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Incremental Analysis

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  1. Managerial AccountingSecond EditionWeygandt / Kieso / Kimmel Prepared by: Ellen L. Sweatt Georgia Perimeter College ELS

  2. Incremental Analysis

  3. Illustration 9-1 Management’s Decision-making Process Consider both financial and nonfinancial information. Nonfinancial information relates to: • Effect of decision on employee turnover • The environment • Overall image of company in community.

  4. Incremental Analysis • Sometimes both costs and revenues vary. • Sometimes only revenues vary. • Sometimes only costs vary.

  5. Illustration 9-2 Incremental Analysis The process of identifying the financial data that change under alternative courses of action. Alternative Alternative Net Income A B Increase (Decrease) Revenues $125,000 $110,000 $(15,000) Costs 100,000 80,000 20,000 Net income $ 25,000 $ 30,000 $ 5,000

  6. Illustration 9-3

  7. Types of Incremental Analysis • Accept an order at a special price. • Make or buy component parts or finished products. • Sell products or process further. • Retain or replace equipment. • Eliminate an unprofitable business segment.

  8. Illustration 9-4 Reject Accept Net Income Order Order Increase (Decrease) Revenues $ -0- $22,000 $ 22,000 Costs -0- 16,000 (16,000) Net income $ -0- $ 6,000 $ 6,000 Accept An Order At A Special Price Assume sales of the products in other markets would not be affected by special order. Assume company is not operating at full capacity.

  9. Illustration 9-5 Make or Buy Assume sales of the products in other markets would not be affected by special order. Assume company is not operating at full capacity.

  10. Illustration 9-5 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 Make or Buy COST TO MAKE Alternatively, Baron may purchase the ignition switches from Ignition, Inc., at a price of $8 per unit. Question: Should Baron make or buy the ignition switches?

  11. Illustration 9-6 Net Income Make Buy Increase (Decrease) Direct materials $ 50,000 $ - 0 - $ 50,000 Direct labor 75,000 - 0 - 75,000 Variable manufacturing costs 40,000 - 0 - 40,000 Fixed manufacturing costs 60,000 50,000 10,000 Purchase price -0- 200,000 (200,000) Total annual cost $225,000 $250,000 $ (25,000) Decision: Barton Company will incur $25,000 of additional costs by buying the switches. Therefore, Barton should continue to make the switches. Make or Buy

  12. Opportunity cost The potential benefit that may be obtained from following an alternative course of action.

  13. Illustration 9-7 Make or Buy - Opportunity Cost Assume the company can use the released capacity to generate $ 28,000 additional income. Net Income Make Buy Increase (Decrease) Total annual cost $225,000 $250,000 $(25,000) Opportunity cost 28,000 - 0 - 28,000 Total cost $253,000 $250,000 $ 3,000 Decision: It is now advantageous to buy the switches. Barton will save $3,000 worth of costs with this alternative.

  14. Illustration 9-8 Direct materials $ 15 Direct labor 10 Variable manufacturing overhead 6 Fixed manufacturing overhead 4 Total manufacturing costs $35 Sell or Process Further? A, Inc. makes tables. The cost to manufacture an unfinished table is $35. Unfinished units sell for $50. Finished tables sell for $60 each. For a finished table direct materials and direct labor costs will increase $2 and $4, respectively. Variable overhead will increase by $2.40 (60% of direct labor). There will be no increase in fixed overhead. Question: Should A, INC. sell the unfinished tables or process them further?

  15. Illustration 9-9 Process Net Income Sell Further Increase (Decrease) Sales per unit $50.00 $60.00 $10.00 Cost per unit Direct materials 15.00 17.00 (2.00) Direct labor 10.00 14.00 (4.00) Variable manufacturing overhead 6.00 8.40 (2.40) Fixed manufacturing overhead 4.00 4.00 - 0 - Total $35.00 $43.40 $(8.40) Net income per unit $15.00 $16.60 $ 1.60 Sell or Process Further? Process further as long as the incremental revenue from such processing exceeds the incremental processing costs.

  16. Joint costs For joint products, all costs incurred prior to the point at which two products are separately identifiable.

  17. Illustration 9-10 Sell/Process Further-Multiple Products Use Incremental Analysis to Decide.

  18. Sunk cost The book value of the old machine is a sunk costwhich is a cost that cannot be changed by any present or future decision. Sunk costs are not relevant in incremental analysis.

  19. Retain or Replace Equipment Jeffcoat Company has a factory machine with a book value of $40,000 and a remaining useful life of four years. A new machine is available for $120,000 and is expected to have zero salvage value at the end of its 4-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 will be scrapped. Question: Should Jeffcoat Company retain or replace the machine?

