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Managerial Accounting Ninth Edition

Weygandt Kimmel Mitchell

Chapter 7

Incremental Analysis

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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.

Decision-Making

LEARNING OBJECTIVE 1

Describe management’s decision-making process and incremental analysis.

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:

Illustration 7.1

LO 1

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

LO 1

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

LO 1

How Incremental Analysis Works Basic approach in incremental analysis

Illustration 7.2

• 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

LO 1

How Incremental Analysis Works Important concepts used in incremental analysis

• Relevant costs and revenues • Opportunity cost • Sunk cost

LO 1

How Incremental Analysis Works Other items to consider

• Sometimes involves changes that seem contrary to intuition

• Variable costs sometimes do not change under alternatives

• Fixed costs sometimes change between alternatives

LO 1

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 products or process them further 4. Repair, retain, or replace equipment 5. Eliminate an unprofitable business segment or product

LO 1

Incremental Analysis Review Question (1 of 2)

Incremental analysis is the process of identifying the financial data that a. do not change under alternative courses of action. b. change under alternative courses of action. c. are mixed under alternative courses of action. d. None of the above

LO 1

Incremental Analysis Review Answer (1 of 2)

Incremental analysis is the process of identifying the financial data that a. do not change under alternative courses of action. b. Answer: change under alternative courses of action. c. are mixed under alternative courses of action. d. None of the above

LO 1

DO IT! 1: Incremental Analysis

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.”

LO 1

DO IT! 1: Incremental Analysis Solution

Complete the following table to show the change in income from choosing Option 2 versus Option 1. Designate any sunk costs with an “S.”

LO 1

Special Orders

LEARNING OBJECTIVE 2

Analyze the relevant costs in accepting an order at a special price.

• 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

LO 2

Special Orders

Sunbelt Company produces 100,000 Smoothie blenders per month, which is 80% of factory 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. Kensington Co. (a foreign wholesaler) has offered to purchase an additional 2,000 blenders from Sunbelt at $11 per unit. Management has determined that acceptance of the offer would not affect normal sales of the product, and the additional units can be manufactured without increasing factory capacity. What should management do?

LO 2

Special Orders Solution

Illustration 7.3

• 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

LO 2

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?

Reject Accept Net Income Increase

(Decrease)

Revenues $─0─ $125,000* $125,000

Costs ─0─ 95,000** (95,000)

Net income $─0─ $ 30,000 $ 30,000 *5,000 × $25

**(5,000 × $18) + (5,000 × $1)

The analysis indicates net income increases by $30,000; therefore, Cobb Company should accept the special order. LO 2

Make or Buy LEARNING OBJECTIVE 3

Analyze the relevant costs in a make-or-buy decision.

Illustration: Baron Company incurs the following annual costs in producing 25,000 ignition switches for motorcycles.

Illustration 7.4 Direct materials $ 50,000

Direct labor 75,000

Variable manufacturing overhead 40,000

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. If they do this, all variable costs and $10,000 of fixed costs will be eliminated. What should Baron do?

LO 3

Make or Buy

Illustration 7.5

• Manufacturing cost is $1 higher per unit than purchase price • Must absorb at least $50,000 of fixed costs under either

option LO 3

Make or Buy Decision Review Question In a make-or-buy decision, relevant costs are: a. Manufacturing costs that will be saved b. The purchase price of the units c. Opportunity costs d. All of the above

LO 3

Make or Buy Decision Review Answer In a make-or-buy decision, relevant costs are: a. Manufacturing costs that will be saved b. The purchase price of the units c. Opportunity costs d. Answer: All of the above

LO 3

Opportunity Cost

The lost potential benefit that could have been obtained from following an alternative course of action. If there is an opportunity to use this productive capacity in some other manner, then this opportunity cost must be considered.

LO 3

Opportunity Cost 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.

Illustration 7.6

LO 3

DO IT! 3: Make or Buy

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 are eliminated.

Make or Buy? LO 3

DO IT! 3: Make or Buy Part a. solution a. Prepare an incremental analysis showing whether the

company should make or buy the electrical cords.

Make Buy Net Income Increase

(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 18,000* 6,000

Purchase price ─0─ 149,400** (149,400)

Total cost $166,000 $167,400 $ (1,400)

*$24,000 × .75

**166,000 × $0.90

Juanita Company should make the components.

LO 3

DO IT! 3: Make or Buy Part b. solution b. Will your answer be different if the released productive

capacity of the production facility will generate additional income of $5,000?

