Spring 2018 Chapter 7 Review

Incremental Analysis

LO 1: Analysis
Terms
Incremental analysis
Relevant cost
Opportunity cost
Sunk cost

Analysis:
 Incremental analysis uses financial data that changes among alternatives to help
decision making
 Incremental analysis identifies probably effect of decisions on future earnings, but
does involve estimates and uncertainty
 Relevant costs and benefits are those that differ among alternatives
 Sunk costs are costs that has already been incurred and that cannot be changed
by any decision made now or in the future, are never relevant
 Opportunity costs are factors in the decision-making process because they differ
among alternatives.
 Incremental analysis looks at quantitative factors, but some qualitative factors
should be considered as well in decision making
Types:
 Accept an order at a special price
 Make or buy a component or finished product
 Sell products as is or process them further
 Repair, retain, or replace equipment
 Eliminate an unprofitable segment or product

Example #1

B Company normally runs at capacity and the Model CY1000 machine is the company’s
production constraint. Management is considering purchasing a new machine, Model
CZ4000 and selling the CY1000. The CZ4000 is more efficient and can produce 20%
more units than the old one. If the new machine is purchased, there should be a
reduction in maintenance costs. The company will need to borrow money in order to
purchase the CZ4000. The increase in volume will require increases in fixed selling
expense, but general administrative expenses will remain unchanged.

Required: For each cost listed below, determine whether the cost is relevant

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or irrelevant to the decision to replace the CY1000.

a) Sales Revenue
b) Direct materials
c) Direct labor
d) Variable manufacturing overhead
e) Rent on the factory building
f) Janitorial salaries
g) President’s salary
h) Book Value of CY1000
i) Cost of CY1000
j) Cost of CZ4000
k) Interest on money borrowed to make purchase.
l) Shipping costs
m) Market value of old machine CY1000
n) Insurance on factory building
o) Salaries paid to personnel in sales office

LO 2: Special Orders

Special orders are the simplest decision: if the special order is not accepted, then
nothing changes; if the special order is accepted, then the only change from the status
quo is the special order itself. Therefore only the special order itself should be analyzed.
Note:
 As long as there is capacity to produce the product, the special order will not affect
fixed costs
 Assume sales of other products will not be affected by the special order
 Compare variable cost per unit to sales price per unit. If sales price exceeds
variable cost per unit, accept the project. Net income would increase by
contribution margin per unit multiplied by number of units.

Example #2

T Company produces a single product. The cost of producing and selling a single unit of
this product at the company’s normal activity level of 8,000 units per year is:

Direct materials $2.50

Direct labor 3.00
Variable manufacturing overhead .50
Fixed manufacturing overhead 4.25
Variable selling and administrative expense 1.50
Fixed selling and administrative expense 2.00

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The normal selling price is $15.00 per unit. The company’s capacity is 10,000 units per
month. An order has been received from an overseas source for 2,000 units at the
special price of $12.00 per unit. This order would not affect regular sales.

Required: a) If the order is accepted, how much will monthly profits increase or
decrease? (The order will not change the company’s total fixed
costs.)

LO 3: Make or Buy

Make or buy decisions do not involve revenue; rather they are least-cost decisions: is it
cheaper to make the product in-house or to contract it out to a supplier? For these
decisions, common allocated fixed costs are rarely relevant.

Buying the product from a supplier may make manufacturing and/or warehouse space
available for an alternative, profitable use. The potential profits are opportunity costs
that are added to the costs of manufacturing the product in-house.

Example #3

For many years L Company has purchased the starters that it installs in its standard line
of garden tractors. Due to a reduction in output, the company has idle capacity that
could be used to produce the starters. The chief engineer has recommended against
this move, however, pointing out that the cost to produce the starters would be greater
than the current $10.00 per unit purchase price. The company’s unit product cost, based
on a production level of 60,000 starters per year, is as follows:

Make
Direct materials $4.00
Direct labor 2.75
Variable manufacturing overhead .50
Fixed manufacturing overhead, traceable 3.00 $180,000
Fixed manufacturing overhead, common
(allocated based on direct labor hours) 2.25 135,000
Total production cost $12.50

An outside supplier has offered to supply the starter to Lansing for only $10.00 per
starter. One-third of the traceable fixed manufacturing costs represent supervisory
salaries and other costs that can be eliminated of the starters are purchased. The other
two-thirds of the traceable fixed manufacturing costs is depreciation of special
manufacturing equipment that has no resale value. The decision would have no effect

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on the common fixed costs of the company and the space being used to produce the
parts would otherwise be idle.

Required: Should the company make or buy the starters?

LO 4: Sell or Process Further Decisions

Terms
Joint products

Rule: Process further as long as the incremental revenue from such processing exceeds
the incremental processing costs

In some industries, multiple products can be produced from a single raw material.
Typically these products emerge after some amount of processing has been done to the
raw material. For example, a lumber mill will process the basic raw material, logs, up to
the point at which they have been cut into lumber. Certainly the rough-cut lumber can be
sold as-is, but it could also be processed further into consumer-ready products. The
sawdust and shavings could also be sold as-is or processed further into products such
as particleboard.
 Costs incurred in processing the basic raw materials up to the point where the
separate products emerge are called joint costs.
 The point where these separate or joint products emerge is called the split-off
point.
 Joint costs are irrelevant for any sell-or-process further decisions. Joint product
costs are sunk costs.
 The additional processing occurs at an additional cost and generates additional
sales revenue.
 The decision whether to process further is based on the incremental profit after the
split off point.

