Accounting 408

Chapter (7)
Incremental Analysis (decision making)

Types of incremental analysis covered in chapter:

(1) Accept or reject an order to a special price. (special order)
(2) Make or buy component or finished products.
(3) Sell or process further a product.
(4) Retain or replace equipment
(5) Eliminate or not an unprofitable business segment

------------------------------------------------------------------------------------------------------------------
(Accept or reject a special order)
Example (1) (7-1):
Hardy Fiber Company is the creator of Y-Go, a technology that weaves silver into its fabrics to kill
bacteria and odor on clothing while managing heat. Y-Go has become very popular as an undergarment
for sports activities. Operating at capacity, the company can produce 1,000,000 undergarments of
Y-Go a year. The per unit and the total costs for an individual garment when the company operates at
full capacity are as follows:

Per Undergarment Total

Direct materials $2.00 $2,000,000
Direct labor 0.50 500,000
Variable manufacturing overhead 1.00 1,000,000
Fixed manufacturing overhead 1.50 1,500,000
Variable selling expenses 0.25 250,000
Totals $5.25 $5,250,000

The U.S. Army has approached Tough Fiber and expressed an interest in purchasing 200,000 Y-Go
undergarments for soldiers in extremely warm climates. The Army would pay the unit cost for direct
materials, direct labor, and variable manufacturing overhead costs. In addition, the Army has agreed
to pay an additional $1 per undergarment to cover all other costs and provide a profit. Presently, Tough
Fiber is operating at 70 percent capacity and does not have any other potential buyers for Y-Go. If
Tough Fiber accepts the Army’s offer, it will not incur any variable selling expenses related to this
order.

Instructions:
Using incremental analysis, determine whether Hardy Fiber should accept the Army’s offer.

SOLUTION

• Decision to accept or to reject is based on the special order’s (contribution margin).

• The contribution margin is calculated based on the special order’s number of units 200,000
undergarments, (DON’T USE the production units of the whole company 1,000,000 undergarments)
• Variable selling cost are (not related and not used, but used only if it mentioned in the example
that it is related to the decision), while fixed costs (selling & manufacturing are not used at all).
• If the result is: Positive (Accept), Negative (Reject).

1
 SOLUTION

The incremental analysis for the special order as follows:

▪ Calculate the contribution margin (if we Reject the order), and (if we Accept the order).
▪ Contribution margin = revenues from the special order – variable manufacturing cost of special order.
▪ If Rejected:
- so, there is no revenues or costs, so both = zero.
▪ If accepted:
- Revenues = special order units x special order offered price per unit.
- Direct material = special order units x direct material cost price per unit.
- Direct labor = special order units x direct labor cost price per unit.
- V. manuf. overhead = special order units x V. manuf. overhead cost price per unit.

Reject order Accept order

(1)
▪ Revenues (200,000 units x $4.5 per unit ) $0.00 $900,000

(-) V. manufacturing costs:

➢ Direct material (200,000 units x $2 per unit) 0.00 (400,000)
➢ Direct labor (200,000 units x $0.50 per unit) 0.00 (100,000)
➢ V. manuf. overhead (200,000 units x $1 per unit) 0.00 (200,000)
= Contribution Margin (CM) $0.00 $200,000

(1) Special order offered price:

**Mentioned in the example:
✓ The Army would pay the unit cost for direct materials, direct labor, and variable manufacturing
overhead costs. In addition, the Army has agreed to pay an additional $1 per undergarment.

✓ So, offered price = (D. mat/unit) + (D. labor/unit) + (V. manuf. Overhead/unit) + 1$ additional
= $2.00 + $0.50 + $1 + $1 = $4.5 per unit

❖ Decision: yes, Hardy Fiber should accept the special order, since it will generate a profit of
$200,000 as incremental analysis indicated.

End of example (1)

2
 (Make or buy)
Example (2) (7-4):
Stahl Inc. has been manufacturing its own shades for its table lamps. The company is currently
operating at 100% of capacity, and variable manufacturing overhead is charged to production at the
rate of 70% of direct labor cost. The direct materials and direct labor cost per unit to make the lamp
shades are $5 and $6, respectively. Normal production is 30,000 table lamps per year.

A supplier offers to make the lamp shades at a price of $15.50 per unit. If Stahl Inc. accepts the
supplier’s offer, all variable manufacturing costs will be eliminated, but the $45,000 of fixed
manufacturing overhead currently being charged to the lamp shades will have to be absorbed by other
products.

Instructions:
(a) Prepare the incremental analysis for the decision to make or buy the lamp shades.
(b) Should Stahl Inc. buy the lamp shades?
(c) Would your answer be different in (b) if the productive capacity released by not making the lamp
shades could be used to produce income of $35,000?

