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Chapter 12 Incremental Analysis
Terms in this set (17)
Describe management's decision-making process and incremental analysis.
Making a decisons is an important managment function
- does not always follow a set pattern
- decisions vary in scope, urgency, and importance
- steps ususally involved In process include:
1. identify the problem and assign responsibility
2. determine and evaluate possible courses of action
3. make a decision
4. review results of the decision
decision making process
- in making business decisions,
- considers both financial and non-financial information
- financial information: revenues and costs; effect on overall profitability
- non-financial info
- effect on employee turnover
- the environment
- overal company image
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 or only revenues may or only cots may vary
how incremental analysis works Example...
- 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
How incremental analysis works
-important concept used in incremental analysis
- relevant cost
- opportunity cost
- sunk cost
- sometimes involves changes that seem contrary to intuition
- variable costs sometimes do not change under alternative
- fixed costs sometimes change between alternatives
Types of incremental analysis
- common types of decisions involving incremental analysis
- accept an order at a special price
- make or buy component part or finished products
- repair, retain, or replace equipment
- eliminate an unprofitable business segment or product
Analyze the relevant costs in accepting an order at a special price.
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
Illustration: Sunbelt Company produces 100,000 Smoothie blenders per month, which is 80% 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 Kensington 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?
- fixed costs do not change since within existing capacity- thus fixed costs ar enot relevant
- variable manufacturing and expected revenues change- thus both are relevant to the decision
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. Cobb will incur additional shipping costs of $1 per unit. Compute the increase or decrease in net income Cobb will realize by accepting the special order, assuming Cobb has excess operating capacity. Should Cobb Company accept the special order?
At Bargain Electronics, it costs $34 per unit ($15 variable and $19 fixed) to make an MP3 player at full capacity that normally sells for $53. A foreign wholesaler offers to buy 3,180 units at $29 each. Bargain Electronics will incur special shipping costs of $4 per unit.Assuming that Bargain Electronics has excess operating capacity, indicate the net income (loss) Bargain Electronics would realize by accepting the special order.
- just multiple units of product (3180) by purchase price by wholesaler ($29) to find revenue costs
- then multiple number of units by the variable cost to get the cost-manufacturing
- finally multiple shipping cost by number of units
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 motor scooters.
- instead of making its own switches, Baron Company might purchase the ignition switches at a price of $8 unit
- total manufacturing cost is $1 higher per unit than purchase price
- must absorb at least 50,000 of fixed costs under either option
- the potential benefit that may be obtained from following an alternative course of action
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.
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 will be eliminated.
(a) Prepare an incremental analysis showing whether the company should make or buy the electrical cords. (b) Will your answer be different if the released productive capacity will generate additional income of $5,000?
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