Incremental Analysis

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Chapter20
Incremental Analysis
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The Challenge ofChanging Markets

• Product markets can change quickly due to
  competitor pricecuts, changing customer
  preferences, and introduction ofnew products by
  competitors.
• Managers must make short-run decisions, with a
  fixed setof resources, to react to the changing
  market place.

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The Concept ofRelevant Cost Information

• Will you drive or fly to Florida for spring
  break?
• You have gathered the following information to
  help you with the decision.
• Motel cost is 80 per night.
• Meal cost is 20 per day.
• Your car insurance is 100 per month.
• Kennel cost for your dog is 5 per day.
• Round-trip cost of gasoline for your car is 200.
• Round-trip airfare and rental car for a week is
  500.
• Driving requires two days, with an overnight
  stay, cutting your time in Florida by two days.

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The Concept ofRelevant Cost Information
8 days _at_ 80
8 days _at_ 20
8 days _at_ 5
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The Concept ofRelevant Cost Information
Costs do not differ,so they are notrelevant to
decision.
Also, car insuranceis not relevant tothe
decision as itis a past cost.
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The Concept ofRelevant Cost Information
Are the extra twodays in Floridaworth the
300extra cost to fly?
Transportationcosts differ betweenthe two
alternatives,so they are relevantto your
decision
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Decision Making

• Decision making involves five steps
• Define the problem.
• Identify the alternatives.
• Collect information on alternatives.
• Eliminate irrelevant information.
• Make a decision with the remaining relevant
  information.

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Relevant Informationin Business Decisions

• Information that varies among the possible
  courses of action being considered.
• Incremental costs and revenues
• Important cost concepts forbusiness decisions.
• Opportunity costs.
• Sunk costs.
• Out-of-pocket costs.

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Opportunity Cost

• The benefit that could have been attained by
  pursuing an alternative course of action.
• Example If you were notattending college, you
  couldbe earning 20,000 per year. Your
  opportunity cost ofattending college for
  oneyear includes the 20,000.
• Opportunity costs are not recorded in the
  accounting records, but are relevant to decisions
  because they are a real sacrifice.

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Sunk Costs VersusOut-of-Pocket Costs

• All costs incurred in the past that cannot be
  changed by any decision made now or in the
  future.
• Sunk costs should not be considered in
  decisions.
• Example You bought an automobile that cost
  10,000 two years ago. The 10,000 cost is sunk
  because whether you drive it, park it, trade it,
  or sell it, you cannot change the 10,000 cost.

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Sunk Costs VersusOut-of-Pocket Costs
Trade ?
Cost 10,000two years ago
Cost 25,000today
The dealer will trade for 20,000 plus your
car.What amount is relevant to your decision,
the 10,000 sunk cost of your car or the20,000
out-of-pocket cash differential?
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Incremental Analysis inCommon Business Decisions
We will now examine several different types of
managerial decisions.
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Special Order Decisions

• The decision to accept additional business
  should be based on incremental costs and
  incremental revenues.
• Incremental amounts are those that occur only
  if the company decides to accept the new business.

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Special Order Decisions

• JamCo currently sells 100,000 units of its
  product. The company has revenue and costs as
  shown below

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Special Order Decisions

• JamCo is approached by an overseascompany
  that offers to purchase10,000 units at 8.50 per
  unit.
• If JamCo accepts the offer, total factory
  overhead will increase by 5,000 total selling
  expenses will increase by 2,000 and total
  administrative expenses will increaseby 1,000.
• Should JamCoaccept the offer?

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Special Order Decisions
First lets look at incorrect reasoningthat
leads to an incorrect decision.
Our cost is 9.00per unit. I cant sell for
8.50 per unit.
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Special Order Decisions
This analysis leads to the correct decision.
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Special Order Decisions
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Special Order Decisions
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Special Order Decisions
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Special Order Decisions
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Special Order Decisions

• We can also look at this decisionusing
  contribution margin.

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Production Constraint Decisions
Managers often face the problem of deciding how
scarce resources are going to be utilized.
Usually, fixed costs are not affected by this
particular decision, so management can focus on
maximizing total contribution margin. Lets
look at the Kaser Company example.
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Production Constraint Decisions

• Kaser Company produces two products and selected
  data is shown below

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Production Constraint Decisions

• Machine A1 is the scarce resource because
  there is excess capacity on other machines.
  Machine A1 is being used at 100 of its capacity.
• Machine A1 capacity is 2,400 minutes per week.
• Should Kaser focus its efforts on Product 1 or 2?

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Production Constraint Decisions

• Lets calculate the contribution margin per unit
  of the scarce resource, machine A1.

