CHAPTER 7

INCREMENTAL
ANALYSIS

Managerial Accounting, Fourth Edition

 Incremental Analysis
 Occurs when there is more than one alternative
choice of action.

Alternative One Alternative Two

 Important Definitions
 Relevant Cost. Costs and revenues that do not
differ between alternatives.
 These can be ignored in incremental analysis
 Opportunity Cost. The benefit given up when one
alternative is chosen over another.
 Opportunity costs are never found in the general
ledger.
 Sunk Cost. A cost that has already been incurred
and will not be changed or avoided by any future
decision.
 Sunk costs are not relevant costs.
 Types of Incremental Analysis

Accept an order at a special price

Make or buy components or finished

products

Sell products or process further

Retain or replace equipment

Eliminate an unprofitable business

segment

Allocate limited resources

LO 2: Describe the concept of incremental analysis.
 McDermott’s Criteria
 When can you sell a product at less than full
cost and still make a profit? When . . .
 You can segregate the market
 You can identify fixed and variable costs
 You have a positive contribution margin
 You have excess capacity or can charge for
opportunity cost
 The minimum price you can charge under these
conditions is:
 Variable costs of the new order plus opportunity cost
 Variable Cost of the New Order
 Variable costs of the new order include:
 Direct labor
 Direct materials
 Variable overhead
 Variable marketing and administrative costs
 Any other costs will be incurred to fulfill the new order
(freight, special handling, and so on).
 Any normal costs that disappear should be
subtracted from variable costs in this formula.
 Opportunity Cost
 The opportunity cost is the contribution margin
of any sales given up.
 The formula is (contribution margin per unit ) × (units
of sales to existing customers given up)
 Example Problem
 McDermott Manufacturing makes computer
monitors.
 Revenue and cost data for the company are
shown below:
 Price $60
 Direct labor $10
 Direct materials $5
 Variable overhead $12
 Fixed overhead $100,000
 Variable marketing $6
 Fixed marketing and administration $50,000
 Example Problem
 A Japanese retailer wants to purchase 5,000
monitors.
 Assume that the purchase needs the criteria
listed earlier by Professor McDermott.
 Additional Information
 The company has the capacity to manufacture
10,000 units per year.
 Currently the company is manufacturing and
selling 8,000 units per year.
 The special order will have no marketing costs
 It will cost $3 to ship the monitors to the
purchaser’s San Francisco warehouse.
 What is the minimum price for which the
company would be willing to sell this special
order?
 Calculation of Variable Costs

Category Amount
Direct labor $10
Direct materials $5
Variable overhead $12
Variable marketing $0
Additional shipping $3
Total variable costs $30

Remember: we delete any savings on the

special order. In this case we save
marketing costs (sales commissions).
 Calculation of Variable Costs

Category Amount
Direct labor $10
Direct materials $5
Variable overhead $12
Variable marketing $0
Additional shipping $3
Total variable costs $30

Also remember: We add any additional costs of

this special order, in this case shipping the
product to San Francisco.
 Calculation of Opportunity Cost
 The company has an excess capacity of 2,000
units (10,000 manufacturing capacity – 8,000
units presently manufactured and sold).
 However the customer wishes to purchase 5,000
monitors.
 The opportunity cost in units, therefore, is 5,000
units of demand - 2,000 units of excess capacity =
3,000 units.
 The opportunity cost in dollars is the contribution
margin per unit times the opportunity cost in units.
 Calculation of Opportunity Cost
 The contribution margin (for existing customers)
is:
 $60 price - $10 direct labor - $5 direct materials
- $12 variable overhead - $6 variable marketing
= $27.
 The total contribution margin lost is, therefore,
$27 × 3000 units = $81,000.
 The opportunity cost per unit sold to the
Japanese is $81,000/5000 units = $16.20 per
unit
 Minimum Price Special Order
 $30 variable costs of special order + $16.20
opportunity cost = $46.20.
 Note: the full cost of the product including fixed
costs is $48.
 What if the customer is willing to pay $47.50 per
unit?
 This is less than the full (absorption) cost of the
product.
 Should they accept the special order?
 Minimum Price Special Order
 The contribution margin is $47 - $30 variable
costs of special order = $17 contribution margin.
 This $17 will cover the opportunity cost of
$16.20 per unit, allowing $.80 per unit to flow to
the bottom line.
 The net impact on the bottom line will be $.80 x
5000 units = $4000
 Bottom line: variable revenues and costs are
relevant, fixed costs are not relevant in short-
term special pricing decisions.
 Another example – the authors

Example
Mexico Co. 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 percent capacity = 100,000 units
Current fixed manufacturing costs = $400,000 or $4 per unit
Variable manufacturing cost = $8 per unit
Normal selling price = $20 per unit

Based strictly on total cost of $12 per unit ($8 + $4),

reject offer as cost exceeds selling price of $11

LO 3: Identify the relevant costs in accepting an order at a special price.

