This chapter introduces the overall concept of incremental analysis which is used as a part of capital budgeting as well as a number of other management decisions to be presented in later chapters.

 


Decision Analysis


Decision-making involves choosing between alternatives. The focus of incremental analysis is to examine what differs between the alternatives. Incremental analysis utilizes up to four major components:

1.    Revenue differences

2.    Cost differences

3.    Cost savings differences

4.    Opportunity costs

Incremental amounts are often called differential or relevant, however thinking of incremental amounts as what 'differs between alternatives' will help you identify incremental amounts from a practical standpoint. Many of the costs that will 'differ' are variable costs because variable costs change in total when activity changes. As such, total variable costs will differ between most decisions. Fixed costs differ only in specified situations. Identifying the behavior of costs enables managers to anticipate how each cost will behave under alternative situations.  

 


Why Use Incremental Analysis?


Managers make decisions by selecting between two or more alternatives. One option managers can use in decision-making is to create pro-forma side-by-side income statements that list each of the company's revenues and costs to be incurred under each decision outcome. However, because many costs are the same regardless of which decision is made, it is preferable and significantly more efficient for managers to concentrate on only the relevant amounts. In fact, it is a total waste of time to prepare and compare income statements for decision-making when incremental analysis identifies the same decision choice more quickly. 

 

Because there is often a significant amount of data and information available, a manager's time is used more effectively if he or she examines only the amounts that differ between the decisions. The amounts that differ are the relevant amounts that are needed to make a decision because no matter what decision a manager makes, irrelevant amounts do not differ between the alternatives.

 


Deciding What is Relevant and What is Not


Revenues and costs that do not differ under alternatives are not relevant and should be ignored in incremental analysis. Revenues and costs that differ are relevant and should be considered in the analysis.

 

Opportunity costs are always relevant because they represent the benefit given up as a result of choosing one option over the other. While opportunity costs are not cash outlays, they represent an increase in profit for one decision over the other. For example, if you decide to attend college and quit your full time job, you are giving up the right to receive your paycheck from your job. This amount will affect your decision because if you quit your job, you will receive no paycheck.

 

Sunk costs are never relevant because they have already occurred and cannot be changed no matter which decision option is chosen. The $200 cost of a biology textbook you purchased last year is not relevant to whether you will enroll in an accounting class this semester. The $200 cost is sunk, and remains the same cost, regardless if you take accounting this semester or not.

 


How to Perform Incremental Analysis


An incremental analysis involves the following steps:

 

Step 1: Identify and compare the revenue amounts under the alternatives. If total revenues differ under the alternatives, the difference is the incremental revenue amount. Any revenue amounts that do not change under the alternatives are irrelevant. Incremental revenues can increase or decrease profit depending on the effect.

Assume that AT, Inc. has been selling 80,000 calculators each year at $7 each.  Management is considering raising the selling price to $8 per unit, but this will likely cause the sales volume to drop to 76,000 units. Since both units and the selling price will change, you must consider both changes as part of the incremental revenue. The incremental approach determines the difference between old and new revenue:

Original revenue - adjusted revenue = (76,000 x $8) - (80,000 x $7) = $48,000

 

Step 2: Identify and compare the costs under both alternatives---both fixed and variable costs. Costs that do not differ between the alternatives are irrelevant, so they are omitted from the analysis. Incremental costs can increase or decrease profit depending on the effect. Incremental costs that increase profit are called cost savings. Opportunity costs increase profit.

Assume that the variable cost of each calculator is $4 and total fixed costs are $100,000 for the period. The relevant variable cost is the difference between the total variable costs under both alternatives. Because total fixed costs remain the same at all levels of activity and the example did not provide any exceptions to this scenario, the fixed costs are not relevant, and as such are not presented in the incremental analysis.

The relevant variable cost is $4 per unit. The number of units to be sold will decrease from 80,000 calculators to 76,000, a decrease of 4,000 calculators. Instead of additional costs, there will be a cost savings because the production of fewer units produces a savings for the company:

 

 Variable cost savings: (80,000 - 76,000) x $4  = $16,000

Step 3: List and clearly label each incremental revenue, incremental cost, incremental cost savings, and opportunity cost amounts. Display any incremental amount that will create an increase in profit with a '+' (plus sign), and any incremental amount that will create a decrease in profit in parentheses. The following rules should be used in the incremental analysis to indicate the effect on profit:

 

Incremental Effect Effect on Profit Display in Incremental Analysis As
Increase in revenue Increase Plus Sign +
Decrease in revenue Decrease Parentheses (  ) 
Increase in costs Decrease Parentheses (  ) 
Decrease in costs (cost savings) Increase Plus Sign +

 

Step 4: Determine the net total of the amounts in the analysis. If the net result is positive, profit is expected to increase, and the decision alternative should be accepted. If the result is negative, profit is expected to decrease, and the decision alterative should not be accepted. The complete incremental analysis is displayed as:

 

Incremental revenue [(80,000 - 76,000) x $4]

+$48,000

Variable cost savings:

 

   (80,000 - 76,000) x $4 

+  16,000

Incremental increase in profit

+$64,000

 

The change in selling price is expected to cause an increase in profit of $64,000.

