ACCOUNTING

AND FINANCIAL STATEMENT

ANALYSIS

Incremental Analysis

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 Learning Objectives

In this chapter you will be introduced to

Incremental analysis:
 Decision making process
 Types of incremental analysis

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 Management’s Decision-Making Process

 Important management function.

 Does not always follow a set pattern.
 Decisions vary in scope, urgency, and
importance.
 5 Steps usually involved in process

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 STEPS IN MANAGEMENT
DECISION MAKING

Five steps in decision making process:

1. Identify the problem and assign responsibility
2. Gather financial information and non-financial
data
3. Determine and evaluate possible courses of
action
4. Make a decision
5. Review results of the decision

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 Management’s Decision-Making Process

Considers both:
 Financial information includes revenues and costs as
well as their effect on overall profitability.

 Non-financial information includes effect on

employee turnover, the environment, or overall
company image.

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 Management’s Decision-Making Process

The Incremental Analysis Approach

 Decisions involve a choice among alternative
actions.
 Process used to identify the financial data that
change under alternative courses of action.
► Both costs and revenues may vary.

► Only revenues may vary.

► Only costs may vary.

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 Management’s Decision-Making Process

How Incremental Analysis Works

Comparison of Alternative B with Alternative A:

► 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.

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 Management’s Decision-Making Process

How Incremental Analysis Works

Important concepts used in incremental analysis:
 Relevant cost.

 Opportunity cost.

 Sunk cost.

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 How
How Incremental
Incremental Analysis
Analysis Works
Works
Uses Three Important Cost Concepts:

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 Types of Incremental Analysis

Common Types of Decisions:

1. Accept an order at a special price.

2. Make or buy.

3. Sell or process further.

4. Retain or replace equipment.

5. Eliminate an unprofitable business segment.

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 Types of Incremental Analysis

Accept an Order at a Special Price

 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.

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 Types of Incremental Analysis

Accept an Order at a Special Price

Illustration: Sunbelt Company produces 100,000 automatic
blenders per month, which is 80 percent of plant capacity. Variable
manufacturing costs are $8 per unit. Fixed manufacturing costs
are $400,000, or $4 per unit. The blenders are normally sold
directly to retailers at $20 each. Sunbelt has an offer from Mexico
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?

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 Types of Incremental Analysis

Accept an Order at a Special Price

 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.

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 Types of Incremental Analysis

Make or Buy
Illustration: Baron Company incurs the following annual costs in
producing 25,000 ignition switches for motor scooters.

Instead of making its own switches, Baron Company might

purchase the ignition switches at a price of $8 per unit. “What
should management do?”
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 Types of Incremental Analysis

Make or Buy

 Total manufacturing cost is $1 higher than purchase price.

 Must absorb at least $50,000 of fixed costs under either option.
 This make-or-buy analysis is complete only if the productive capacity used to make
the ignition switches cannot be converted to another purpose.

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 Types of Incremental Analysis

Make or Buy – Opportunity Cost

Illustration: Assume that through buying the switches, Baron
Company can use the released productive capacity to generate
additional income of $28,000 from producing a different product.
This lost income is an additional cost of continuing to make the
switches in the make-or-buy decision.

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 Types of Incremental Analysis

Sell or Process Further

 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.

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 Types of Incremental Analysis

Sell or Process Further

Illustration: Woodmasters Inc. makes tables. The cost to manufacture
an unfinished table is $35. The selling price per unfinished unit is $50.
Management concludes
that some of the
unused capacity may 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.

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 Types of Incremental Analysis

Sell or Process Further

Incremental analysis on a per unit basis is as follows.

Should Woodmasters sell or process further?

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 Types of Incremental Analysis

Retain or Replace Equipment

Illustration: Jeffcoat Company is considering replacing a factory
machine with a new machine. The existing factory machine has a
book value of $40,000 and a remaining useful life of four years. 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
Jeffcoat acquires the new machine, variable manufacturing costs
are expected to decrease from $160,000 to $125,000 annually,
and the old unit will be scrapped. Prepare the incremental
analysis for the four-year period.

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 Types of Incremental Analysis

Retain or Replace Equipment

Prepare the incremental analysis for the four-year period.

Retain
RetainororReplace?
Replace?

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 Types of Incremental Analysis

Retain or Replace Equipment

Additional Considerations
 Book value of old machine does not affect the decision.

► Book value is a sunk cost.

► 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.

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 Types of Incremental Analysis

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 contribution margin lost.

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 Types of Incremental Analysis

Eliminate an Unprofitable Segment

Illustration: Martina Company manufactures three models of
tennis rackets:
► Profitable lines: Pro and Master Should Champ
be eliminated?
► Unprofitable line: Champ

Segment
income
data

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 Types of Incremental Analysis

Eliminate an Unprofitable Segment

Prepare income data after eliminating Champ product line.

Assume fixed costs are allocated 2/3 to Pro and 1/3 to Master.

Total income is decreased by $10,000.

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 Types of Incremental Analysis

Eliminate an Unprofitable Segment

Incremental analysis of Champ provided the same results:

Do Not Eliminate Champ

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