 Accept an Order at a Special Price

Within existing capacity, no change in fixed costs -

they are not relevant for this decision
Total variable costs change – they are relevant

Revenue increases $22,000; variable costs increase

$16,000
Income increases by $6,000
Accept the Special Order

LO 3: Identify the relevant costs in accepting an order at a special price.

 Let’s Review
It costs a company $14 of variable costs and $6 of
fixed costs to produce product Z200 that sells for
$30. A foreign buyer offers to purchase 3,000 units
at $18 each. If the special offer is accepted and
produced with unused capacity, net income will:

a. Decrease $6,000.
$6,000
b. Increase $6,000.
c. Increase $12,000.
d. Increase $9,000.

LO 3: Identify the relevant costs in accepting an order at a special price.

 Make or Buy

Management must decide whether to make or buy

components.
The decision to buy parts or services rather than
making them is called outsourcing.
Example: Costs to produce 25,000 switches

LO 4: Identify the relevant costs in a make-or-buy decision.

 Make or Buy – Example Continued

Switches can be purchased for $8 per switch

(25,000 x $8 = $200,000)
At first look, the switches should be purchased;
thus saving $1 per unit
Buying the switches eliminates all variable costs,
but only $10,000 of fixed costs
However, $50,000 of fixed costs remain even if
the switches are purchased

LO 4: Identify the relevant costs in a make-or-buy decision.

 Make or Buy – Example Continued

Switches can be purchased for $8 per switch

(25,000 x $8 = $200,000)
At first look, the switches should be purchased;
thus saving $1 per unit
Buying the switches eliminates all variable costs,
but only $10,000 of fixed costs
However, $50,000 of fixed costs remain even if
the switches are purchased!!!!!

LO 4: Identify the relevant costs in a make-or-buy decision.

 Make or Buy – Example Continued

The relevant costs for incremental analysis are:

Baron Company will incur $25,000 additional cost if

switches are purchased
Continue to make switches

LO 4: Identify the relevant costs in a make-or-buy decision.

 Make or Buy

Opportunity Costs
Definition: The potential benefits that may be
obtained from following an alternative course of
action.

New assumption:
Now assume Baron Company can use the newly available
productive capacity from buying the switches to
generate additional income of $28,000 by making
another product.

If Baron makes the switches, this possible income

is lost.
LO 4: Identify the relevant costs in a make-or-buy decision.
Make or Buy – Opportunity Cost Example
This opportunity cost, the lost income, is
added to the “Make” column as an additional
“cost” for comparative purposes

It is now advantageous to buy the

switches: Baron Company will be $3,000
better off
LO 4: Identify the relevant costs in a make-or-buy decision.
 Let’s Review

In a make-or-buy decision, relevant costs are:

a. Manufacturing costs that will be saved.

saved
b. The purchase price of the units.
c. Opportunity costs.
d. All of the above.

LO 4: Identify the relevant costs in a make-or-buy decision.

 Sell or Process Further

Many manufacturers have the option of selling a

product now or continuing to process the product
hoping to sell the refined product at a higher price

Decision Rule:
Process further as long as
the incremental revenue from
such processing exceeds the
incremental processing costs

LO 5: Identify the relevant costs in determining whether

to sell or process materials further.
 Sell or Process Further - Example

Single-Product Case
Cost to manufacture one unfinished table:

Selling price of unfinished unit is $50; unused capacity

can be used to finish the tables to sell for $60
Relevant unit costs of finishing tables:
Direct materials increase $2; Direct labor increases $4
Variable manufacturing overhead costs increase by $2.40 (60
percent of direct labor increase)
Fixed manufacturing costs will not increase

LO 5: Identify the relevant costs in determining whether

to sell or process materials further.
 Sell or Process Further

Incremental revenues ($10) exceed incremental costs

($8.40); Income increases $1.60 per unit
Process further

LO 5: Identify the relevant costs in determining whether

to sell or process materials further .
 Sell or Process Further
Multiple-Product Case

In many industries, a number of end-products are

produced from a single raw material and a common
production process
Multiple end-products are commonly called joint
products
Petroleum – gasoline, lubricating oil, kerosene
Meat Packing – meat, hides, bones

LO 5: Identify the relevant costs in determining whether

to sell or process materials further.
 Sell or Process Further

Multiple-Product Case
All costs incurred prior to the point at which the products are
separately identifiable (the split-off point) are called joint costs

Joint costs are (for purposes of determining product cost)

allocated to individual products on the basis of relative sales
value

Joint costs are not relevant for any sell-or-process-further

decisions

Joint product costs are sunk costs.