Example #4

U Company processes slaughtered steers. All carcasses are processed to the point
where they can be sold as sides of beef to grocery stores, butcher shops and
restaurants. The cost to process each steer is $700. The carcass can be sold for $600
and the hides can be sold for $300 each. Joint costs are allocated to the products based
on total sales value at the split-off point. 100,000 steers are processed each year.

The carcasses may be processed further by cutting them into consumer-ready products
such as steaks and chops. Further processing is very labor intensive, incurring an
addition $500 per carcass. The finished products from each carcass can be sold for

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$1,300. The hides can be cleaned before being sold. Cleaning adds $75 of additional
cost. Cleaned hides can be sold for $350.

Required: Which products should be sold at the split-off point and which
products should be processed further?

LO 5: Repair, Retain, or Replace

For this decision, management needs to decide would decision would benefit the
company over a period of time.

Note:
 Book value of old equipment is not relevant as it is a sunk cost
 Compare relevant costs to determine which is a cheaper alternative, including any
revenue that can be generated based on the alternatives

Example #5

The Company is trying to determine whether to repair an old delivery truck, or replace it
with a new one. The old delivery truck as purchased for $60,000, and has a current
accumulated depreciation of 45,000. The current truck has a remaining useful life of five
years, but could be sold now for $2,000. The new truck would have a purchase price of
$72,000, and would have a useful life of 5 years, with no salvage value. The purchase
of the new truck would decrease variable manufacturing costs from $30,000 per year to
$25,000 per year.

Required: Determine is management should keep the old truck or buy the new one.

LO 6: Eliminating a Segment or Product

For this decision, the question is whether avoiding traceable and perhaps common fixed
costs will offset the lost contribution margin from the eliminated segment or product.
Eliminating a segment or product may also affect the profitability of some or all of the
remaining segments or products. These effects must be included in the analysis of the
decision.

 It is important to only focus on the relevant costs, or the data that chances under
the alternative.
 A decision to discontinue a segment or product based on the net loss is
inappropriate.

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Example #6

B Company, a retailing company, has two departments, X and Y. A recent monthly

contribution format income state for the company follows.

X Y Total
Sales $3,000,000 $1,000,000 $4,000,000
Variable expenses 900,000 400,000 1,300,000
Contribution margin 2,100,000 600,000 2,700,000
Fixed expenses 1,400,000 800,000 2,200,000
Operating income (loss) $700,000 ($200,000) $500,000

A study indicates that $640,000 of the fixed expenses being charged to Y are sunk costs
or allocated costs that will continue even if Y is dropped.

Required: If Department Y is discontinued, will this be a positive move or a

negative move for the company as a whole?

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Solution #1

Relevant: a, b, c, d, j, k, l, m, o
Not Relevant: e, f, g, h, i, n

Solution #2
a)
Selling price $12.00
Direct materials $2.50
Direct labor 3.00
Variable manufacturing overhead .50
Variable selling and administrative expense 1.50
Total variable expenses 7.50
Contribution margin 4.50
Units sold 2,000
Increase in Net income $9,000

Solution #3

Relevant Costs
Make Buy
Direct materials $4.00
Direct labor 2.75
Variable manufacturing overhead .50
Fixed manufacturing overhead, traceable 1.00
Purchase price $10.00
Total relevant cost $8.25 $10.00
Units produced 60,000 60,000
Total Cost $495,000 $600,000

The two-thirds of the traceable fixed manufacturing overhead costs that cannot be
eliminated, and all of the common fixed manufacturing overhead costs, are irrelevant
and not included for decision making purposes. The company would save $105,000 per
year by making the parts itself. In other words, profits would decline by $105,000 per
year if the parts were purchased from the outside supplier.

Solution #4

Selling the products at the split-off point is profitable as the total sales value of each
steer is $900 and the joint costs are $700, producing a profit of $200 per steer.

Further processing of hides:

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Cleaning the hides generates $50 of additional revenue: $350 sales value after cleaning
- $300 sales value at the split-off point. However, the cost of cleaning each hide is $75.
Therefore cleaning each hides results in a $25 loss: $50 - $75. Hides should be sold at
the split-off point.

Further processing of carcasses:

Cutting the caresses into consumer-ready products generates $700 of additional
revenue: $1,300 sales value of the consumer-ready products - $600 sales value at the
split-off point. However, the cost of further processing each carcass is $500. Therefore
further processing results in a $200 profit: $700 - $500. Carcasses should be sold after
processing beyond the split-off point.

Solution #5

Old Truck New Truck Net Income

(decrease)
Variable Manufacturing $150,000 $125,000 25,000
Cost
New Truck Cost 72,000 (72,000)
Sale of old truck (2,000) 2,000
Total $150,000 $195,000 (45,000)

Note: The company should keep the old truck as it will cost less over the 5 year period.
When comparing alternatives, Alternative 1- Alternative 2= net income (decrease)

Solution #6

Continue Eliminate Total

Sales $1,000,000 0 $(1,000,000)
Variable expenses 400,000 0 400,000
Contribution margin 600,000 0 (600,000)
Fixed expenses 800,000 640,000 160,000
Operating income (loss) ($200,000) (640,000) $(440,000)

The incremental analysis concludes that management should continue with Department
Y, as if they eliminate this it will cause an additional loss of $440,000.

Note: When comparing alternatives, make sure to recognize if the line item would initially
increase or decrease the operating income.

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