  20. Illustration 9-14 Net Income Retain Replace Increase (Decrease) Variable manufacturing costs $640,000a $500,000b $140,000 New machine cost 120,000 (120,000) Total $640,000 $620,000 $ 20,000 a(4 years x $160,000) b(4 years x $125,000) Retain or Replace Equipment Decision: It would be to the company’s advantage to replace the equipment. The lower variable manufacturing costs due to replacement more than offset the cost of the new equipment.

  21. Eliminate An Unprofitable Segment Often fixed costs allocated to the unprofitable segment must be absorbed by the other segments. It is possible for net income to decrease when an unprofitable segment is eliminated.

  22. Illustration 9-15 Pro Master Champ Total Sales $800,000 $300,000 $100,000 $1,200,000 Variable expenses 520,000 210,000 90,000 820,000 Contribution margin 280,000 90,000 10,000 380,000 Fixed expenses 80,000 50,000 30,000 160,000 Net income $200,000 $ 40,000 $(20,000) $ 220,000 Eliminate An Unprofitable Segment Martina Company manufactures tennis racquets in three models: Pro, Master, and Champ. Pro and Master are profitable lines, whereas Champ operates at a loss. Condensed income statement data are: Question: Should the Champ segment be eliminated?

  23. Illustrations 9-15&9-16 Pro Master Champ Total Sales $800,000 $300,000 $100,000 $1,200,000 Variable expenses 520,000 210,000 90,000 820,000 Contribution margin 280,000 90,000 10,000 380,000 Fixed expenses 80,000 50,000 30,000 160,000 Net income $200,000 $ 40,000 $(20,000) $ 220,000 Pro Master Total Sales $800,000 $300,000 $1,100,000 Variable expenses 520,000 210,000 730,000 Contribution margin 280,000 90,000 370,000 Fixed expenses100,000 60,000 160,000 Net income $200,000 $ 40,000 $ 210,000 ELIMINATE CHAMP? Eliminate An Unprofitable Segment Decision:Total net income decreases $10,000 ($220,000 – $210,000) if the Champ line is discontinued.

  24. Illustrations 9-15&9-16 Pro Master Total Sales $800,000 $300,000 $1,100,000 Variable expenses 520,000 210,000 730,000 Contribution margin 280,000 90,000 370,000 Fixed expenses100,000 60,000 160,000 Net income $200,000 $ 40,000 $ 210,000 ELIMINATE CHAMP? Pro Master Champ Total Sales $800,000 $300,000 $100,000 $1,200,000 Variable expenses 520,000 210,000 90,000 820,000 Contribution margin 280,000 90,000 10,000 380,000 Fixed expenses 80,000 50,000 30,000 160,000 Net income $200,000 $ 40,000 $(20,000) $ 220,000 Eliminate An Unprofitable Segment Decision:Total net income decreases $10,000 ($220,000 – $210,000) if the Champ line is discontinued.

  25. Illustrations 9-17 Net Income Continue Eliminate Increase (Decrease Sales $100,000 $ - 0 - $(100,000) Variable expenses 90,000 - 0 - 90,000 Contribution margin 10,000 - 0 - (10,000) Fixed expenses 30,000 30,000 - 0 - Net income $(20,000) $ 30,000) $ (10,000) Eliminate An Unprofitable Segment Decision:Total net income decreases $10,000 ($220,000 – $210,000) if the Champ line is discontinued. OR

  26. Joint products Multiple end-products produced from a single raw material and a common process.

  27. Sales Mix The relative combination in which a company’s products are sold.

  28. Unit Data VCRs TVs Selling price $500 $800 Variable costs 300 400 Contribution margin $200 $400 Sales mix 3 1 Illustration 9-18 Sales Mix

  29. Illustration 9-21 Limited Resources Collins Co. manufactures deluxe and standard pen and pencil sets. The limited resource is machine capacity, which is 3,600 hours per month. Relevant data consists of: Deluxe Standard Contribution margin per unit $8 $6 Machine hours required per unit .4 .2 Question: Should Collins Co. shift its sales mix toward deluxe or standard sets?

  30. Illustration 9-22 Limited Resources Deluxe Standard Contribution margin per unit (a) $8 $6 Machine hours required per unit (b) .4 .2 Contribution margin per unit of limited resource (a  b) $20 $30 Decision:Since the standard set has the higher contribution margin per unit of limited resource, sales mix should shift towards that product.