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Production Constraint Decisions
Lets calculate the contribution margin per unit
of the scarce resource, machine A1.
Product 2 should be emphasized. It is the more
valuable use of the scarce resource, machine A1,
yielding a contribution margin of 30 per minute
as opposed to 24 for Product 1.
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Production Constraint Decisions
Lets calculate the contribution margin per unit
of the scarce resource, machine A1.
If there are no other considerations, the best
plan would be to produce to meet current demand
for Product 2 and then use any capacity that
remains to make Product 1.
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Production Constraint Decisions

• Lets see how this plan would work.

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Production Constraint Decisions
Lets see how this plan would work.
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Production Constraint Decisions
Lets see how this plan would work.
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Production Constraint Decisions

• According to the plan, we will produce 2,200
  units of Product 2 and 1,300 of Product 1. Our
  contribution margin looks like this.

The total contribution margin for Kaser is
64,200.
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Make or Buy Decisions
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Make or Buy Decisions

• Incremental costs also are important in the
  decision to make a product or buy it from a
  supplier.
• The cost to produce an item must include(1)
  direct materials, (2) direct labor and (3)
  incremental overhead.
• We should not use the predetermined overhead rate
  to determine product cost.

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Make or Buy Decisions

• Exitel makes computer chips used inone of its
  products. Unit costs, based on production of
  20,000 chips per year, are

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Make or Buy Decisions

• An outside supplier has offered to provide the
  20,000 chips at a cost of 25 per chip. Fixed
  overhead costs will not be avoided if the chips
  are purchased. Exitel has no alternative use for
  the facilities.
• Should Exitel accept the offer?

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Make or Buy Decisions
Differential costs of making (costs avoided if
bought from outside supplier)
Exitel should not pay 25 per unit to an outside
supplier to avoid the 15 per unit differential
cost of making the part. Fixed costs are
irrelevant to decision.
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Make or Buy Decisions

• If Exitel buys the chips from the outside
  supplier, the idle facilities could be leased to
  another company for 250,000 per year.
• Should Exitel buy the chips andlease the
  facilities?

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Make or Buy Decisions
The opportunity cost of facilities changes the
decision.
The real question to answer is, What is the
best use of Exitels facilities?
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Sell, Scrap, or Rebuild Decisions

• Costs incurred in manufacturing units of
  product that do not meet quality standards are
  sunk costs and cannot be recovered.
• As long as rebuild costs are recovered through
  sale of the product, and rebuilding does not
  interfere with normal production, we should
  rebuild.

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Sell, Scrap, or Rebuild Decisions

• OserCo has 10,000 defective units thatcost
  1.00 each to make. The units can be scrapped
  now for .40 each or rebuilt at an additional
  cost of .80 per unit.
• If rebuilt, the units can be sold for the normal
  selling price of 1.50 each. Rebuilding the
  10,000 defective units will prevent the
  production of 10,000 new units that would also
  sell for 1.50.
• Should OserCo scrap or rebuild?

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Sell, Scrap, or Rebuild Decisions
10,000 units 0.40 per unit
10,000 units 1.50 per unit
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Sell, Scrap, or Rebuild Decisions
10,000 units 0.80 per unit
10,000 units (1.50 - 1.00) per unit
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Sell, Scrap, or Rebuild Decisions
OserCo should scrap the units now.
If OserCo fails to include the opportunity
cost,the rework option would show a return of
7,000,mistakenly making rebuild appear more
favorable.
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Joint Product Decisions
Two or more products produced from acommon input
are called joint products.
Product 1
Joint costs arethe costs ofprocessing prior to
the split-off point.
Joint Costs
Product 2
Product 3
The split-off point is the point in a process
where joint products can be recognized as
separate products.
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Joint Product Decisions

• Businesses are often faced with the decision
  to sell partially completed products at the
  split-off point or to process them to completion.
• General rule process further only if
  incremental revenues gt incremental costs.

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Joint Product Decisions
Ames Co. produces two products, A and B, from
this process.
Should the products besold at split-off
orprocessed further?
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Joint Product Decisions
Product A incremental revenue 120,000 -
70,000 Product B incremental revenue
65,000 - 50,000
Decision Process product A, but sell product B
at the split-off point. Note that the 100,000
joint cost is irrelevant to the processing
decision.
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Joint Product Decisions
Joint costs are really common costs incurred to
simultaneously produce a variety of end products.
Joint costs are commonly allocated to end
products on the basis of the relative sales value
of each product or on some other basis.
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Joint Product Decisions

• Joint costs are not relevantin decisions
  regarding what to do witha product after the
  split-off point.
• As a general rule . . .
• It is always profitable to continue processing a
  joint product after the split-off point so long
  as the incremental revenue exceeds the
  incremental processing costs.

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End of Chapter 20
Hey dude,its party time!