INCREMENTAL ANALYSIS

Lecture # 21
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THE CHALLENGE OF
CHANGING MARKETS

 Product markets can change quickly due to competitor price

cuts, changing customer preferences, and introduction of
new products by competitors.
 Managers must make short-run decisions, with a fixed set
of resources, to react to the changing market place.

Special Product Make Joint

order mix or buy product
decisions decisions decisions decisions

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THE CONCEPT OF
RELEVANT COST INFORMATION
 Will
Will you
you drive
drive or
or fly
fly to
to Florida
Florida for
for spring
spring break?
break?
 You
You have
have gathered
gathered the
the following
following information
information to
to help
help you
you with
with
the
the decision.
decision.
 Motel cost is $80 per night.
Motel cost is $80 per night.
 Meal cost is $20 per day.
Meal cost is $20 per day.
 Your car insurance is $100 per month.
Your car insurance is $100 per month.
 Kennel cost for your dog is $5 per day.
Kennel cost for your dog is $5 per day.
 Round-trip cost of gasoline for your car is $200.
Round-trip cost of gasoline for your car is $200.
 Round-trip airfare and rental car for a week is $500.
Round-trip airfare and rental car for a week is $500.
 Driving
Driving requires
requires two
two days,
days, with
with an
an overnight
overnight stay,
stay, cutting
cutting your
your
time
time in
in Florida
Florida by
by two
two days.
days.

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THE CONCEPT OF
RELEVANT COST INFORMATION

Florida Spring Break

Drive/Fly Analysis
8 days @ $80
Cost Drive Fly
Motel $ 640 $ 640 8 days @ $20
Eating out costs 160 160
Kennel cost 40 40 8 days @ $5
Car insurance 100 100
Gasoline 200 -
Airfare/rental car - 500

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THE CONCEPT OF
RELEVANT COST INFORMATION

Florida Spring Break

Drive/Fly Analysis
Cost Drive Fly
Motel $ 640 $ 640
Eating out costs 160 160 Costs do not differ,
so they are not
Kennel cost 40 40
relevant to decision.
Car insurance 100 100
Gasoline 200 - Also, car insurance
Airfare/rental car - 500 is not relevant to
the decision as it
is a past cost.
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THE CONCEPT OF
RELEVANT COST INFORMATION

Florida Spring Break Are

Are the
the extra
extra two
two
Drive/Fly Analysis days
days inin Florida
Florida
worth
worth the
the $300
$300
Cost Drive Fly extra
extra cost
cost to
to fly?
fly?
Motel $ 640 $ 640
Eating out costs 160 160
Kennel cost 40 40 Transportation
Car insurance 100 100 costs differ between
Gasoline 200 - the two alternatives,
Airfare/rental car - 500 so they are relevant
to your decision
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DECISION MAKING

Decision making involves five

steps:
 Define the problem.
 Identify the alternatives.
 Collect information on alternatives.
 Eliminate irrelevant information.
 Make a decision with the
remaining relevant information.
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RELEVANT INFORMATION
IN BUSINESS DECISIONS

Information that varies among the possible

courses of action being considered.
— Incremental costs and revenues —

Important cost concepts for 2

1
business decisions.
 Opportunity costs.
 Sunk costs.
 Out-of-pocket costs.

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OPPORTUNITY COST
The benefit that could have been attained by
pursuing an alternative course of action.
Example: If you were not attending
college, you could be earning
$20,000 per year. Your opportunity
cost of attending college for one year
includes the $20,000.

Opportunity costs are not recorded in the accounting

records, but are relevant to decisions because they are
a real sacrifice.
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SUNK COSTS VERSUS

OUT-OF-POCKET COSTS

All
All costs
costs incurred
incurred in
in the
the past
past that
that cannot
cannot be
be changed
changed by
by any
any
decision
decision made
made now
now or or in
in the
the future.
future.
Sunk
Sunk costs
costs should
should not
not be
be considered
considered in
in decisions.
decisions.

Example:
Example: You
You bought
bought an an automobile
automobile that that cost
cost $10,000
$10,000
two
two years
years ago.
ago. The
The $10,000
$10,000 costcost is
is sunk
sunk because
because
whether
whether you
you drive
drive it,
it, park
park it,
it, trade
trade it,
it, or
or sell
sell it,
it, you
you
cannot
cannot change
change the
the $10,000
$10,000 cost.
cost.

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SUNK COSTS VERSUS

OUT-OF-POCKET COSTS

Cost = $10,000 Cost = $25,000

Trade ?
two years ago today

The
The dealer
dealer will
will trade
trade for
for $20,000
$20,000 plus
plus your
your car.
car.
What
What amount
amount is is relevant
relevant to
to your
your decision,
decision,
the
the $10,000
$10,000 sunk
sunk cost
cost of
of your
your car
car or
or the
the
$20,000
$20,000 out-of-pocket
out-of-pocket cashcash differential?
differential?