Make Buy Net Income Increase (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, the answer is different. The analysis shows that net income increases by $3,600 if Juanita Company purchases the electrical cords rather than making them.

Juanita Company should buy the components.

LO 3

Sell or Process Further

LEARNING OBJECTIVE 4

Analyze the relevant costs and revenues in determining whether to sell or process materials further.

May have option to sell product at a given point in production or continuing to process and sell later at a higher price. Decision Rule: • Process further as long as the incremental revenue

from such processing exceeds the incremental processing costs.

LO 4

Single-Product Case 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.

Illustration 7.7

Direct materials $15

Direct labor 10

Variable manufacturing overhead 6

Fixed manufacturing overhead 4

Manufacturing cost per unit $35

LO 4

Single-Product Case Solution (1 of 2)

Illustration 7.8

Should Woodmasters sell or process further?

LO 4

Single-Product Case Solution (2 of 2)

Illustration 7.8

Woodmasters should process further.

LO 4

Multiple-Product Case Joint production process-Creamery

Cream and skim milk are products that result from the processing of raw milk.

Illustration 7.9

Joint product costs are sunk costs and thus not relevant to the sell-or-process-further decision.

LO 4

Multiple-Product Case Cost and revenue data per day for cream

Illustration 7.10

Determine whether the company should simply sell the cream or process it further into cottage cheese.

LO 4

Multiple-Product Case Analysis of whether to sell cream or process further (1 of 2)

Illustration 7.11

Marais should orbegin underline should notend underline process the cream further?

LO 4

Multiple-Product Case Analysis of whether to sell cream or process further (2 of 2)

Illustration 7.11

Marais should not process the cream further.

LO 4

Multiple-Product Case Cost and revenue data per day for skim milk

Illustration 7.12

Determine whether the company should sell the skim milk or process further into condensed milk.

LO 4

Multiple-Product Case Sell skim milk or process into condensed milk? (1 of 2)

Illustration 7.13

Marais should or should not process the skim milk further?

LO 4

Multiple-Product Case Sell skim milk or process into condensed milk? (2 of 2)

Illustration 7.13

Marais should process the skim milk further.

LO 4

Sell or Process Further Review Question

Process further as long as the incremental revenue from processing exceeds: a. Incremental processing costs b. Variable processing costs c. Fixed processing costs d. No correct answer is given

LO 4

Sell or Process Further Review Answer

Process further as long as the incremental revenue from processing exceeds: a. Answer: Incremental processing costs b. Variable processing costs c. Fixed processing costs d. No correct answer is given

LO 4

DO IT! 4: Sell or Process Further

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.

LO 4

DO IT! 4: Sell or Process Further Solution

Prepare an analysis showing whether Easy Does It should sell unpainted or painted chairs.

Sell Process Further Net Income Increase

(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

LO 4

Repair, Retain, or Replace Equipment

LEARNING OBJECTIVE 5

Analyze the relevant costs to be considered in repairing, retaining, or replacing equipment.

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.

LO 5

Repair, Retain, or Replace Equipment Incremental analysis-retain or replace equipment (1 of 2) Prepare the incremental analysis for the four-year period.

Illustration 7.14

Retain or Replace? LO 5

Repair, Retain, or Replace Equipment Incremental analysis-retain or replace equipment (2 of 2) Prepare the incremental analysis for the four-year period.

Illustration 7.14

Jeffcoat Company should replace the machine.

LO 5

Repair, Retain, or Replace Equipment Additional Considerations

• Suppose that the manager spent $90,000 repairing a machine two months ago o The amount spent to repair the machine is irrelevant to

the current decision 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

LO 5

DO IT! 5: Repair or Replace

Rochester Roofing is faced with a decision. The company relies very heavily 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. It has just determined that 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 from $70,000 to $50,000 each year. The company could also rent 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.

LO 5

DO IT! 5: Repair or Replace Prepare an incremental analysis that shows whether the company should repair or replace the equipment. Solution:

Retain Equipment

Replace Equipment

Net Income Increase (Decrease)

Operating expenses $420,000* $300,000** $120,000

Repair costs 40,000 40,000

Rental revenue $(12,000)*** 12,000

New machine cost 170,000 (170,000)

Sale of old machine (25,000) 25,000

Total cost $460,000 $433,000 $27,000

*6 Years × $70,000

**6 Years × $50,000

***6 Years × $2,000

The analysis indicates that purchasing the new machine would increase net income for the 6-year period by $27,000. LO 5

Eliminate Unprofitable Segment or Product

LEARNING OBJECTIVE 6

Analyze the relevant costs in deciding whether to eliminate an 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

LO 6

Eliminate Unprofitable Segment Segment income data Illustration: Venus Company manufactures three models of tennis rackets: • Profitable lines: Pro and Master • Unprofitable line: Champ

Should Champ be eliminated?

