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Incremental Analysis
LEARNING OBJECTIVES
1.
2.
3.
4.
5.
6.
7.
Copyright 2013 John Wiley & Sons, Inc.Kimmel, Accounting, 5/e, Instructors Manual(For Instructor Use Only)
20-1
CHAPTER REVIEW
Incremental Analysis
1.
2.
(L.O. 2) Business decisions involve a choice among alternative courses of action. In making such
decisions, management ordinarily considers both financial and nonfinancial information. The
process used to identify the financial data that change under alternative courses of action is called
incremental analysis.
a. Incremental analysis involves not only identifying relevant revenues and costs, but also
determining the probable effects of the decision on future earnings.
b. Data for incremental analysis involves estimates and uncertainty.
c. Gathering data may involve market analysts, engineers, and accountants.
3.
4.
In incremental analysis, both costs and revenues may change. However, in some cases
(1) variable costs may not change under the alternative courses of action, and (2) fixed costs may
change.
20-2
(L.O. 3) An order at a special price should be accepted when the incremental revenue from the
order exceeds the incremental costs.
a. It is assumed that sales in other markets will not be affected by the special order.
b. If the units can be produced within existing plant capacity, generally only variable costs will be
affected.
Copyright 2013 John Wiley & Sons, Inc.Kimmel, Accounting, 5/e, Instructors Manual(For Instructor Use Only)
Make or Buy
6.
(L.O. 4) In a make or buy decision, management must determine the costs which are different
under the two alternatives. If there is an opportunity to use the productive capacity for another
purpose, opportunity cost should be considered. Opportunity cost is the potential benefit that
may be obtained by following an alternative course of action. This cost is an additional cost of
making the component.
(L.O. 5) The basic decision rule in a sell or process further decision is: Process further as long
as the incremental revenue from such processing exceeds the incremental processing costs.
Incremental revenue is the increase in sales which results from processing the product further.
8.
(L.O. 6) In a decision to retain or replace equipment, management compares the costs which
are affected by the two alternatives. Generally, these are variable manufacturing costs and the
cost of the new equipment.
a. The book value of the old machine is a sunk cost which does not affect the decision.
b. However, any trade-in allowance or cash disposal value of the existing asset must be
considered.
Copyright 2013 John Wiley & Sons, Inc.Kimmel, Accounting, 5/e, Instructors Manual(For Instructor Use Only)
20-3
LECTURE OUTLINE
A.
b.
c.
Make a decision.
d.
Incremental Analysis.
1. The process used to identify the financial data that change under
alternative courses of action is called incremental analysis.
2. Data are relevant to the decision if they will vary in the future among the
possible alternatives.
3. Incremental analysis sometimes involves changes that might seem
contrary to your intuition. For example, sometimes:
20-4
a.
b.
Copyright 2013 John Wiley & Sons, Inc.Kimmel, Accounting, 5/e, Instructors Manual(For Instructor Use Only)
b.
If other sales are affected, then the company would have to consider
the lost sales in making the decision.
c.
5. Make or buy.
a.
Copyright 2013 John Wiley & Sons, Inc.Kimmel, Accounting, 5/e, Instructors Manual(For Instructor Use Only)
20-5
MANAGEMENT INSIGHT
Amazon has a subscription-based free shipping program available to customers
for $79 per year. These Prime customers get free shipping on as many goods
as they want to buy from Amazon for an entire year.
What are the relevant revenues and costs that Amazon should consider relative
to the decision whether to offer the Prime free-shipping subscription?
The relevant revenues to consider would be the estimated change in
revenue that would result from offering free shipping and the $79
annual fee for a Prime subscription. The relevant costs would be the
estimated additional shipping costs that the company would incur.
Answer:
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a.
b.
The basic decision rule is: Process further as long as the incremental revenue from such processing exceeds the incremental
processing costs.
c.
d.
All costs incurred prior to the point at which the joint products are
separately identifiable (the split-off point) are called joint costs.
e.
Copyright 2013 John Wiley & Sons, Inc.Kimmel, Accounting, 5/e, Instructors Manual(For Instructor Use Only)
f.
b.
c.
d.
The book value of the old asset does not affect the decision. Book
value is a sunk cost, which is a cost that cannot be changed by any
present or future decision.
b.
c.
