Scheduled maintenance: Wednesday, February 8 from 10PM to 11PM PST
Upgrade to remove ads
Only $35.99/year

Accounting 2: Chapter 20 "Incremental Analysis"

Terms in this set (16)

Management's decision-making process
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

Considers financial and non-financial information
Incremental Analysis Approach
process used to identify the financial data that change under alternative courses of action.

uses relevant cost to analyze what is cost is relevant to the situation
Relevant Cost
A cost that is relevant to a particular decision because it is a future cost and differs among alternatives
Opportunity Cost
The lost potential benefit that could have been obtained from following an alternative course of action. In the make-or-buy decision, it is important for management to take into account the social impact of its choice.
Sunk Cost
a cost that has already been paid and cannot be recovered
Special Orders
why?
- 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
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 Smoothie 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?
1. We must identify the relevant costs and data for this decision.

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.

2. What happens when we accept the order

Revenues: $22,000 (2,000 blenders at $11 per unit)
Costs: $16,000 (2,000 blenders at $8 variable cost)
Net Income: 6,000 (revenues - costs)

3. What if we reject the order?

We would recognize $0 in revenues, costs, net income

If the special order price is greater than the variable cost per unit then there is a contribution margin to be made to cover the company's fixed costs or increase net income.
Make-or-buy
a company's decision on whether to make or buy based on its core competence. The production cost and quality problems are the major triggers of make-or -buy decisions.
Baron Company incurs the following annual costs in producing 25,000 ignition switches for motor scooters.

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. What should Baron do?
Analyze the Buy decision and compare it to the make decision

Buy:
Direct materials: 0
Direct labor: 0
Variable manufacturing overhead: 0
Fixed manufacturing overhead: 50,000
Purchase price (25,000 x 8): 200,000

Total annual cost: 250,000

Make:
Direct materials: $50,000
Direct labor: 75,000
Variable manufacturing overhead: 40,000
Fixed manufacturing overhead: 60,000
Purchase Price: 0

Total annual cost: 225,000

Manufacturing cost is $1 higher per unit than purchase price.

Net income suffers a 25,000 decrease by switching to buying. (250,000 [buy] - 225,000 [make])

thus the company should make the switches.
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.
Analysis of decisions

Make:
Total annual cost: $225,000
Opportunity cost: 38,000
Total cost: $263,000

Buy:
Total annual cost: $250,000
Opportunity cost: 0
Total cost: $250,000

Net income increases $13,000 (263,000 - 250,000) when the opportunity cost is considered.
sell or process materials further
may have option to sell product at a given point in production or to process further and sell at a higher price

Decision Rule:
-Process further as long as the incremental revenue from such processing exceeds the incremental processing costs
-Incremental revenue > incremental costs
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.
Sell Unfinished Decision:

Sales price per unit: $50
Cost per unit:
-Direct materials: $15
-Direct labor: $10
-Variable manufacturing overhead: $6
-Fixed manufacturing overhead: $4
Total: $35
Net Income per unit: $15 (50 [sales price per unit] - 35 [total cost per unit])

Process Further Decision:

Sales price per unit: $60
Cost per unit:
-Direct materials: $17
-Direct labor: $14
-Variable manufacturing overhead: $8.40
-Fixed manufacturing overhead: $4
Total: $43.40
Net Income per unit: $16.60 (60 [sales price per unit] - 43.40 [total cost per unit])

Net income increase: $1.60

60-50= 10
35-43.40= (8.40)
10-8.40 = 1.60
Multiple-Product Case
joint product costs are sunk costs and thus not relevant to the sell-or-process further decision
Repairing, Retaining, or Replacing Equipment
book value of old machines does not affect the decision.
-book value is a sunk cost
-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
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.
Variable manufacturing Costs: $640,000 (160,000 x 4 years)
New Machine Costs: 0
Sale of old machine: 0
Total: 640,000

Variable manufacturing Costs: $500,000 (125,000 x 5 years)
New Machine Costs: $120,000
Sale of old machine: (5,000)
Total: $615,000

Net income:
Variable manufacturing Costs: $140,000
New Machine Costs: (120,000)
Sale of old machine: 5,000
Total: 25,000 (640,000 - 615,000)

The company should replace the equipment because they are losing $25,000 by retaining the equipment. Their net income would increase $25,000 by replacing the old machine.
eliminate an unprofitable segment or product
key: focus on relevant costs
-consider effect on related product lines

Decision Rule: retain the segment unless fixed costs eliminated exceed contribution margin lost

fixed costs allocated to unprofitable segment must be absorbed by the other segments

net income may decrease when an unprofitable segment is eliminated
Sets found in the same folder