SOLUTION

This type of examples is about comparing the cost of manufacturing the part (making) to the
cost of purchasing the part (buying) from an outside supplier. and
choose the lowest cost alternative.

Required (a): Prepare the incremental analysis for the decision to make or buy the lamp shades:

(1) (2) (3) = (1-2)

Cost of Make Cost of Buy Net income
Increase
(decrease)
▪ Direct material (30,000 units x $5.00 per unit) $150,000 -- $150,000
(+) Direct labor (30,000 units x $6.00 per unit) 180,000 -- (1) 180,000
(+) V. manuf. Overhead ($180,000 x 70%) 126,000 -- 126,000
(+) F. manuf. Overhead (given) 45,000 45,000 (2) 0
(+) Purchase price. (30,000 units x $15.50 per unit) -- 465,000 (465,000)
= Total annual costs $501,000 $510,000 (9000)

(1) All variable manufacturing costs:

**Mentioned in the example:
✓ If accepts the supplier’s offer, all variable manufacturing costs will be eliminated.
So, it is considered as (avoidable cost), meaning it will be removed (if we buy the part) = Zero.

(2) fixed manufacturing overhead:

**Mentioned in the example:
✓ If accepts the supplier’s offer, the $45,000 of fixed manufacturing overhead currently being
charged to the lamp shades will have to be absorbed by other products. (this sentence means it
is (Not avoidable cost) in both cases (if we buy the part) or (if we make the part).

3
 Required (b): Should Swayze Inc. buy the lamp shades?

➢ The cost of buy ($510,000) is greater than the cost of make ($501,000).
➢ No, Stahl Inc. should not purchase the shades, it will generate a loss of $9000 as incremental
analysis indicated.

Required (c): Would your answer be different in (b) if the productive capacity released by not
making the lamp shades could be used to produce income of $35,000?

(1) (2) (3) = (1-2)

Make Buy Net income
Increase
(decrease)
= Total annual costs (from required [a]) $501,000 $510,000 (9000)
(+) opportunity costs. 35,000 0 35,000
= total costs. $536,000 $510,000 $26,000

➢ Yes, by purchasing the lamp shades, a total cost saving of $26,000 will result.

End of example (2)

4
 (Make or buy)
Example (3) (7-5):
Sytelc has recently started the manufacture of RecRobo, a three-wheeled robot that can scan a home
for fires and gas leaks and then transmit this information to a mobile phone. The cost structure to
manufacture 20,000 RecRobo’s is as follows:

• Direct materials ($40 per robot) $800,000

• Direct labor ($30 per robot) 600,000
• Variable overhead ($6 per robot) 120,000
• Allocated fixed overhead ($25 per robot) 500,000
= Total $2,020,000

Selleck is approached by Padong Inc., which offers to make RecRobo for $90 per unit or $1,800,000.

Instructions:
(a) Using incremental analysis, determine whether Selleck should accept this offer under each of the
following independent assumptions:
1. Assume that $300,000 of the fixed overhead cost can be reduced (avoided).
2. Assume that none of the fixed overhead can be reduced (non-avoided). However, if the
robots are purchased from Padong Inc., Selleck can use the released productive resources
to generate additional income of $300,000.

(b) Describe the qualitative factors that might affect the decision to purchase the robots from an
outside supplier.

SOLUTION

Required (a): (1) Assume that $300,000 of the fixed overhead cost can be reduced (avoided).

(1) (2) (3) = (1-2)

Make Buy Net income
Increase
(decrease)
▪ Direct material. $800,000 0 $800,000
(+) Direct labor. 600,000 0 600,000
(+) V. manuf. Overhead. 120,000 0 120,000
(+) F. manuf. Overhead. 500,000 200,000 (1) 300,000
(+) Purchase price. 0 1,800,000 (1,800,000)
= Total annual costs $2,020,000 $2,000,000 $20,000

(3) fixed manufacturing overhead:

**Mentioned in the example:
✓ Assume that $300,000 of the fixed overhead cost can be reduced (avoided), so in case of
(buying) the RecRobo, (fixed costs non avoidable = 500,000 – 300,000 = $200,000).

❖ Decision: yes, the offer should be accepted as net income will increase by $20,000.

5
 Required (a): (2) Assume that none of the fixed overhead can be reduced (avoided). However, if
the robots are purchased from Padong Inc., Selleck can use the released productive resources to
generate additional income of $300,000.

(1) (2) (3) = (1-2)

Make Buy Net income
Increase
(decrease)
▪ Direct material. $800,000 0 $800,000
(+) Direct labor. 600,000 0 600,000
(+) V. manuf. Overhead. 120,000 0 120,000
(+) F. manuf. Overhead. 500,000 500,000 (1) 0
(+) Purchase price. 0 1,800,000 (1,800,000)
= Total annual costs (from required [a]) $2.020,000 $2,300,000 (280,000)
(+) opportunity costs. 300,000 0 300,000
= total costs. $2,320,000 $2,300,000 $20,000

❖ Decision: yes, the offer should be accepted as net income will increase by $20,000.

