CHAPTER 7

INCREMENTAL ANALYSIS

CHAPTER LEARNING OBJECTIVES

1. Describe management’s decision-making process and incremental analysis. Management’s decision-making process consists of (a) identifying the problem and assigning responsibility for the decision, (b) determining and evaluating possible courses of action, (c) making the decision, and (d) reviewing the results of the decision. Incremental analysis identifies financial data that change under alternative courses of action. These data are relevant to the decision because they will vary across the possible alternatives.

2. Analyze the relevant costs in accepting an order at a special price. The relevant costs are those that change if the order is accepted. The relevant information in accepting an order at a special price is the difference between the variable manufacturing costs to produce the special order and expected revenues. Any changes in fixed costs, opportunity cost, or other incremental costs or savings (such as additional shipping) should be considered.

3. Analyze the relevant costs in a make-or-buy decision. In a make-or-buy decision, the relevant costs are (a) the variable manufacturing costs that will be saved as well as changes to fixed manufacturing costs, (b) the purchase price, and (c) opportunity cost.

4. Analyze the relevant costs and revenues in determining whether to sell or process materials further. The decision rule for whether to sell or process materials further is: Process further as long as the incremental revenue from processing exceeds the incremental processing costs.

5. Analyze the relevant costs to be considered in repairing, retaining, or replacing equipment. The relevant costs to be considered in determining whether equipment should be repaired, retained, or replaced are the effects on variable costs and the cost of the new equipment. Also, any disposal value of the existing asset must be considered.

6. Analyze the relevant costs in deciding whether to eliminate an unprofitable segment or product. In deciding whether to eliminate an unprofitable segment or product, the relevant costs are the variable costs that drive the contribution margin, if any, produced by the segment or product. Opportunity cost and reduction of fixed expenses must also be considered.

TRUE-FALSE STATEMENTS

1. An important step in management’s decision-making process is determining and evaluating possible courses of action.

2. In making decisions, management ordinarily considers both financial and nonfinancial information.

3. In incremental analysis, total variable costs will change under alternative courses of action while total fixed costs will remain constant.

4. Accountants are mainly involved in developing nonfinancial information for management’s consideration in choosing among alternatives.

5. Decision-making involves choosing among alternative courses of action.

6. Financial data are developed for a course of action on an incremental basis and then compared to data developed on a differential basis before a decision is made.

7. In incremental analysis, total fixed costs remain constant under alternative courses of action.

8. A special one-time order should not be accepted if the unit selling price is less than the unit variable cost.

9. If a company has excess capacity and present markets will not be affected, it would be profitable to accept an order at a special unit selling price even though it is less than the unit variable cost to manufacture the item.

10. A company should never accept a special order for its product for less than its regular sales price.

11. If a company is operating at less than full capacity, the incremental costs of a special order will likely include variable manufacturing costs, but not fixed costs.

12. The decision rule for an incremental make-or-buy decision is: Choose the lowest cost alternative.

13. A decision whether to continue to make a product or buy it externally depends on the external price and the amount of variable and fixed costs that can be eliminated assuming no alternative uses of resources.

14. An opportunity cost is the lost potential benefit that could have been obtained by following an alternative course of action.

15. If an incremental make or buy analysis indicates that it is cheaper to buy rather than make an item, management should always choose the lowest cost alternative.

16. In a sell or process further decision, management should process further as long as the incremental revenues from additional processing exceed the incremental variable costs.

17. It is generally better to sell now rather than process further because of the time value of money.

18. The basic decision rule in a sell or process further decision is: Process further if the incremental revenue from processing exceeds the incremental processing costs.

19. In an equipment replacement decision, the book value of the old equipment is considered an opportunity cost.

20. In an equipment replacement decision, the book value of the old equipment is considered a sunk cost.

21. In an equipment replacement decision, the salvage value of the old equipment is relevant in incremental analysis.

22. It is better not to replace old equipment if it is not fully depreciated.

23. From a quantitative standpoint, a segment should be eliminated if its contribution margin is less than the fixed costs that can be eliminated.

24. The elimination of an unprofitable product line may adversely affect the remaining product lines.

25. Many incremental analysis decisions have qualitative considerations, but since they are not easily measured, they should be ignored.

26. Accounting contributes to management’s decision-making process through internal reports that review the actual impact of the decision.

27. The process used to identify the financial data that change under alternative courses of action is called allocation of limited resources.