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SPECIAL ORDER DECISIONS

The decision to accept
additional business should
be based on incremental
costs and incremental
revenues.

Incremental amounts are

those that occur only if
the company decides to
accept the new business.
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SPECIAL ORDER DECISIONS

View Co. currently sells 100,000 units of its
product. The company has revenue and costs
as shown below:
Per Unit Total
Sales $ 10.00 $ 1,000,000
Direct materials 3.50 350,000
Direct labor 2.20 220,000
Factory overhead 1.10 110,000
Selling expenses 1.40 140,000
Administrative expenses 0.80 80,000
Total expenses $ 9.00 $ 900,000
Operating income $ 1.00 $ 100,000

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SPECIAL ORDER DECISIONS

View Co. is approached by an overseas
company that offers to purchase
10,000 units at $8.50 per unit.
If View Co. accepts the offer, total factory
overhead will increase by $5,000; total selling expenses will
increase by $2,000; and total administrative expenses will increase
by $1,000.
Should View Co.
accept the offer?

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SPECIAL ORDER DECISIONS

First
First let’s
let’s look
look at
at incorrect
incorrect reasoning
reasoning
that
that leads
leads toto an
an incorrect
incorrect decision.
decision.

Our cost is $9.00

per unit. I can’t sell
for $8.50 per unit.

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SPECIAL ORDER DECISIONS

Current Additional
Business Business Combined
Sales $ 1,000,000 $ 85,000 $ 1,085,000
Direct materials $ 350,000 $ 35,000 $ 385,000
Direct labor 220,000 22,000 242,000
Factory overhead 110,000 5,000 115,000
Selling expenses 140,000 2,000 142,000
Admin. expenses 80,000 1,000 81,000
Total expenses $ 900,000 $ 65,000 $ 965,000
Operating income $ 100,000 $ 20,000 $ 120,000

This analysis leads to the correct decision.

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SPECIAL ORDER DECISIONS

Current Additional
Business Business Combined
Sales $ 1,000,000 $ 85,000 $ 1,085,000
Direct materials $ 350,000 $ 35,000 $ 385,000
Direct labor 220,000 22,000 242,000
Factory overhead 110,000 5,000 115,000
Selling expenses 140,000 2,000 142,000
Admin. expenses 80,000 1,000 81,000
Total expenses $ 900,000 $ 65,000 $ 965,000
Operating income $ 100,000 $ 20,000 $ 120,000

10,000 new units × $8.50 selling price = $85,000

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SPECIAL ORDER DECISIONS

Current Additional
Business Business Combined
Sales $ 1,000,000 $ 85,000 $ 1,085,000
Direct materials $ 350,000 $ 35,000 $ 385,000
Direct labor 220,000 22,000 242,000
Factory overhead 110,000 5,000 115,000
Selling expenses 140,000 2,000 142,000
Admin. expenses 80,000 1,000 81,000
Total expenses $ 900,000 $ 65,000 $ 965,000
Operating income $ 100,000 $ 20,000 $ 120,000

10,000 new units × $3.50 = $35,000

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SPECIAL ORDER DECISIONS

Current Additional
Business Business Combined
Sales $ 1,000,000 $ 85,000 $ 1,085,000
Direct materials $ 350,000 $ 35,000 $ 385,000
Direct labor 220,000 22,000 242,000
Factory overhead 110,000 5,000 115,000
Selling expenses 140,000 2,000 142,000
Admin. expenses 80,000 1,000 81,000
Total expenses $ 900,000 $ 65,000 $ 965,000
Operating income $ 100,000 $ 20,000 $ 120,000

10,000 new units × $2.20 = $22,000

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SPECIAL ORDER DECISIONS

Current Additional
Business Business Combined
Sales $ 1,000,000 $ 85,000 $ 1,085,000
Even
Direct though the$$8.50
materials selling price
350,000 $ is less than
35,000 $ the
385,000
normal
Direct labor$10 selling price, View Co. should
220,000 22,000accept 242,000
the
offer
Factory because net income
overhead 110,000will increase by $20,000.
5,000 115,000
Selling expenses 140,000 2,000 142,000
Admin. expenses 80,000 1,000 81,000
Total expenses $ 900,000 $ 65,000 $ 965,000
Operating income $ 100,000 $ 20,000 $ 120,000

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SPECIAL ORDER DECISIONS

We can also look at this decision
using contribution margin.
Per Unit Total
Special order revenue $ 8.50 $ 85,000
Direct materials 3.50 35,000
Direct labor 2.20 22,000
Contribution margin $ 2.80 $ 28,000
Increase in fixed costs:
Factory overhead $ 5,000
Selling expenses 2,000
Administrative expenses 1,000
Special order profit $ 20,000

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