ppt07.ppt

CHAPTER
CHAPTER
Prepared by: Angela Davis, CPA, CA, CFE, MSc
ACCOUNTING
MANAGERIAL
Tools for Business Decision-Making
Fourth Canadian Edition
1
WEYGANDT KIMMEL KIESO ALY

CHAPTER
CHAPTER
C
H
APTER
Prepared by:
Angela Davis, CPA, CA, CFE, MSc
C
H
APTER
Study Objectives
1. Describe management’s decision-making process and the concept of incremental
analysis.
2. Identify the relevant costs in accepting an order at a special price.
3. Identify the relevant costs in a make-or-buy decision.
4. Identify the relevant costs in deciding whether to sell or process materials further.
5. Identify the relevant costs in deciding whether to retain or replace equipment.
6. Identify the relevant costs in deciding whether to eliminate an unprofitable
segment.
7. Determine the sales mix when a company has limited resources.
7 Incremental Analysis
7

CHAPTER 7
Management’s
Decision-Making Process
 Does not always follow a set pattern or process
• Decisions vary in scope
• Decisions vary in urgency and importance
 However some steps can be identified:
3 Copyright John Wiley & Sons Canada, Ltd.

CHAPTER 7
Management’s
Decision-Making Process
 Considers both financial and non-financial
information
• Financial information
• Revenues and costs
• Overall profitability
• Nonfinancial information
• Effect of decision on employee turnover
• Environment
• Overall image of company

CHAPTER 7
Management’s Decision-Making
Incremental Analysis Approach
 Decisions involve a choice among alternative actions
 Financial data relevant to a decision are the data that
vary in the future among alternatives
• Both costs and revenues may vary, or
• Only revenues may vary, or
• Only costs may vary
 Incremental Analysis: Process to identify financial
data that change under alternative actions
• Identifies probable effects of decisions on future
earnings

CHAPTER 7
How Incremental Analysis Works – Example
 Alternative B is being compared to Alternative A
• Incremental revenue is $15,000 less under
Alternative B
• Incremental cost savings of $20,000 is realized
• Alternative B produces $5,000 more net income
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

CHAPTER 7
Management’s Decision Making
How Incremental Analysis Works
 Relevant cost: In incremental analysis, the only factors to
be considered are: (1) those costs and revenues that are
different for each alternative, and (2) those costs and
revenues that will occur in the future.
 Opportunity cost: In choosing to take one action, the
company must often give up the opportunity to benefit
from some other action. This lost benefit is called an
opportunity cost.
 Sunk cost: Costs that have already been incurred and will
not be changed or avoided by any future decision are
called sunk costs. Sunk costs are not relevant costs.

CHAPTER 7
Let’s Review
When making decisions, a general rule would be
a. fixed costs are always relevant.
b. variable (unit-level) costs are always
irrelevant.
c. future costs and revenues are always relevant.
d. future revenues and costs which differ are
always relevant.

CHAPTER 7
Let’s Review: Solution
When making decisions, a general rule would be
a. fixed costs are always relevant.
b. variable (unit-level) costs are always
irrelevant.
c. future costs and revenues are always relevant.
d. future revenues and costs which differ are
always relevant.

CHAPTER 7
Types of Incremental Analysis
1. Accept an order at a special price
2. Make or buy component parts or finished
products
3. Sell products or process further
4. Retain or replace equipment
5. Eliminate or retain an unprofitable business
segment
6. Allocate limited resources

CHAPTER 7
Incremental Analysis
Accept an Order at a Special Price
 Obtain additional business by making price
concessions
 Assumes sales of the products in other markets
would not be affected by special order
 Assumes company is not operating at full capacity

CHAPTER 7
Accept an Order at a Special Price – Example
 Customer offers to buy a special order of 2,000
blenders at $11 per unit from Sunbelt.
• No effect on normal sales; sufficient plant capacity
• Operating at 80% capacity = 100,000 units
• Current fixed manufacturing costs = $400,000 or $4
per unit
• Variable manufacturing cost = $8 per unit
• Normal selling prince = $20 per unit
 Based strictly on total cost of $12 per unit ($8 + $4),
reject offer as cost exceeds selling price of $11

CHAPTER 7
Accept an Order at a Special Price –
Example: Continued
 No change in fixed costs since within existing capacity –
thus fixed costs are not relevant
 Only total variable costs change – thus they are relevant
 Revenue increases $22,000; variable costs increase by
$16,000;
 Thus, net income increases $6,000
Decision: Accept the offer. Income will increase by $6,000.