28. If a company is operating at full capacity, the incremental costs of a special order will likely include fixed manufacturing costs.

29. The basic decision rule in a sell or process further decision is: Sell without further processing as long as the incremental revenue from processing exceeds the incremental processing costs.

30. In deciding on the future status of an unprofitable segment, management should recognize that net income could decrease is the unprofitable segment is eliminated.

MULTIPLE CHOICE QUESTIONS

31. A major accounting contribution to the managerial decision-making process in evaluating alternative courses of action is to

a. assign responsibility for the decision.

b. provide relevant revenue and cost data about each course of action.

c. determine the amount of money that should be spent on a project.

d. decide which actions that management should consider.

32. Which of the following stages of the managerial decision-making process is improperly sequenced?

a. Evaluate possible courses of action  Make decision.

b. Assign responsibility for the decision  Identify the problem.

c. Identify the problem  Determine possible courses of action.

d. Assign responsibility for decision  Determine possible courses of action.

33. Internal reports that review the actual impact of decisions are prepared by

a. department heads.

b. the controller.

c. management accountants.

d. factory workers.

34. Which of the following steps in the management decision-making process does not generally involve the managerial accountant?

a. Determine possible courses of action

b. Make the appropriate decision based on relevant data

c. Prepare internal reports that review the impact of decisions

d. None of these answers are correct.

35. Which is the first step in the management decision-making process?

a. Determine and evaluate possible courses of action

b. Review results of the decision

c. Identify the problem and assign responsibility

d. Make the appropriate decision based on relevant data

36. Which of the following is always a relevant cost?

a. Sunk cost

b. Fixed cost

c. Variable cost

d. Opportunity cost

37. Costs that will differ between alternative courses of action and influence the outcome of a decision are called

a. sunk costs.

b. unavoidable costs.

c. relevant costs.

d. product costs.

38. A revenue that differs between alternative courses of action and makes a difference in decision-making is called a(n)

a. sales revenue.

b. incremental revenue.

c. unavoidable revenue.

d. irrelevant revenue.

39. Alvarez Company is considering the following alternatives:

Alternative A Alternative B

Revenues $50,000 $60,000

Variable costs 30,000 30,000

Fixed costs 10,000 16,000

What is the incremental profit?

a. $10,000

b. $0

c. $6,000

d. $4,000

Ex. 180

Roland Company operates a small factory in which it manufactures two products: A and B. Production and sales result for last year were as follow:

A   B  

Units sold 8,000 16,000

Selling price per unit 65 52

Unit variable cost 35 30

Unit fixed cost 15 15

For purposes of simplicity, the firm allocates total fixed costs over the total number of units of A and B produced and sold.

The research department has developed a new product (C) as a replacement for product B. Market studies show that Roland Company could sell 11,000 units of C next year at a unit selling price of $80. The unit variable cost of C is $39. The introduction of product C will lead to a 10% increase in demand for product A and discontinuation of product B. If the company does not introduce the new product, it expects next year’s result to be the same as last year’s.

Instructions

Should Roland Company introduce product C next year? Explain why or why not. Show calculations to support your decision.

Ex. 181

Felter Company produced and sold 50,000 units of product and is operating at 70% of plant capacity. Unit information about its product is as follows:

Sales price $70

Variable manufacturing cost $45

Fixed manufacturing cost ($500,000 ÷ 50,000) 10 55

Profit per unit $15

The company received a proposal from a foreign company to buy 10,000 units of Felter Company’s product for $50 per unit. This is a one-time only order and acceptance of this proposal will not affect the company’s regular sales. The president of Felter Company is reluctant to accept the proposal because he is concerned that the company will lose money on the special order.

Instructions

Prepare a schedule reflecting an incremental analysis of this proposal and indicate the effect the acceptance of this order might have on the company’s income.

Ex. 182

Carney Company manufactures cappuccino makers. For the first eight months of 2022, the company reported the following operating results while operating at 80% of plant capacity:

Sales (500,000 units) $90,000,000

Cost of goods sold 54,000,000

Gross profit 36,000,000

Operating expenses 24,000,000

Net income $12,000,000

An analysis of costs and expenses reveals that variable cost of goods sold is $95 per unit and variable operating expenses are $35 per unit.

In September, Carney Company receives a special order for 40,000 machines at $135 each from a major coffee shop franchise. Acceptance of the order would result in $10,000 of shipping costs but no increase in fixed expenses.