They have already been incurred and cannot be changed

LO 5: Identify the relevant costs in determining whether

to sell or process materials further.
 Sell or Process Further - Example
Multiple-Product Case

Marais Creamery must decide whether to:

Sell cream and skim milk now
or
Process each further before selling

LO 5: Identify the relevant costs in determining whether

to sell or process materials further.
 Sell or Process Further – Example Continued

The daily cost and revenue data for Marais Creamery are:

LO 5: Identify the relevant costs in determining whether

to sell or process materials further.
Sell or Process Further – Example Continued

Sell cream or process further into cottage cheese?

Do not process cream further:

To do so will incur an incremental loss of $2,000

LO 5: Identify the relevant costs in determining whether

to sell or process materials further.
 Sell or Process Further

Sell skim milk or process further into condensed milk?

Marais should process the skim milk:

To do so will increase net income by $7,000

LO 5: Identify the relevant costs in determining whether

to sell or process materials further.
 Let’s Review
The decision rule in a sell-or-process-further decision
is:
process further as long as the incremental
revenue from processing exceeds:

a. Incremental processing costs.

costs
b. Variable processing costs.
c. Fixed processing costs.
d. No correct answer is given.

LO 5: Identify the relevant costs in determining whether

to sell or process materials further.
 Retain or Replace Equipment
Management must decide whether a company should
continue to use an asset or replace it
Example: Assessment of replacement of a factory
machine:
Old Machine New Machine

Book value $40,000

Cost $120,000
Remaining useful life four years four years
Scrap value -0- -0-

Variable costs:
Decrease from $160,000
to $125,000 annually
LO 6: Identify the relevant costs to be considered in
retaining or replacing equipment.
 Retain or Replace Equipment - Example

Replace the equipment - Lower variable manufacturing costs

more than offset cost of new equipment.
The book value of the old machine does not affect the
decision – it is a sunk cost.
However, any trade-in allowance or cash disposal value of
the old asset is relevant

LO 6: Identify the relevant costs to be considered in

retaining or replacing equipment.
 Let’s Review
In a decision to retain or replace equipment, the book
value of the old equipment is a(an):

a. Opportunity cost.
cost
b. Sunk cost.
c. Incremental cost.
d. Marginal cost.

LO 6: Identify the relevant costs to be considered in

retaining or replacing equipment.
 Eliminate an Unprofitable Segment

Should the company 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

LO 7: Identify the relevant costs in deciding whether

to eliminate an unprofitable segment.
Eliminate an Unprofitable Segment - Example

Martina Company manufactures three models of tennis

racquets: Profitable lines: Pro and Master
Unprofitable line: Champ

Condensed Income Statement data:

Should the Champ line be eliminated?

LO 7: Identify the relevant costs in deciding whether

to eliminate an unprofitable segment.
Eliminate an Unprofitable Segment - Example

If Champ is eliminated, must allocate its $30,000

share of 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)
LO 7: Identify the relevant costs in deciding whether
to eliminate an unprofitable segment.
Eliminate an Unprofitable Segment - Example
Incremental analysis of Champ provides the same
results:

Decision: Do not eliminate Champ

LO 7: Identify the relevant costs in deciding whether
to eliminate an unprofitable segment.
 Let’s Review

If an unprofitable segment is eliminated:

a. Net income will always increase.

increase
b. Variable expenses of the eliminated segment will
have to be absorbed by other segments.
c. Fixed expenses allocated to the eliminated
segment will have to be absorbed by other
segments.
d. Net income will always decrease.

LO 7: Identify the relevant costs in deciding whether

to eliminate an unprofitable segment .
 Other Considerations in Decision Making

Many decisions involving incremental analysis have

important qualitative features that must be
considered in addition to the quantitative factors.