 


Qualitative Issues


There are two components of an incremental analysis. The analysis showing the differences in revenues and costs is a quantitative analysis. A qualitative analysis lists the effects that cannot be quantified monetarily. Qualitative factors must be considered regardless if the incremental analysis indicates to accept or reject. They supplement the quantitative decision and are often considered more important than the financial aspects. For example, if a company decides to buy, rather than produce a component of one of its products, the quality of the purchased products may be poor, causing customers to quit doing business with the company producing the products.

 

A variety of qualitative factors should be considered including the quality of the product or component if outsourced, employee morale, ambience, perception, service to customers, contribution to the 'green' environment, goodwill as a corporate citizen, safety, and others.

 


Walk Through Problem - Incremental Calculations


Walker Company sells hammers. During the past year, 4,000 hammers were produced and sold at $20 each. Variable costs per unit were $9 and total fixed costs were $32,000. Walker would like to lower the selling price per hammer to $19 each, and feels that this will increase sales to 4,600 hammers per year. How much is the incremental revenue? How much is the incremental profit? Which costs are not relevant and why?

Solution

Incremental revenue is the difference between the total revenue if the selling price remains the same and total revenue if the selling price is decreased:

 

Incremental revenue = (4,600 x $19) - (4,000 x $20) = $7,400

Variable costs are relevant because additional costs will be incurred to produce the additional 600 hammers.  Incremental variable cost is:

 

Incremental cost =  (4,600 - 4,000) x $9 = $5,400

 

Fixed costs are not relevant because total fixed costs remain at $32,000 regardless of whether the selling price stays at $20 or is reduced to $19.

 

Incremental profit is the net change of the incremental revenue and incremental cost amounts. These incremental differences are listed in the incremental analysis with incremental revenue shown as an increase +  and incremental variable costs shown as a decrease in parentheses.

 

Incremental revenue (4,600 x $19) - (4,000 x $20)

    +$7,400

Incremental variable costs (4,600 - 4,000) x $9 

(5,400)

Incremental increase in profit

   +$2,000

 


Walk Through Problem - Incremental Analysis


Don’s Donuts budgets the following total costs for the production of 24,000 boxes of donuts next month:

 

Rent

  $ 3,000

Materials

18,000

Hourly labor

12,000

Manager's salary

4,000

Depreciation

2,000

 

The normal selling price is $4.00 per box, and Don's usually sells 24,000 boxes per month. A new convenience store has offered to pay Don’s Donuts $3.00 per box to supply them with 3,000 boxes of donuts during the next month. Assuming that Don’s has the capacity to fill this order along with its other production, and that accepting this order will not cause problems with any of their other customers, should Don’s Donuts sell the 3,000 boxes to the convenience store? Justify your answer with an incremental analysis. 

Solution

Incremental revenue is the difference by which total revenue will change if Don's Donuts agrees to produce the 3,000 boxes of donuts for the convenience store. Don's original sales of donuts to regular customers will not change so regular sales can be ignored, as these amounts are not incremental.

 

Incremental revenue = $3.00 x 3,000 = $9,000

 

If the order is accepted, revenue increases by $9,000 due to the increase of 3,000 boxes sold at $3 per box.

 

Fixed costs consist of rent, manager's salary, and depreciation. Because fixed costs remain the same in total no matter how many boxes of donuts are produced and sold, they are not incremental. The incremental cost consists only of variable costs. For current customers, total variable costs are $18,000 for materials plus $12,000 for hourly labor, or a total of $30,000 when 24,000 boxes of donuts are produced and sold. The unit variable cost is:

 

Unit variable cost = $30,000 / 24,000 = $1.25 per box

 

Because the special order consists of 3,000 additional boxes of donuts, the incremental variable costs will be:

 

Incremental variable costs =  $1.25 x 3,000 boxes = $3,750

 

Because variable costs increase when more donuts are sold, profit will decline as it relates to incremental variable costs. When profit declines, parentheses are placed around the amount in the incremental analysis to show the effect on profit. The incremental analysis should appear as follows:

Incremental revenue ($3.00 x 3,000)

     +$ 9,000

Incremental variable costs  ($1.25 x 3,000)

(3,750)

Incremental increase in profit

     +$ 5,250

Should Don's Donuts sell the additional 3,000 boxes of donuts to the convenience store? Yes, it should, because incremental profits will increase by $5,250.

 


This page was last edited on Friday January 02, 2015 03:56 PM

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