Instructions

(a) Prepare an incremental analysis for the special order.

Ex. 183

Gregg Company supplies schools with floor mats to use in physical education classes. Gregg has received a special order from a large school district to buy 600 mats at $45 each. Acceptance of the special order will not affect fixed costs but will result in $1,200 of shipping costs.

For the first 6 months of 2022, the company reported the following operating results while operating at 80% capacity:

Sales (100,000 units) $7,000,000

Cost of goods sold 4,200,000

Gross profit 2,800,000

Operating expenses 2,000,000

Net income $ 800,000

Cost of goods sold was 75% variable and 25% fixed; operating expenses were 70% variable and 30% fixed.

Ex 183 (cont.)

Instructions

(a) Prepare an incremental analysis for the special order.

Ex. 184

Larkin Company produces golf discs which it normally sells to retailers for $6 each. The cost of manufacturing 25,000 golf discs is:

Materials $ 10,000

Labor 30,000

Variable overhead 20,000

Fixed overhead 40,000

Total $100,000

Larkin also incurs 5% sales commission ($0.30) on each disc sold.

Rudd Corporation offers Larkin $4.25 per disc for 3,000 discs. Rudd would sell the discs under its own brand name in foreign markets not served by Larkin. If Larkin accepts the offer, its fixed overhead will increase from $40,000 to $43,000 due to the purchase of a new imprinting machine. No sales commission will result from the special order. Larkin has sufficient capacity to accommodate the special order.

Instructions

(a) Prepare an incremental analysis for the special order.

(b) Should Larkin accept the special order? Why or why not?

Ex. 185

Kasten, Inc. budgeted 10,000 widgets for production during 2022. Kasten has capacity to produce 12,000 units. Fixed factory overhead is allocated to production. The following estimated costs were provided:

Direct material ($7/unit) $ 70,000

Direct labor ($15/hr. × 2 hrs./unit) 300,000

Variable manufacturing overhead ($4/unit) 40,000

Fixed factory overhead costs ($5/unit) 50,000

Total $460,000

Cost per unit = $46

Instructions

1. Kasten received an order for 1,000 units from a new customer in a country in which Kasten has never done business. This customer has offered $43 per widget. Should Kasten accept the order?

2. Kasten received an offer from another company to manufacture the same quality widgets for $39. Should Kasten outsources the manufacture of all 10,000 widgets and focus only on distribution?

Ex. 186

Coyle Company manufactured 6,000 units of a component part that is used in its product and incurred the following costs:

Direct materials $35,000

Direct labor 15,000

Variable manufacturing overhead 10,000

Fixed manufacturing overhead 20,000

$80,000

Another company has offered to sell the same component part to the company for $13 per unit. The fixed manufacturing overhead consists mainly of depreciation on the equipment used to manufacture the part and would not be reduced if the component part was purchased from the outside firm. If the component part is purchased from the outside firm, Coyle Company has the opportunity to use the factory equipment to produce another product which is estimated to have a contribution margin of $22,000.

Instructions

Prepare an incremental analysis report for Coyle Company which can serve as informational input into this make or buy decision.

Ex. 187

Agler Corporation currently manufactures a subassembly for its main product. The costs per unit are as follows:

Direct materials $ 1

Direct labor 10

Variable overhead 5

Fixed overhead 8

Total $24

Funkhouser Company has contacted Agler with an offer to sell it 4,000 of the subassemblies for $17 each. If Agler buys the subassemblies, $2 of the fixed overhead per unit will be allocated to other products.

Ex. 187 (Cont.)

Instructions

Ex. 188

Kuhn Bicycle Company manufactures its own seats for its bicycles. The company is currently operating at 100% capacity. Variable manufacturing overhead is charged to production at the rate of 60% of direct labor cost. The direct materials and direct labor cost per unit to make the bicycle seats are $8.00 and $9.00, respectively. Normal production is 50,000 bicycles per year.

A supplier offers to make the bicycle seats at a price of $21 each. If the bicycle company accepts this offer, all variable manufacturing costs will be eliminated, but the $30,000 of fixed manufacturing overhead currently being charged to the bicycle seats will have to be absorbed by other products.

Instructions

(a) Prepare the incremental analysis for the decision to make or buy the bicycle seats.