Illustration 7.15

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

LO 6

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

Illustration 7.16

Pro Master 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.

LO 6

Eliminate Unprofitable Segment Incremental analysis-no reduction in fixed costs

Incremental analysis of Champ provided the same results: Do Not Eliminate Champ

Illustration 7.17

LO 6

Eliminate Unprofitable Segment Incremental analysis-reduction in fixed costs Assume that $22,000 of the fixed costs attributed to the Champ line can be eliminated if the line is discontinued.

Eliminate Champ Illustration 7.18

LO 6

Incremental Analysis Review Question (2 of 2)

If an unprofitable segment is eliminated a. net income will always increase. b. variable expenses of the eliminated segment will have

to be absorbed by other segments. c. fixed expenses allocated to the eliminated segment

will have to be absorbed by other segments. d. net income will always decrease.

LO 6

Incremental Analysis Review Answer (2 of 2)

If an unprofitable segment is eliminated a. net income will always increase. b. variable expenses of the eliminated segment will have

to be absorbed by other segments. c. Answer: fixed expenses allocated to the eliminated

segment will have to be absorbed by other segments. d. net income will always decrease.

LO 6

DO IT! 6: Unprofitable Segments

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.

LO 6

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

Should Eliminate

Continue Eliminate Net Income Increase (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

LO 6

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Managerial Accounting
Chapter Outline
Decision-Making
Decision-Making Process
Incremental Analysis Approach
How Incremental Analysis Works�Basic approach in incremental analysis
How Incremental Analysis Works�Important concepts used in incremental analysis
How Incremental Analysis Works�Other items to consider
Types of Incremental Analysis
Incremental Analysis�Review Question (1 of 2)
Incremental Analysis�Review Answer (1 of 2)
DO IT! 1: Incremental Analysis
DO IT! 1: Incremental Analysis�Solution
Special Orders
Special Orders
Special Orders�Solution
DO IT! 2: Special Orders
Make or Buy
Make or Buy
Make or Buy Decision�Review Question
Make or Buy Decision�Review Answer
Opportunity Cost
Opportunity Cost�Illustration
DO IT! 3: Make or Buy
DO IT! 3: Make or Buy�Part a. solution
DO IT! 3: Make or Buy�Part b. solution
Sell or Process Further
Single-Product Case
Single-Product Case�Solution (1 of 2)
Single-Product Case�Solution (2 of 2)
Multiple-Product Case�Joint production process-Creamery
Multiple-Product Case�Cost and revenue data per day for cream
Multiple-Product Case�Analysis of whether to sell cream or process further (1 of 2)
Multiple-Product Case�Analysis of whether to sell cream or process further (2 of 2)
Multiple-Product Case�Cost and revenue data per day for skim milk
Multiple-Product Case�Sell skim milk or process into condensed milk? (1 of 2)
Multiple-Product Case�Sell skim milk or process into condensed milk? (2 of 2)
Sell or Process Further�Review Question
Sell or Process Further�Review Answer
DO IT! 4: Sell or Process Further
DO IT! 4: Sell or Process Further�Solution
Repair, Retain, or Replace Equipment
Repair, Retain, or Replace Equipment�Incremental analysis-retain or replace equipment (1 of 2)
Repair, Retain, or Replace Equipment�Incremental analysis-retain or replace equipment (2 of 2)
Repair, Retain, or Replace Equipment�Additional Considerations
DO IT! 5: Repair or Replace
DO IT! 5: Repair or Replace
Eliminate Unprofitable Segment or Product
Eliminate Unprofitable Segment�Segment income data
Eliminate Unprofitable Segment�Income data after eliminating Champ
Eliminate Unprofitable Segment�Incremental analysis-no reduction in fixed costs
Eliminate Unprofitable Segment�Incremental analysis-reduction in fixed costs
Incremental Analysis�Review Question (2 of 2)
Incremental Analysis�Review Answer (2 of 2)
DO IT! 6: Unprofitable Segments
DO IT! 6: Unprofitable Segments�Solution
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