Copyright 2013 John Wiley & Sons, Inc.Kimmel, Accounting, 5/e, Instructors Manual(For Instructor Use Only)
20-7
MANAGEMENT INSIGHT
Buck Knives, a company with 260 employees and a 170,000-square foot facility,
moved from Southern California to Idaho to save itself from financial ruin. Moving
the factory would cost about $8.5 million, plus $4 million to move key employees.
The company received only $7.5 million (instead of an estimated $11 million) for
its California property, only 58 of 75 key employees were willing to move, the new
plant price increased by $1.5 million, and wages surged in Idaho due to low
unemployment.
What were some of the factors that complicated the companys decision to
move? How should the company have incorporated such factors into its
incremental analysis?
Answer:
The company received only $7.5 million for its California property,
only 58 of 75 key employees were wiling to move, construction was
delayed by a year which caused the new plant to increase in price by
$1.5 million, and wages surged in Idaho due to low unemployment. In
performing incremental analysis of the decision to move, a company
should perform sensitivity analysis. This would include evaluating the
impact on the decision if all costs were, for example, 10% higher than
expected or if cost savings were 10% lower than expected.
MANAGEMENT INSIGHT
Managers of companies with excess plant capacity are often tempted to add new
products. Often, the effect on incremental overhead costs of changes in
servicing customers is less understood. For example, if customers are given the
option to purchase by the case or by the pallet, the company may need to
develop different warehousing, shipping and handling procedures to address the
two different purchase options.
20-8
Copyright 2013 John Wiley & Sons, Inc.Kimmel, Accounting, 5/e, Instructors Manual(For Instructor Use Only)
Copyright 2013 John Wiley & Sons, Inc.Kimmel, Accounting, 5/e, Instructors Manual(For Instructor Use Only)
20-9
20 MINUTE QUIZ
Circle the correct answer.
True/False
1.
2.
In incremental analysis fixed costs may not change under alternative courses of action,
while variable costs may change.
True
3.
False
Any trade-in allowance or cash disposal value of the old asset is relevant in a retain or
replace equipment decision.
True
20-10
False
Joint product costs are relevant for any sell-or-process further decisions.
True
10.
False
9.
False
Opportunity costs are costs that have already been incurred and will not be avoided by
any future decision.
True
8.
False
7.
False
Book value is a sunk cost and is therefore relevant in incremental analysis of retain or
replace equipment.
True
6.
False
The basic decision rule to sell or process further is: process further as long as the
incremental revenue from such processing exceeds the incremental processing costs.
True
5.
False
The relevant data to consider in accepting an order at a special price are the additional
manufacturing costs incurred and expected revenues.
True
4.
False
False
Copyright 2013 John Wiley & Sons, Inc.Kimmel, Accounting, 5/e, Instructors Manual(For Instructor Use Only)
Multiple Choice
1.
2.
If revenues are $315,000 under alternative A and $324,000 under alternative B, and
costs are $285,000 for A and $306,000 for B, then using the basic approach in
incremental analysis, incremental revenues, costs, and net income, in comparing B to A
are respectively
a. $9,000, $(21,000), $(12,000).
b. $(9,000), $21,000, $12,000.
c. $9,000, $21,000, $12,000.
d. $(9,000), $(21,000), $(12,000).
3.
The cost to manufacture an unfinished unit is $120 ($90 variable, $30 fixed). The selling
price per unit is $150. The company has unused productive capacity and has determined
that units could be finished and sold for $195 with an increase in variable costs of 40%.
What is the additional net income per unit to be gained by finishing the unit?
a. $9.
b. $30.
c. $45.
d. $36.
4.
The potential benefit that may be obtained from following an alternative course of action
is called
a. opportunity benefit.
b. opportunity cost.
c. relevant cost.
d. sunk cost.
5.
In a make or buy decision, the relevant costs include each of the following except the
a. variable manufacturing costs that will be saved.
b. fixed manufacturing costs that can be eliminated.
c. opportunity costs.
d. each of the above is a relevant cost.
Copyright 2013 John Wiley & Sons, Inc.Kimmel, Accounting, 5/e, Instructors Manual(For Instructor Use Only)
20-11
ANSWERS TO QUIZ
True/False
1.
2.
3.
4.
5.
True
True
True
True
False
6.
7.
8.
9.
10.
False
False
True
False
True
Multiple Choice
1.
2.
3.
4.
5.
20-12
d.
a.
a.
b.
d.
Copyright 2013 John Wiley & Sons, Inc.Kimmel, Accounting, 5/e, Instructors Manual(For Instructor Use Only)