Ex. 189

Larkin, Inc. uses 1,000 units of the component NJF1 every month to manufacture one of its products. The unit costs incurred to manufacture the component are as follows:

Direct materials $ 65

Direct labor 48

Overhead 96

Total $209

Overhead costs include variable material handling costs of $10 that are applied to products on the basis of direct material costs. The remainder of the overhead costs are applied on the basis of direct labor dollars and consist of 50% variable costs and 50% fixed costs.

A vendor has offered to supply the NJF1 component at a price of $175 per unit.

Instructions

(a) Should Larkin purchase the component from the outside vendor if its capacity remains idle?

(b) Should Larkin purchase the component from the outside vendor if it can use its facilities to manufacture another product? What information will Larkin need to make an accurate decision? Show your calculations.

Ex. 190

A company manufactures three products using the same production process. The costs incurred up to the split-off point are $200,000. These costs are allocated to the products on the basis of their sales value at the split-off point. The number of units produced, the selling prices per unit of the three products at the split-off point and after further processing, and the additional processing costs are as follow:

Number of Selling Price Selling Price Additional

Product Units Produced at Split-off after Processing Processing Costs

X 5,000 $10.00 $15.00 $14,000

Y 10,000 11.60 16.20 21,000

Z 4,000 19.40 21.60 12,000

Instructions

(a) Which product(s) should be processed further and which should be sold at the split-off point?

(b) Would your decision be different if the company was using the quantity of output to allocate joint costs? Explain.

Ex. 191

Spencer Chemical Corporation produces an oil-based chemical product which it sells to paint manufacturers. In 2022, the company incurred $344,000 of costs to produce 40,000 gallons of the chemical. The selling price of the chemical is $12.00 per gallon. The costs per unit to manufacture a gallon of the chemical are presented below:

Direct materials $6.00

Direct labor 1.20

Variable manufacturing overhead .80

Fixed manufacturing overhead .60

Total manufacturing costs $8.60

Ex. 191 (Cont.)

The company is considering manufacturing the paint itself. If the company processes the chemical further and manufactures the paint itself, the following additional costs per gallon will be incurred: Direct materials $1.70, Direct labor $.60, Variable manufacturing overhead $.50. No increase in fixed manufacturing overhead is expected. The company can sell the paint at $15.50 per gallon.

Instructions

Determine the incremental per gallon increase in net income and the total increase in net income if the company manufactures the paint.

Ex. 192

Ecker, Inc. produces milk at a total cost of $66,000. The production generates 60,000 gallons of milk which can be sold for $1 per gallon to a pasteurization company, or the milk can be processed further into ice cream and then sold for $3 per gallon. It costs $75,000 more to turn the annual milk supply into ice cream.

Instructions

If Ecker processes the milk into ice cream, how much is the incremental profit or loss? Should Ecker process the milk into ice cream or sell it as is?

Ex. 193

Speedy Bikes could sell its bicycles to retailers either assembled or unassembled. The cost of an unassembled bike is as follows.

Direct materials $150

Direct labor 70

Variable overhead (70% of direct labor) 49

Fixed overhead (30% of direct labor) 21

Manufacturing cost per unit $290

The unassembled bikes are sold to retailers at $450 each.

Speedy has unused productive capacity that is expected to continue indefinitely; management has concluded that some of this capacity could be used to assemble the bikes and sell them at $495 each. Assembling the bikes will increase direct materials by $5 per bike and direct labor by $10 per bike. Additional variable overhead will be incurred at the normal rates, but there will be no additional fixed overhead as a result of assembling the bikes.

Instructions

(a) Prepare an incremental analysis for the sell-or-process-further decision.

(b) Should Speedy sell or process further? Why or why not?

Ex. 194

Harris Timber Corporation uses a machine that removes the bark from cut timber. The machine is unreliable and results in a significant amount of downtime and excessive labor costs. Management is considering replacing the machine with a more efficient one which will minimize downtime and excessive labor costs. Data are presented below for the two machines:

Old Machine New Machine

Original purchase cost $340,000 $370,000

Accumulated depreciation 230,000 —

Estimated life 5 years 5 years

Ex. 194 (Cont.)

It is estimated that the new machine will produce annual cost savings of $85,000. The old machine can be sold to a scrap dealer for $8,000. Both machines will have a salvage value of zero if operated for the remainder of their useful lives.

Instructions

Determine whether the company should purchase the new machine.

Ex. 195

Kinder Enterprises relies heavily on a copier machine to process its paperwork. Recently the copy clerk has not been able to process all the necessary copies within the regular work week. Management is considering updating the copier machine with a faster model.

