INCREMENTAL ANALYSIS/RELEVANT COSTING will not be affected.

In most cases, fixed costs

are irrelevant.
Decision making is the process of choosing from at least two Continue if segment’s avoidable revenue is
Continue or
alternatives. For business entities, management must choose greater than the avoidable costs; otherwise
Shutdown a
in favor of the option that maximizes the company profits. consider shutting down the segment since
business
allocated fixed cost is usually unavoidable, it
Short-term decisions: segment
is considered irrelevant.
Process further if additional revenue from
✓ Accept or reject a special order. processing further is greater than further
Sell or
processing costs.
✓ Sell or process further. Process
further a
Joint costs, since already incurred prior to the
✓ Make or buy. product
split-off point, are considered sunk costs and
irrelevant.
✓ Retain or replace equipment. Best Product Identify and measure the constraint on the
Combination limited resources(s). Rank the product(s)
✓ Continue or shut down a business segment. (Optimization according to the highest contribution margin
of Scarce per unit of limited resources.
✓ Choosing the best product combination. Resources)
Change in Identify the factor to change and the amount
✓ Utilization of scarce resources. Profit Factors of contemplated change. Change the profit
(related with factor if it will cause an improvement on the
✓ Selecting a change in profit factors. CVP Analysis) company’s overall profit position.

DEFINITIONS

Relevant Costs – future costs that are expected to be different Management’s Decision-Making Process
under each alternative course of action.
• The steps are:
Differential Costs – increases (increments) or decreases
(decrements) in total costs that result from selecting one 1. Identify the problem and assign responsibility.
alternative instead of another.
2. Determine and evaluate possible courses of action.
Avoidable Costs – costs that will be saved or those that will not
be incurred if a certain decision is made. 3. Make a decision.

Opportunity Costs – the benefit lost by taking one action as 4. Review the results of the decision.
opposed to another.
• Accounting’s contribution to the decision-making process
Sunk Costs – refer to the non-recoverable costs incurred in the occurs primarily in steps (b) and (d)—evaluating possible
past. courses of action and reviewing results.

Joint Costs – costs incurred in simultaneously processing or

manufacturing two or more products which are difficult to
Incremental Analysis
identify individually as separate types of products until a
certain processing stage known as the point of separation or • The process used to identify the financial data that
split-off point. change under alternative courses of action is called
incremental analysis.
Further Processing Costs – costs incurred beyond the split off
point as separated joint products are to be processed further. • These data are relevant to the decision because they will
vary in the future among the possible alternatives.
Split-Off Point – the earliest stage in the production where
joint products can be recognized as distinct and separate
• Incremental analysis sometimes involves changes that
products.
might seem contrary to your intuition. For example,
sometimes:
Shutdown Costs – usual costs that a company will continue
even if it decides to discontinue or shutdown the operation of
▪ Variable costs do not change under the alternative
a company segment.
courses of action.

DECISION CRITERIA ▪ Fixed costs do change.

Nature of
Decision Criteria a. Accept an order at a special price
Alternatives
Make or Buy Choose the option that has the lower cost. In
▪ The relevant information is the difference between
a most cases, fixed costs are irrelevant. the variable manufacturing costs to produce the
part/product Consider opportunity costs, if any.
special order and expected revenues.
Accept or Accept the order when the additional
Reject a revenue from the special order exceeds ▪ If other sales are affected, then the company would have
special order additional cost, provided the regular market to consider the lost sales in making the decision.

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 ▪ If the company is operating at full capacity, it is likely that ▪ In deciding on the future status of an unprofitable
the special order would be rejected. segment, management should consider the effect of
elimination on related segments.
b. Make or buy
- - END - -
▪ In a make or buy decision, the relevant costs are:

o The variable manufacturing costs that will be

saved.

o The fixed manufacturing costs that can be

eliminated.

o The purchase price.

o Opportunity costs: The potential benefit that may

be obtained by following an alternative course of
action.

c. Sell or process further

▪ Many manufacturers have the option of selling

products at a given point in the production cycle or
continuing to process with the expectation of selling
them at a later point at a higherprice.

▪ The basic decision rule is: Process further as long as

the incremental revenue from such processing
exceeds the incremental processing costs.

▪ All costs incurred prior to the point at which the two

products are separately identifiable (the split-off
point) are called joint costs.

▪ Joint product costs must be allocated to individual

products, frequently done based on the relative
sales value of the joint products.

▪ The allocation of joint product costs is important for the

determination of product cost but is irrelevant for any
sell-or-process-further decisions since these joint
costs are sunk costs.

d. Retain or replace equipment

▪ Management often has to decide whether to continue

using an asset or replace it.

▪ The relevant items to be considered are:

o The effects on variable costs.

o The cost of the new equipment.

▪ Any disposal value of the existing asset must also be

considered.

▪ 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.

e. Eliminate an unprofitable segment

▪ In deciding whether to eliminate an unprofitable

segment, the relevant information is the contribution
margin produced by the segment and the disposition
of the segment’s fixed expenses.

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