processing
costs of $8.40.
Copyright ©2018 John Wiley & Sons, Inc. 25
Multiple-Product Case (1 of 5)
Cream and skim milk are products that result from the processing of raw
milk.

Joint product costs are sunk costs and thus not relevant to the sell-or-
process further decision.
Copyright ©2018 John Wiley & Sons, Inc. 26
Multiple-Product Case (2 of 5)
Cost and revenue date per day for cream.
Costs (per day)
Joint cost allocated to cream $ 9,000
Cost to process cream into cottage cheese 10,000

Revenues from Products (per day)

Cream $19,000
Cottage cheese 27,000

Determine whether the company should simply sell the cream or

process it further into cottage cheese.
Copyright ©2018 John Wiley & Sons, Inc. 27
Multiple-Product Case (3 of 5)
Net Income
Process Increase
Sell Further (Decrease)
Sales per day $19,000 $27,000 $ 8,000
Cost per day to process cream into
cottage cheese 0 10,000 (10,000)
Net income per day $19,000 $17,000 $(2,000)

Marais should not process the cream further

Copyright ©2018 John Wiley & Sons, Inc. 28

Multiple-Product Case (4 of 5)
Cost and revenue date per day for cream.
Costs (per day)
Joint cost allocated to skim milk $ 5,000
Cost to process skim into condensed milk 8,000

Revenues from Products (per day)

Skim milk $11,000
Condensed milk 26,000

Determine whether the company should sell the skim milk or

process further into condensed milk.
Copyright ©2018 John Wiley & Sons, Inc. 29
Multiple-Product Case (5 of 5)
Net Income
Process Increase
Sell Further (Decrease)
Sales per day $11,000 $26,000 $ 15,000
Cost per day to process skim milk into
condensed milk 0 8,000 (8,000)
Net income per day $11,000 $18,000 $7,000

Marais should process the cream further

Copyright ©2018 John Wiley & Sons, Inc. 30

DO IT! 4: Sell or Process Further (1 of 3)
Easy Does It manufactures unpainted furniture for the do-
it-yourself (DIY) market. It currently sells a child’s rocking
chair for $25. Production costs per unit are $12 variable
and $8 fixed. Easy Does It is considering painting the
rocking chair and selling it for $35. Variable costs to paint
each chair are expected to be $9, and fixed costs are
expected to be $2. Prepare an analysis showing whether
Easy Does It should sell unpainted or painted chairs.

Copyright ©2018 John Wiley & Sons, Inc. 31

DO IT! 4: Sell or Process Further (2 of 3)
Prepare an analysis showing whether Easy Does It should sell
unpainted or painted chairs.
Net Income
Process Increase
Sell Further (Decrease)
Revenues $25 $35 $10
Variable costs 12 21a (9)
Fixed costs 8 10b (2)
Net income $5 $4 $(1)
a$12 + $9
b$8 + $2
This analysis indicates that the rocking chair should be sold unpainted because
net income per chair will be $1 greater.
Copyright ©2018 John Wiley & Sons, Inc. 32
Repair, Retain, or Replace Equipment (1 of 2)
Illustration: Jeffcoat Company has a factory machine that
originally cost $110,000. It has a balance in Accumulated
Depreciation of $70,000, so the machine’s book value is
$40,000. It has a remaining useful life of four years. The
company is considering replacing this machine with a new
machine. A new machine is available that costs $120,000. It is
expected to have zero salvage value at the end of its four-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 could be sold for
$5,000. Prepare the incremental analysis for the four-year
period.

Copyright ©2018 John Wiley & Sons, Inc. 33

DO IT! 4: Sell or Process Further (3 of 3)
Prepare the incremental analysis for the four-year period.
Net Income
Retain Replace Increase
Equipment Equipment (Decrease)
Variable manufacturing costs $640,000* $500,000** $140,000
New machine cost 120,000 (120,000)
Sale of old machine . (5,000) 5,000
Total $640,000 $615,000 $25,000

*(4 years × $160,000)

**(4 years × $125,000)
Replace equipment since variable manufacturing costs due to
replacement more than offset the cost of the new equipment.
Copyright ©2018 John Wiley & Sons, Inc. 34
Repair, Retain, or Replace Equipment (2 of 2)
Additional Considerations
• Book value of old machine does not affect the decision
o Book value is a sunk cost
o Costs which cannot be changed by future decisions (sunk
cost) are not relevant in incremental analysis
• Any trade-in allowance or cash disposal value of the
existing asset is relevant