Current Copier New Model

Original purchase cost $10,000 $20,000

Accumulated depreciation 8,000 —

Estimated operating costs (annual) 7,000 2,600

Useful life 5 years 5 years

If sold now, the current copier would have a salvage value of $1,000. If operated for the remainder of its useful life, the current machine would have zero salvage value. The new machine is expected to have zero salvage value after five years.

Instructions

Prepare an analysis to show whether the company should retain or replace the machine.

Ex. 196

Milwaukee, Inc. has three divisions: Bud, Wise, and Er. The results of operations for May, 2022 are presented below.

Bud Wise Er Total

Units sold 3,000 5,000 2,000 10,000

Revenue $70,000 $50,000 $40,000 $160,000

Less variable costs 32,000 26,000 16,000 74,000

Less direct fixed costs 14,000 19,000 12,000 45,000

Less allocated fixed costs 6,000 10,000 4,000 20,000

Net income $18,000 $ (5,000) $ 8,000 $ 21,000

All of the allocated costs will continue even if a division is discontinued. Milwaukee allocates indirect fixed costs based on the number of units to be sold. Since the Wise division has a net loss, Milwaukee is concerned that it should be discontinued. Milwaukee thinks that if the division is closed, that sales at the Bud division will increase by 12% while sales at the Er division will stay the same.

Instructions

(a) Prepare an analysis showing the effect of discontinuing the Wise division.

(b) Should Milwaukee close the Wise division? Briefly indicate why or why not.

Ex. 197

Roberts Forest Corporation operates two divisions, the Timber Division and the Consumer Division. The Timber Division manufactures and sells logs to paper manufacturers. The Consumer Division operates retail lumber mills which sell a variety of products in the do-it-yourself homeowner market. The company is considering disposing of the Consumer Division since it has been consistently unprofitable for a number of years. The income statements for the two divisions for the year ended December 31, 2022 are presented below:

Ex. 197 (Cont.)

Timber Division Consumer Division Total

Sales $1,500,000 $500,000 $2,000,000

Cost of goods sold 900,000 350,000 1,250,000

Gross profit 600,000 150,000 750,000

Selling & administrative expenses 250,000 180,000 430,000

Net income $ 350,000 $ (30,000) $ 320,000

In the Consumer Division, 70% of the cost of goods sold are variable costs and 35% of selling and administrative expenses are variable costs. The management of the company feels it can save $45,000 of fixed cost of goods sold and $50,000 of fixed selling expenses if it discontinues operation of the Consumer Division.

Instructions

(a) Determine whether the company should discontinue operating the Consumer Division.

(b) If the company had discontinued the division for 2022, determine what net income would have been.

Ex. 198

Mercer has three product lines in its retail stores: flipflops, sandals, and slippers. Results of the fourth quarter are presented below:

Flipflops Sandals Slippers Total

Units sold 1,000 2,000 2,000 5,000

Revenue $20,000 $40,000 $25,000 $85,000

Variable departmental costs 17,000 22,000 12,000 51,000

Direct fixed costs 1,000 3,000 2,000 6,000

Allocated fixed costs 7,000 7,000 7,000 21,000

Net income (loss) $ (5,000) $ 8,000 $ 4,000 $ 7,000

The allocated fixed costs are unavoidable. Demand of individual products are not affected by changes in other product lines.

Instructions

What will happen to profits if Mercer discontinues the Flipflops product line?

Ex. 199

A recent accounting graduate from Marvel State University evaluated the operating performance of Fanning Company’s four divisions. The following presentation was made to Fanning’s Board of Directors. During the presentation, the accountant made the recommendation to eliminate the Southern Division stating that total net income would increase by $60,000. (See analysis below.)

Other 3 Divisions Southern Division Total

Sales $2,000,000 $480,000 $2,480,000

Cost of Goods Sold 950,000 400,000 1,350,000

Gross Profit 1,050,000 80,000 1,130,000

Operating Expenses 800,000 140,000 940,000

Net Income $ 250,000 $ (60,000) $ 190,000

For the other divisions, cost of goods sold is 80% variable and operating expenses are 70% variable. The cost of goods sold for the Southern Division is 30% fixed, and its operating expenses are 75% fixed. If the division is eliminated, only $15,000 of the fixed operating costs will be eliminated.

Instructions