Required (b): Describe the qualitative factors that might affect the decision to purchase the
robots from an outside supplier.

➢ Qualitative factors include the possibility of laying off those employees that produced the robot
and the resulting poor morale of the remaining employees, maintaining quality standards, and
controlling the purchase price in the future.

End of example (3)

6
 (Sell or process further)
Example (4) (7-6):

Shynee Minerals, processes materials extracted from mines. The most common raw material that it
processes results in three joint products: Sarco, Barco, and Larco. Each of these products can be sold
as is, or it can be processed further and sold for a higher price. The company incurs joint costs of
$180,000 to process one batch of the raw material that produces the three joint products. The
following cost and sales information is available for one batch of each product.

Sales value at Allocated joint Cost to process Sales value of

split-off point costs further processed product
➢ Sarco. $200,000 $40,000 $120,000 $300,000
➢ Barco. 300,000 60,000 89,000 400,000
➢ Larco. 400,000 80,000 250,000 800,000

Instructions:
Determine whether each of the three joint products should be sold as is, or processed further.

SOLUTION

** Decision is based on (incremental profit or loss) **

• incremental profit or loss = Incremental revenues – Incremental costs.

= if Positive (so, should be sold after further processing)
= if Negative (so, should be sold at split-off point)
(1) Incremental revenues = Sales value of processed product - Sales value at split-off point.
➢ Sarco = $300,000 – 200,000 = $100,000
➢ Barco = $400,000 – 300,000 = $100,000
➢ Larco = $800,000 – 400,000 = $400,000
(2) Incremental costs = Cost to process further.
➢ Sarco = $120,000
➢ Barco = $89,000
➢ Larco = $250,000

Sarco Barco Larco

Incremental revenues $100,000 $100,000 $400,000
(-) Incremental costs (120,000) (89,000) (250,000)
= Incremental profit (loss) ($20,000) $11,000 $150,000

❖ Decision:

- Sarco: Negative (so, sold at split-off point).

- Barco: Positive (so, sold after further processing).
- Larco: Positive (so, sold after further processing).

End of example (4)

7
 (Sell or process further)
Example (5) (7-7):
Benson Inc. produces three separate products from a common process costing $100,000. Each of the
products can be sold at the split-off point or can be processed further and then sold for a higher price.
Shown below are cost and selling price data for a recent period.

Sales value at Cost to process Sales value of

split-off point further processed product
➢ Product 12 $50,000 $100,000 $190,000
➢ Product 14 10,000 30,000 35,000
➢ Product 16 60,000 150,000 220,000

Instructions:
(a) Determine total net income if all products are sold at the split-off point.
(b) Determine total net income if all products are sold after further processing.
(c) Using incremental analysis, determine which products should be sold at the split-off point and
which should be processed further.
(d) Determine total net income using the results from (c) and explain why the net income is different
from that determined in (b).
SOLUTION

Required (a): Determine total net income if all products are sold at the split-off point:

common process costing $100,000: is considered as joint cost for the 3 products together (12,14,16).

▪ Sales at split of point (for 3 products) $120,000 ($50,000 + 10,000 + 60,000)

(-) joint costs (Given) (100,000)
= Net income $20,000

Required (b): Determine total net income if all products are sold after further processing:

Sales value of processed product (for 3 products) $445,000 ($190,000 + 35,000 + 220,000)
(-) joint costs (Given). (100,000)
(-) Cost to process further (for 3 products) (280,00) ($100,000 + 30,000 + 150,000)
= Net income $65,000

Required (c): Using incremental analysis, determine which products should be sold at the split-
off point and which should be processed further:

(1) Incremental revenues = Sales value of processed product - Sales value at split-off point.
➢ Product 12 = $190,000 – 50,000 = $140,000
➢ Product 14 = $35,000 – 10,000 = $25,000
➢ Product 16 = $220,000 – 60,000 = $160,000
(2) Incremental costs = Cost to process further.
➢ Product 12 = $100,000
➢ Product 14 = $30,000
➢ Product 16 = $150,000

8
 Product 12 Product 14 Product 16
Incremental revenues. $140,000 $25,000 $160,000
(-) Incremental costs. (100,000) (30,000) (150,000)
= Incremental profit (loss) $40,000 ($5000) $10,000

❖ Decision:
- Product 12: Positive (so, sold after further processing).
- Product 14: Negative (so, sold at split-off point).
- Product 16: Positive (so, sold after further processing).