CHAPTER 7
Special order
 Forge Company produces cast-iron skillets. A local campground recently made a special order
offer; the campground would like to purchase 1,000 skillets branded with their logo. Forge
Company is currently producing and selling 20,000 skillets; the company has the excess capacity
to handle this special order. The campground has offered to pay $30 for each skillet. An
accountant at Forge Company provides an estimate of the unit product cost as follows:
 This special order would require an investment of $5,000 for the molds required for the
custom logo brand. These molds would have no other purpose and would have no salvage
value. The special order skillets would also have an additional variable cost of $2.00 per unit
associated with the custom logos. This special order would not have any effect on the
company's other sales
Direct materials $6.00
Direct labour (variable) $3.50
Variable manufacturing overhead $1.00
Fixed manufacturing overhead $4.00
Total unit cost $14.50

CHAPTER 7
Solution
Reject Accept
Revenue 1000x$30 $30,000
Variable ($6+3.50+1 (10,500)
Machine (5,000)
Logo $2x 1000) (2,000)
12,500

CHAPTER 7
Let’s Review
Of several types of decisions that involve
incremental analysis, the most common are:
a. accept an order at a special price.
b. make or buy component parts.
c. sell products or process further.
d. all of the above.

CHAPTER 7
Of several types of decisions that involve
incremental analysis, the most common are:
a. accept an order at a special price.
b. make or buy component parts.
c. sell products or process further.
 Page 288 BE7-3

CHAPTER 7
Make or Buy - Example
 Outsourcing: The decision to buy parts or services rather
than making them
 Baron Co. incurs the following costs to make 25,000 switches:
 Switches can be purchased for $8 per switch ($200,000)
• Eliminates all variable costs and $10,000 of fixed costs;
however, $50,000 of fixed costs remain
Direct materials $ 50,000
Direct labour 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

CHAPTER 7
Make or Buy – Example: Continued
 Based on analysis of costs under both alternatives:
• Purchasing adds $25,000 to cost of switches
Make Buy Net Income Increase
(Decrease)
Direct materials $50,000 $ 0 $50,000
Direct labour 75,000 $ 0 75,000
Variable manufacturing costs 40,000 $ 0 40,000
Fixed manufacturing costs 60,000 50,000 10,000
Purchase price (25,000 x $8) 200,000 (200,000)
Total Annual Cost 225,000 $250,000 ($25,000)
Decision: Continue to make switches.

CHAPTER 7
Opportunity Costs
Baron Company – Example: Continued
 Opportunity cost – the potential benefit that may be
obtained from following an alternative course of
action
 Example: Assume that buying the switches allows
Baron to use the released capacity to generate
$38,000 additional income.

CHAPTER 7
Net Income Increase
Make Buy (Decrease)
Total annual cost $225,000 $250,000 $(25,000)
Opportunity cost 38,000 - 0 - 38,000
Total cost $263,000 $250,000 $ 13,000
Decision: Based on the analysis, Baron should buy the
switches as the company will earn an additional
$13,000 in Net Income.
 Thus, the $38,000 lost income is an additional cost of
making the switches
Opportunity Costs
Baron Company – Example: Continued

CHAPTER 7
Let’s Review
In a make-or-buy decision, the relevant costs are:
a. the manufacturing costs that will be saved.
b. the purchase price of the units.
c. opportunity costs.

CHAPTER 7
Make or Buy
 Part Z45 is a part used in the production of blenders at Andrew
Corporation. The following costs and data relate to the production of
Part Z45:
 Andrew Corporation can purchase the part from an outside supplier for $4.25
per unit. If they purchase from the outside supplier, 40% of the fixed costs
would be avoided
 Should they make or buy the part
Number of parts produced annually 20,000
Fixed costs $40,000
Variable costs $66,000
Total cost to produce $106,000

CHAPTER 7
Solution
Units 20,000 Make Buy
Fixed cost ($40,000x60%) 40,000 24000
Variable cost 66,000
Purchase (20000x$4.25) 85,000
106,000 109,000

CHAPTER 7
In a make-or-buy decision, the relevant costs are:
a. the manufacturing costs that will be saved.
b. the purchase price of the units.
c. opportunity costs.
PAGE 288 BE7-5

CHAPTER 7
Sell or Process Further
 Manufacturers may have to decide, at a given point in
production, whether to sell now or to process further
and sell at a higher price later
 Decision Rule:
• Process further as long as the incremental revenue
from such processing exceeds the incremental
processing costs

CHAPTER 7
Single-Product Case
 Cost to manufacture one unfinished table:
Direct materials $15
Direct labour 10
Variable manufacturing overhead 6
Fixed manufacturing overhead 4
Manufacturing cost per unit $35
Selling price of unfinished unit is $50
 Unused capacity is available to enable the company to
finish the tables
Selling price of finished unit is $60