Copyright ©2018 John Wiley & Sons, Inc. 35

DO IT! 5: Repair or Replace (1 of 2)
Rochester Roofing is faced with a decision. The company relies on
the use of its 60-foot extension lift for work on large homes and
commercial properties. Last year, the company spent $60,000
refurbishing the lift. Another $40,000 of repair work is required.
Alternatively, Rochester Roofing has found a newer used lift that is
for sale for $170,000. The company estimates that both the old and
new lifts would have useful lives of 6 years. However, the new lift is
more efficient and thus would reduce operating expenses by about
$20,000 per year. The company could also rent out the new lift for
about $2,000 per year. The old lift is not suitable for rental. The old
lift could currently be sold for $25,000 if the new lift is purchased.
Prepare an incremental analysis that shows whether the company
should repair or replace the equipment.
Copyright ©2018 John Wiley & Sons, Inc. 36
DO IT! 5: Repair or Replace (2 of 2)
Prepare an incremental analysis that shows whether the company
should repair or replace the equipment.
Net Income
Retain Replace Increase
Equipment Equipment (Decrease)
Operating expenses (6 years × $20,000) $120,000 $120,000
Repair costs 40,000 40,000
Rental revenue (6 years × $2,000) $ (12,000) 12,000
New machine cost 170,000 (170,000)
Sale of old machine . (25,000) 25,000
Total cost $160,000 $133,000 $27,000
Purchasing the new machine would increase net income for the 6-year period by
$27,000.
Copyright ©2018 John Wiley & Sons, Inc. 37
Eliminate Unprofitable Segment or Product

• 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 contribution margin lost

Copyright ©2018 John Wiley & Sons, Inc. 38

Eliminate Unprofitable Segment (1 of 4)
Illustration: Venus Company manufactures three models of tennis
rackets:
• Profitable lines: Pro and Master
• Unprofitable line: Champ
Should Champ be eliminated?
Pro Master Champ Total
Sales $800,000 $300,000 $100,000 $1,200,000
Variable costs 520,000 210,000 90,000 820,000
Contribution margin 280,000 90,000 10,000 380,000
Fixed costs 80,000 50,000 30,000 160,000
Net income $200,000 $40,000 $(20,000) $220,000

Copyright ©2018 John Wiley & Sons, Inc. 39

Eliminate Unprofitable Segment (2 of 4)
Prepare income data after eliminating Champ product line. Assume fixed
costs are allocated 2/3 to Pro and 1/3 to Master.

Pro Master Champ Total

Sales $800,000 $300,000 $1,100,000
Variable costs 520,000 210,000 730,000
Contribution margin 280,000 90,000 370,000
Fixed costs 100,000 60,000 . 160,000
Net income $180,000 $30,000 . $210,000

Total income is decreased by $10,000.

Copyright ©2018 John Wiley & Sons, Inc. 40

Eliminate Unprofitable Segment (3 of 4)
Incremental analysis of Champ provided the same results:

Net Income
Increase
Continue Eliminate (Decrease)
Sales $100,000 $ 0 $(100,000)
Variable costs 90,000 0 90,000
Contribution margin 10,000 0 (10,000)
Fixed costs 30,000 30,000 0
Net income 20,000 $(30,000) $(10,000)

Do Not Eliminate Champ

Copyright ©2018 John Wiley & Sons, Inc. 41

Eliminate Unprofitable Segment (4 of 4)
Assume that $22,000 of the fixed costs attributed to the Champ line can be
eliminated if the line is discontinued.
Net Income
Increase
Continue Eliminate (Decrease)
Sales $100,000 $ 0 $(100,000)
Variable costs 90,000 0 90,000
Contribution margin 10,000 0 (10,000)
Fixed costs 30,000 8,000 22,000
Net income 20,000 $(8,000) $(12,000)

Eliminate Champ

Copyright ©2018 John Wiley & Sons, Inc. 42

DO IT! 6: Unprofitable Segments (1 of 2)
Lambert, Inc. manufactures several types of accessories.
For the year, the knit hats and scarves line had sales of
$400,000, variable expenses of $310,000, and fixed
expenses of $120,000. Therefore, the knit hats and
scarves line had a net loss of $30,000. If Lambert
eliminates the knit hats and scarves line, $20,000 of fixed
costs will remain.
Prepare an analysis showing whether the company
should eliminate the knit hats and scarves line.

Copyright ©2018 John Wiley & Sons, Inc. 43

DO IT! 6: Unprofitable Segments (2 of 2)
Prepare an analysis showing whether the company should eliminate the knit hats
and scarves line.

Net Income
Increase
Continue Eliminate (Decrease)
Sales $400,000 $ 0 $(400,000)
Variable costs 310,000 0 310,000
Contribution margin 90,000 0 (90,000)
Fixed costs 120,000 20,000 100,000
Net income $(30,000) $(20,000) $10,000

Lambert should eliminate the knit hats and scarves line because net income will
increase $10,000.
Copyright ©2018 John Wiley & Sons, Inc. 44
Copyright
Copyright © 2018 John Wiley & Sons, Inc.
All rights reserved. Reproduction or translation of this work beyond that permitted in
Section 117 of the 1976 United States Act without the express written permission of the
copyright owner is unlawful. Request for further information should be addressed to the
Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies
for his/her own use only and not for distribution or resale. The Publisher assumes no
responsibility for errors, omissions, or damages, caused by the use of these programs or
from the use of the information contained herein.

Copyright ©2018 John Wiley & Sons, Inc. 45