Required (d): Determine total net income using the results from (c) and explain why the net
income is different from that determined in (b):

**According to required (c) results:

- Product 12: sold after further processing (sales value = $190,000) (additional cost = $100,000)
- Product 14: sold at split-off point (sales value = $10,000) (No additional cost incurred)
- Product 16: sold after further processing (sales value = $220,000) (additional cost = $150,000)

Sales value of processed product (for 3 products) $420,000 ($190,000 + 10,000 + 220,000)
(-) joint costs (Given). (100,000)
(-) Cost to process further (for 3 products) (250,00) ($100,000 + 150,000)
= Net income $70,000

**explain why the net income is different from that determined in (b):

Net income in required (c) is $5000 higher than Net income in required (b), because product 14 is not
processed further which result in that increase.

End of example (5)

9
 (Retain or Replace)
Example (6) (7-9):
On January 2, 2011, Lucas Hospital purchased a $100,000 special radiology scanner from Rickard Inc.
The scanner has a useful life of 5 years and will have no disposal value (salvage value) at the end of its
useful life. The straight-line method of depreciation is used on this scanner. Annual operating costs
with this scanner are $105,000.

Approximately one year later, the hospital is approached by Harmon Technology salesperson, Jane
Black, who indicated that purchasing the scanner in 2011 from Rickard Inc. was a mistake. She points
out that Harmon has a scanner that will save Lucas Hospital $27,000 a year in operating expenses over
its 4-year useful life. She notes that the new scanner will cost $120,000 and has the same capabilities
as the scanner purchased last year. The hospital agrees that both scanners are of equal quality. The
new scanner will have no disposal value. Black agrees to buy the old scanner from Lucas Hospital for
$30,000.

Instructions:

(a) If Lucas Hospital sells its old scanner on January 2, 2012, compute the gain or loss on the sale.

(b) Using incremental analysis, determine if Lucas Hospital should purchase the new scanner on
January 2, 2012.

(c) Explain why Lucas Hospital might be reluctant to purchase the new scanner, regardless of the
results indicated by the incremental analysis in (b).

SOLUTION

Required (a): Compute the gain or loss on the sale:

**Gain or loss on sale = selling price – asset’s book value at the date of sale**

• Selling price = $30,000 (given).

• Asset’s book value = asset’s original value – accumulated depreciation.
= $100,000 – 20,000 = $80,000.

➢ Original value = $100,000. (given).

➢ Annual Depreciation = (original value – salvage value) / useful life years.
= ($100,000 – 0) / 5years = 20,000$ annually

So, **Gain or loss on sale = $30,000 – 80,000 = ($50,000) loss on sale**

Required (b): Retain or replace:

Retain (old scanner) Replace (new scanner)
(1)
- Operating costs. $420,000 $312,000
- New scanner cost. -- 120,000
- Old scanner salvage. -- (30,000)
Total cost. $420,000 $402,000
(1) Operating costs = annual operating costs x years.
- Retain = $105,000 x 4 years = $420,000.
- Replace = ($105,000 – 27,000 savings in costs) x 4years = $312,000.

**So, replace the scanner, it will generate a $18,000 savings.

10
 (continue or eliminate)
Example (7):

Mary Mayers, a recent graduate of rolling’s accounting program, evaluated the operating performance
of shaw Company’s six divisions. Mary made the following presentation to Shaw’s Board of Directors
and suggested the Erie division to be eliminated. “she said. “our total profits would increase by
$24,500.”

The Other Five Divisions Erie Division total

▪ Sales $1,664,200 $100,000 $1,764,200
▪ Cost of goods sold 978,520 76,500 1,055,020
▪ Gross profit 685,680 23,500 709,180
▪ Operating expenses 527,940 48,000 575,940
▪ Net income (loss) $157,740 $(24,500) $133,240

In the Erie Division, cost of goods sold is $60,000 variable and $16,500 fixed, and operating expenses
are $25,000 variable and $23,000 fixed. None of the Erie Division’s fixed costs will be eliminated if
the division is discontinued.

Instructions

Is Mary right about eliminating the Erie Division? Prepare a schedule to support your answer

SOLUTION

If Continue If Eliminated
Sales $100,000 0
(-) T. Variable Costs. (a) (85,000) 0
= Contribution margin. 15,000 0
(-) T. Fixed Costs. (b) (39,500) (39,500)
= net income (loss) (24,500) (39,500)

(a) T. Variable Costs = V. cost of goods sold + V. operating expenses.

= 60,000 + 25,000 = $85,000.

(b) T. Fixed Costs = F. cost of goods sold + F. operating expenses.

= 16,500 + 23,000 = $39,500.

Decision:
Mary is incorrect. The incremental analysis shows that net income will be $15,000 (39,500 – 24,500)
less if the Erie Division is eliminated. This amount equals the contribution margin that would be lost
through discontinuing the division.

(Note: None of the fixed costs can be avoided.)

11