CHAPTER 7
 Relevant unit costs of finishing tables:
• Direct materials increase $2
• Direct labour increase $4
• Variable manufacturing overhead costs increase
by $2.40 (60% of direct labour increase)
• Fixed manufacturing costs will not increase
Single-Product Case: Continued

CHAPTER 7
Decision: Process further. Incremental revenue $10
exceeds incremental processing costs $8.40; income
increases $1.60 per unit.
Single-Product Case: Continued

CHAPTER 7
 Especially appropriate when multiple products are
produced simultaneously
 Many end-products are produced from a single raw
material and a common production process
 Joint products – multiple end products
• Petroleum – gasoline, lubricating oil, kerosene
• Meat Packing – meat, hides, bones
Multiple-Product Case

CHAPTER 7
 Joint costs
• all costs incurred prior to split-off point
• allocate to individual products based on relative sales
value
 Sunk costs
• already incurred and cannot be changed
• Irrelevant for sell or process further decisions
 Joint costs are sunk costs for sell or process further
decisions.
Multiple-Product Case: Continued

CHAPTER 7
Sell cream and skim milk or
Process them further before selling
Marais Creamery Decision – Example

CHAPTER 7
 Sell cream or process further into cottage cheese?
 Joint cost allocated to cream $9,000
 Processing cream into cottage cheese $10,000
 Expected revenue per day:
Cream $19,000
Cottage cheese $27,000

CHAPTER 7
Decision: Do not process the cream further.
Incremental revenue $8,000 is less than incremental
costs $10,000; income decreases by $2,000.

CHAPTER 7
 Sell skim milk or process further into condensed milk?
• Joint cost allocated to skim milk $5,000
• Processing skim milk into condensed milk $8,000
• Expected revenue per day:
Skim milk $11,000
Condensed milk $26,000

CHAPTER 7
Decision: Process the skim milk further.
Incremental revenue $15,000 exceeds incremental
costs $8,000; Income increases by $7,000.

CHAPTER 7
Let’s Review
The decision rule in a sell or process further decision
is to process further as long as the incremental
revenue from processing is more than the:
a. incremental processing costs.
b. variable processing costs.
c. fixed processing costs.
d. no correct answer given.

CHAPTER 7
The decision rule in a sell or process further decision
is to process further as long as the incremental
revenue from processing is more than the:
a. incremental processing costs.
b. variable processing costs.
c. fixed processing costs.
d. no correct answer given.
 PAGE 288-BE7-6/7

CHAPTER 7
Process further
 Auto Components has an inventory of 500 obsolete
remote-entry keys that are carried in inventory at a
manufacturing cost of $100,000. Production Supervisor
Natasha Buss must decide to do one of the following:
• Process the inventory further at a cost of $20,000, with the
expectation of selling it for $28,000
• Scrap the inventory for a sale price of $6,000
 What should Buss do? Present figures to support your
decision.

CHAPTER 7
Solution
Details Sell Process
further
Net income/
decrease
Revenue 6,000 28,000
Process
further cost
20,000
Revenue $6,000 $8,000 $2,000

CHAPTER 7
Retain or Replace Equipment – Example
 Assessment of replacement of a factory machine:
 Variable costs:
Decrease from $160,000
to $125,000 annually
Old Machine New Machine
Book value $40,000
Cost of new machine $120,000
Remaining useful life 4 years 4 years
Scrap value $5,000 - 0 -

CHAPTER 7
Decision: Replace equipment.
Lower variable manufacturing costs more than offsets
the cost of new equipment. The book value of the old
machine does not affect the decision.
Retain or Replace Equipment –
Example: Continued

CHAPTER 7
Let’s Review
 What is the salvage value of old equipment
considered to be?
a. A relevant cost
b. A non-incremental cost
c. An opportunity cost
d. A cost that is not differential

CHAPTER 7
 What is the salvage value of old equipment
considered to be?
a. A relevant cost
b. A non-incremental cost
c. An opportunity cost
d. A cost that is not differential
e. PAGE 289BE7-8

CHAPTER 7
Eliminate an Unprofitable Segment
 Key: Focus on relevant costs
 Consider effect on related product lines
 Fixed costs allocated to the unprofitable segment
must be absorbed by the other segments
 Net income may decrease when an unprofitable
segment is eliminated
 Decision Rule: Retain the segment unless fixed costs
eliminated exceed the contribution margin lost

CHAPTER 7
 Manufactures three models of tennis racquets:
• Profitable lines: Pro and Master
• Unprofitable line: Champ
 Condensed Income Statement data:
Should Champ line be eliminated?
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
Martina Company – Example

