Transcript Managerial Accounting Chapter 11

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ACG 4361
Incremental Analysis
Prepared by
Diane Tanner
University of North Florida
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What is Incremental Analysis?
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 An approach to simplifying complex business
decisions
 Allows us to focus on only the few things that
matter
 Much quicker decision making
 Mingling irrelevant costs with relevant costs may cause
confusion and distract attention from critical matters
 Incremental amounts are often called differential or
relevant
Incremental Analysis Components
Incremental Revenue
The additional revenue as a
result of selecting one
alternative over another
Incremental Cost
The additional cost as a
result of selecting one
alternative over another
Incremental Savings
The reduction of cost as a
result of selecting one
alternative over another
Usually combined with
incremental costs
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Terminology
Avoidable Cost
Can be avoided if a certain decision
is made
Sunk Cost
A cost that has already been
incurred and irreversible
Opportunity Cost
Represents the benefit forgone by
selecting one alternative over
another
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Preparing a Single Column
Incremental Analysis
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Step 1: Compare revenues under both alternatives
• ‘Change’ in revenues = relevant revenues
Step 2: Compare costs under both alternatives
• ‘Change’ in costs = relevant costs and cost savings
Step 3: List and clearly label each incremental line item
• Display as a positive amount if the incremental
amount increases profit (i.e., a benefit)
• Display as a (negative) amount in ( ) parentheses if
the amount causes profit to decline
Step 4: Label the bottom line as ‘Incremental
increase(or decrease) in profit if ………………..’
(replacing …. with the nature of the analysis)
Qualitative Issues
• Nonfinancial issues should always be considered,
regardless if the financial incremental increase or
decrease in profit is positive or negative
• Should be considered regardless if the outcome
points to accepting or rejecting the decision
• Includes:
– Employee morale
– Control over design, quality, timeliness of delivery,
& reliability
– Environmental effects and safety
– Future expectations of customers/suppliers
– Contractual issues
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Types of Incremental Decisions
 Capacity constraints – limited resources
 Outsourcing / make-or-buy
 Keep or drop
 A customer, product, segment, or subdivision
 Special order decisions
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Capacity Constraints
• Often called product mix decisions
• Exists when demand exceeds production that is
limited by a particular resource
– Labor hours
– Machine hours
– Space
– Materials
• Goal is to maximize the contribution margin per
unit of the constrained resource, such as
– CM per labor hour
– CM per square foot
– CM per yard of fabric
No particular incremental
analysis format required
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Outsourcing Decisions
• Also known as a make or buy decision
• Relates to whether an item should be made
internally (or service performed internally) or
purchased from an external supplier/provider
• Only incremental costs and cost savings are
relevant
• No incremental revenue exists because the
selling price of the cost object will not be changed
A single column incremental
analysis is prepared.
Keep or Drop Products or Segments
 Relates to whether a company should drop a product or
segment that appears to have an operating loss, or keep it
• Incremental cost savings and incremental revenues are
relevant
– Incremental costs will result if demand changes occur
in other products/segments
 Caution
 Allocated fixed costs are not usually eliminated and
must be absorbed by other products
Cost Allocation Death Spiral
A single column incremental
analysis is prepared.
Special Orders
 Two types
 One-time-only orders
 Goal is to recover all incremental and opportunity
costs
 Long-run orders
 Goal is to recover the full cost of products and
opportunity costs
 Companies cannot operate successfully in the longrun without recovering ‘all’ costs
 Incremental revenues, incremental costs, and opportunity
costs are relevant
 Capacity considerations are relevant
A single column incremental
analysis is prepared.
One-Time-Only Special Orders
 If idle capacity exists
 Minimum selling price of the special order is the
incremental cost
 Opportunity cost is zero
 If idle capacity does not exist
 Minimum selling price of the special order is the
incremental cost plus the opportunity cost
 Opportunity cost
 Contribution margin of the sales to regular
customers that must be given up in order to accept
the special order
Special Order Minimum Price Example
AutoWash is an automatic car wash with a capacity of 2,000 cars per
month. Its current demand is 1,800 washes per month. The unit cost of
washing one car follows:
Variable cost of washing
Allocated fixed manufacturing overhead
$4.60
1.80
Bug Patrol has offered to purchase 500 washes per month at $6.00 per
wash even though regular customers pay $7.00 each. What is the least
price per car wash that AutoWash should accept from Bug Patrol?
Incremental cost + Opportunity cost = Minimum price
Number of washes over capacity:
Capacity
2,000
Special order
(500)
Regular customers (1,800)
Over capacity
(300)
Opportunity cost:
CM per wash ($7.00 - $4.60)
# of washes over capacity
Total opportunity cost
Incremental cost: 500 × $4.60 = $2,300
Opportunity cost of 300 washes: 720
Minimum price of the order
$3,020
$2.40
300
$720
Minimum price for each
wash:
$3,020 ÷ 500 = $6.04
The End
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