Managerial accounting 5th jiambalvo ch07

Incremental Analysis An alternative that yields an incremental profit should be selected  Incremental costs are referred to as relevant costs  Also called differential costs beca

Incremental Analysis

 Incremental analysis

 All decisions involve a choice

among alternative courses of action

 The solution to business problems involves incremental analysis

of the incremental revenue and incremental costs incurred when one alternative is chosen over

Incremental Analysis

 Incremental Revenue

 Additional revenue received by

selecting one alternative over another

 Incremental Cost

 Additional cost incurred by

selecting one alternative over another

 Incremental Profit

 Difference between incremental

Incremental Analysis

 An alternative that yields an

incremental profit should be

selected

 Incremental costs are referred to

as relevant costs

 Also called differential costs

because they are the costs that

differ between decision

 Alternative 1 is the status quo

 Alternative 2 involved the company extending their hours from 8 pm to midnight

incremental costs and revenues associated with choosing one

alternative over another

Incremental Analysis

Example

Incremental Analysis

Example

Incremental Analysis

 Incremental Analysis can be

extended to more than two

alternatives

 Calculate profit for each

alternative

 The alternative with the highest

profit is the best alternative

the profit of any other alternative

is its incremental profit

“What Does This Product

decision, some will not

Which of the following is likely to be an

incremental cost associated with increasing planned production run of 1,000 units to

Analysis of Decisions Faced

2 The decision to make or buy a

product

3 The decision to drop a product

Additional Processing Decision

 Manufacturers must occasionally

decide whether to:

 Sell a product in a partially

completed stage, or

 Incur additional processing costs

required to complete the product

 Costs incurred to date of decision

on partially complete product are not relevant, i.e sunk costs.

Additional Processing Decision – Bridge Computer Example

Additional Processing Decision – Bridge Computer Example

Summary of cost information

Additional Processing Decision – Bridge Computer Example

Additional Processing Decision – Bridge Computer Example

 Incremental analysis summary

 Incremental revenues are $500

 Incremental costs are $400

 Would you spend $400 to generate

an additional $500?

Answer: Yes, incremental profit is

$100

Additional Processing Decision – Bridge Computer Example

Additional Processing Decision – Bridge Computer Example

Incremental analysis summary

Sell Partially Complete

Sell Fully Complete Incremental

Additional Processing Costs 0 (400) (400) b

Gain (loss) per unit ($300) ($200) $100 c

a Incremental revenue associated with alternative 2

b Incremental cost associated with alternative 2

c Incremental profit associated with alternative 2

Additional Processing Decision

Make or Buy Decisions

 Most manufactured goods are

made up of numerous components

 In some cases, a company may

purchase one or more of these components from another company

or manufacture them themselves

 The analysis of this decision

concentrates solely on incremental costs

Make-or-Buy Decisions – General Refrigeration Example

Make-or-Buy Decisions – General Refrigeration Example

 A key issue is to determine which

of the above costs are incremental

 None of the $15 million of variable manufacturing costs will be

incurred if the part is purchased

 The fixed costs associated with

depreciation will not be saved

irrelevant sunk costs

Make-or-Buy Decisions – General Refrigeration Example

Make-or-Buy Decisions – General Refrigeration Example

 Some fixed costs are avoidable

supervisors will be saved

 The savings total $390,000 of

avoidable fixed costs

 It will cost the company an

Make-or-Buy Decisions – General Refrigeration Example

Make-or-Buy Decisions – General Refrigeration Example

Make-or-Buy Decisions – General Refrigeration Example

Make-or-Buy Decisions – General Refrigeration Example

Incremental cost analysis – 3 column

format

Make-or-Buy Decisions – General Refrigeration Example

Make-or-Buy Decisions – General Refrigeration Example

Incremental cost analysis - single column

format

Which of the following is not likely to be an incremental cost for a make-or-buy

decision?

Answer: d

Depreciation of building is not likely to

change no matter which alternative is

chosen in a make-or-buy decision

Test Your Knowledge 2

 An opportunity cost is the value of benefits foregone by selecting one decision alternative over another

 For example, if you spend $1,000

instead of investing in a certificate

of deposit, the interest that could have been earned is an opportunity cost

 Since opportunity costs differ

depending on the option selected, they are incremental costs

Opportunity Costs

Which of the following is true?

Test Your Knowledge 3

 Suppose the Tennessee plant is

currently spending $500,000 per

year to rent space for

manufacturing shelving used in the refrigeration units

Make-or-Buy Decisions – General Refrigeration Example

Make-or-Buy Decisions – General Refrigeration Example

Incremental analysis with opportunity

costs

Dropping a Product Line

 Analysis involves calculating the

change in income that will result from dropping the product line

 If income increases, the product

line should be dropped

 If income decreases, the product

line should not be dropped

incremental revenues and costs that result from dropping the product

line

Dropping a Product Line –

Mercer Hardware

Dropping a Product Line –

Mercer Hardware

 Mercer Hardware sells 3 product

lines, tools, hardware and garden

 Direct fixed costs are directly

traceable to each product line

 Allocated fixed costs are not directly traceable to a product line

not avoidable, thus no common fixed costs will be saved if the product

Dropping a Product Line – Mercer Hardware Example

Dropping a Product Line – Mercer Hardware Example

Profit calculation with three product lines

Dropping a Product Line – Mercer Hardware Example

Dropping a Product Line – Mercer Hardware Example

Profit calculation with two product lines

Tools

Hardware Supplies

Total

2 products

Total

3 products Sales $120,000 $200,000 $320,000 $400,000

Traceable costs:

Cost of goods sold (81,000) (90,000) (171,000) (231,000)

Other variable costs (2,000) (4,000) (6,000) (7,000)Direct fixed costs (8,000) (5,000) (13,000) (16,500)Non-traceable costs

Company fixed costs (30,000) (50,000) (80,000) (80,000)

Division net income ($1,000) $51,000 $50,000 $65,500

Mercer Hardware Product Line Income Statement For the Year Ended December 31, 2006

Dropping a Product Line – Mercer Hardware Example

Dropping a Product Line – Mercer Hardware Example

Beware of the Cost Allocation

Death Spiral

Beware of the Cost Allocation

Death Spiral

 When dropping a product line

 Common fixed costs are not

incremental

 Common fixed cost allocation is

spread among remaining product lines

 Management must understand

and remember this impact when

making decisions

Terminology Summary

 Avoidable costs

 Costs that can be avoided by taking

a particular course of action

 Always incremental costs, and

therefore relevant to a decision

 Sunk costs

 Already occurred and not reversible

 Are not incremental because they

do not differ among alternatives

 Not relevant in decision making

Terminology Summary

 Many students assume that fixed

costs are equivalent to sunk costs

 This is not always the case

 Fixed costs can be sunk, not sunk

and irrelevant, or possibly relevant

 Opportunity costs

 Represent the benefit foregone by

selecting a particular alternative

 They are always incremental and

Which of the following costs should not

be taken into consideration when

Classify each of the following as sunk and irrelevant, not sunk but still irrelevant, or not sunk and relevant

Depreciation on equipment already purchased

Sunk and irrelevant (not incremental)

President’s salary, which will not change for

both action A and action B

Not sunk and irrelevant (not incremental)

Salary of supervisory who will be retained for action A and fired for action B

Test Your Knowledge 5

Decisions Involving Joint Costs

 Stage of production in which

individual products are identified

 Product may undergo further

processing and may incur additional

Allocation of Joint Costs

 For financial reporting, the cost of

common inputs must be allocated to the joint products

no matter what the company does with the joint products beyond the split-off point

production of an individual joint product and irrelevant to decisions

Joint Products Example

Joint Cost Allocation

Methods

Joint Cost Allocation

Methods

Physical quantity of output

Joint costs allocated to product A =

Joint costs allocated to product B =

Joint Cost Allocation

Methods

Joint Cost Allocation

Methods

Relative sales value

Joint costs allocated to product A =

Joint costs allocated to product B =

Joint Cost Allocation

Example

Joint Cost Allocation

Example

physical quantity of output

 500 feet of grade A lumber that sells for

$1 per foot, and

 500 feet of grade B lumber that sells for

$0.50 per foot

Joint costs allocated to product A =

Joint Cost Allocation

Example

Joint Cost Allocation

Example

physical quantity of output

 500 feet of grade A lumber that sells for

$1 per foot, and

 500 feet of grade B lumber that sells for

$0.50 per foot

Joint costs allocated to product B =

Joint Cost Allocation

 500 feet of grade A lumber that sells for

$1 per foot, sales value 500 * 1 = $500, and

 500 feet of grade B lumber that sells for

$0.50 per foot, sales value 500 * 0.50 =

$250

Joint Cost Allocation

 500 feet of grade A lumber that sells for

$1 per foot, sales value 500 * 1 = $500, and

 500 feet of grade B lumber that sells for

$0.50 per foot, sales value 500 * 0.50 =

$250

Joint costs allocated to product B =

Additional Processing Decisions and Joint Costs

Additional Processing Decisions and Joint Costs

 Joint costs not relevant to decisions made after the split-off point

because they are not incremental

 Joint costs incurred prior to the

split-off point are sunk costs and

must be incurred no matter what

happens after the split-off point

The joint costs incurred in a joint

Qualitative Considerations in

Decision Analysis

Qualitative Considerations in

Decision Analysis

features that are difficult to quantify

but should be given careful

Qualitative Considerations in

Decision Analysis

Qualitative Considerations in

Decision Analysis

Qualitative Factors

Appendix – The Theory of

Constraints

Appendix – The Theory of

Constraints

 The Theory of Constraints is an

approach to production and

constraint management developed

by Eli Goldratt

 Five step process

 Large increases in profit can be

achieved by elimination of bottlenecks in production processes

Appendix – The Theory of

1 Identify the Binding Constraint

The binding constraint is the process

that limits throughput

2 Optimize Use of the Constraint

Produce products with the highest

contribution margin per unit of the

constraint

Appendix – The Theory of

Managers should focus their attention

on trying to loosed the constraint and

not on process improvements

Appendix – The Theory of

4 Break the Constraint

This can be done many ways including

cross training workers, outsourcing,

purchasing additional equipment or

hiring new workers

5 Identify a New Binding Constraint

Identify the additional bottlenecks If

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