CHAPTER 7
 If Champ is eliminated, allocate its $30,000 fixed costs:
2/3 to Pro and 1/3 to Master
 Revised Income Statement data:
 Total income has decreased by $10,000
($220,000 - $210,000)
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 expenses 100,000 60,000 160,000
Net income $180,000 $ 30,000 $ 210,000
Martina Company – Example: Continued

CHAPTER 7
 Incremental analysis of Champ provides the same results
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)
Decision: Do not eliminate Champ.
 Decrease in net income is due to Champ’s contribution
margin of $10,000 that will not be realized if the
segment is discontinued
Martina Company – Example: Continued

CHAPTER 7
Knight Fashion operates three departments: Men’s, Women’s, and Accessories.
Knight Fashion allocates all fixed expenses (unavoidable building depreciation and
utilities) based on each department’s floor space. Departmental operating income
data for the third quarter of the current year are as follows:
Should Knight Fashion drop any of the departments??

CHAPTER 7
Solution
Women’s Eliminate
Sales revenue 54,000 0
Variable cost 30,000 0
Contribution margin 24,000 0 0
Fixed cost 30,000 30,000
Net profit/loss (6,000) ($30,000) (24,000)
Sales revenue 100,000 Eliminate
Variable cost 80,000 0
Contribution margin 20,000 0
Fixed cost 25,000 25,000
Net profit/loss (5,000) (25,000) (20,000)

CHAPTER 7
Let’s Review
 How should that portion of fixed costs that are unavoidable
be handled when making a decision on whether to eliminate
an unprofitable segment?
a. They should be subtracted from the contribution margin
and if that results in a net loss, the segment should be
eliminated.
b. They should not be considered as they are not relevant.
c. They should be allocated to other segments. If that
causes a loss in another segment, that segment should
be eliminated as well.
d. Fixed costs are never relevant.

CHAPTER 7
 How should that portion of fixed costs that are unavoidable
be handled when making a decision on whether to eliminate
an unprofitable segment?
a. They should be subtracted from the contribution margin
and if that results in a net loss, the segment should be
eliminated.
b. They should not be considered as they are not relevant.
c. They should be allocated to other segments. If that
causes a loss in another segment, that segment should
be eliminated as well.
d. Fixed costs are never relevant.
e. PAGE 289BE7-9

CHAPTER 7
Allocate Limited Resources
 Resources are always limited
• floor space for a retail firm
• raw material, direct labour hours, or machine
capacity for a manufacturing firm
 Management must decide which products to make
and sell to maximize net income

CHAPTER 7
 Produces standard and deluxe pen and
pencil sets
 Limiting resource – 3,600 machine hours
per month
 Deluxe set has higher contribution margin: $8
 Standard set takes fewer machine hours per unit
Deluxe set Standard set
Contribution margin per unit $8 $6
Machine hours required 0.4 per unit 0.2 per unit
Bilodeau Company – Example

CHAPTER 7
 Must calculate contribution margin per unit of
limited resource
 Standard sets have higher contribution margin per unit
of limited resources
Decision: Shift sales mix to standard sets or increase
machine capacity.
Deluxe Sets Standard Sets
Contribution margin per unit (a) $8 $6
Machine hours required (b) ÷ 0.4 ÷ 0.2
Contribution margin per unit of
limited resource [(a) ÷ (b)] $ 20 $ 30
Bilodeau Company – Example: Continued

CHAPTER 7
 Alternative: Increase machine capacity from 3,600 to 4,200
hours
 To maximize net income, all 600 hours should be used to
produce standard sets.
 PAGE 289BE7-10
Produce Produce
Deluxe Sets Standard Sets
Machine hours (a) 600 600
Contribution margin per unit
of limited resource (b) $20 $30
Contribution margin [(a) x (b)] $12,000 $18,000
Bilodeau Company – Example: Continued

CHAPTER 7
Theory of Constraints
 Approach used to identify and manage constraints
so as to achieve company goals
 Requires identification of constraints
 Continual attempts to reduce or eliminate
constraints

CHAPTER 7
Other Considerations
 Qualitative factors
• Potential effects of decision on employees
and community
• Low morale
• Employee turnover
 Incremental Analysis and Activity-Based
Costing
• Completely consistent with each other
• ABC better identifies relevant costs resulting
in better incremental analysis

CHAPTER 7
Let’s Review
Which of the following is not a qualitative factor?
a. Employee satisfaction
b. Quality control process
c. Customer satisfaction
d. Cost of labour per unit

CHAPTER 7
Which of the following is not a qualitative factor?
a. Employee satisfaction
b. Quality control process
c. Customer satisfaction
d. Cost of labour per unit

CHAPTER
CHAPTER 7
Copyright John Wiley & Sons Canada, Ltd.
Copyright © 2015 John Wiley & Sons Canada, Ltd. All rights
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