Example – cost of lost morale due to outsourcing or

eliminating a plant

Incremental analysis is completely consistent with

activity-based costing (ABC)

ABC often results in better identification of relevant

costs and, thus, better incremental analysis
 All About You

What is a Degree Worth?

Over a life time of work, college graduates earn an
average of $500,000 more than associate degree
holders and $900,000 more than high-school
graduates.
Tuition costs about $8,655 a year to attend a public
four-year college and about $1,359 for a public two
year institution.
About 600,000 students drop out
of four-year colleges each year.
 All About You

What is a Degree Worth?

You are working two jobs,

your grades are suffering,
you feel depressed: Should
you drop out of school?

Is it better to stay in school

even if you only take one class
each semester?
 Chapter Review - Exercise 7-1
Identify each of the following statements as true or false.
1. The first step in management’s decision-making process is False
“Determine and evaluate possible courses of action.”

2. The final step in management’s decision-making process is

to actually make the decision. False

3. Accounting’s contribution to management’s decision-

making process occurs primarily in evaluating possible True
courses of action and in reviewing the results.

4. In making business decisions, management ordinarily

considers only financial information because it is False
objectively determined.
 Chapter Review - Exercise 7-1 Continued
Identify each of the following statements as true or false.
5. Decisions involve a choice among alternative courses of True
action.

6. The process used to identify the financial data that

change under alternative courses of action is called True
incremental analysis.

7. Costs that are the same under all alternative courses of

False
action sometimes affect the decision.

8. When using incremental analysis, some costs will always

change under alternative courses of action, but revenues will
not. False

9. Variable costs will change under alternative courses of

action, but fixed costs will not. False
Problems Come Next!
 Brief Exercise One
 The steps in management decision-making
process are listed in random order below.
Indicate the order in which the step should be
executed.
 Identify the problem and assign responsibility.
 Determine and evaluate possible courses of action.
 Make a decision.
 Review results of the decision.
  
 Exercise One
 Given the following list of statements about
decision making and incremental analysis,
determine which are true and which are false.
 If false, correct the statement.
 Statements
 The first step in management ‘s decision-making
process is: Determine and evaluate possible
courses of action.
 False. The first step in management decision making
process is identified the problem and assign
responsibility
 The final step in management’s decision-making
process is to actually make the decision.
 False. The final step in management’s decision-
making process is to review the results of the
decision.
 Statements
 Accounting’s contribution to management’s
decision-making process occurs primarily in
evaluating possible courses of action and in
reviewing the results.
 True
 In making business decisions, management
ordinarily considers only financial information
because it is objectively determined.
 False. In making business decisions,
management ordinarily considers both financial
and nonfinancial information.
 Statements
 Decisions involve a choice among alternative
courses of action.
 True
 The process used to identify the financial data
that changes under alternative courses of action
is called incremental analysis.
 True
 Costs that are the same under all alternative
courses of action sometimes affect the decision.
 False. Costs that are the same are not relevant.
 Statements
 When using incremental analysis, some costs will
always change under alternative courses of actions,
but revenues will not.
 False. When using incremental analysis, either
costs or revenues or both will change under
alternative courses of action.
 Variable costs will change under variable
courses of action, but fixed costs will not.
 False. Sometimes variable costs will not change
under alternative courses of action, but fixed costs
will.
 Exercise 7-2
 A company produces golf discs which normally
sellto retailers for seven dollars each.
 The cost of manufacturing 20,000 golf discs is.
 Materials $10,000
 Labor $30,000
 Variable overhead $20,000
 Fixed overhead $40,000
 Total cost $100,000
 The company incurs a 5% sales commission
($0.35) on each disc sold.
 Exercise 7-2
 An outside firm offers $4.75 per disc for 5,000
discs.
 This company would sell the discs under its own
brand in foreign markets yet not served.
 If the manufacturer accepts the offer, it’s fixed
overhead will increase from $40,000 to $45,000
due to the purchase of a new printing machine.
 No sales commissions will result from the
special order.
 Exercise 7-2
 Prepare an incremental analysis for the special
order.
(a) Reject Accept
Order Order Net Income
Effect
Revenues $ -0- $23,750 $23,750
Materials ($0.50)  -0-   (2,500) (2,500)
Labor ($1.50)  -0-   (7,500) (7,500)
Variable overhead  -0-  
($1.00)   (5,000) (5,000)
Fixed overhead -0-   (5,000) (5,000)
Sales commissions   -0-   -0-      -0-    
Net income $ -0- $ 3,750 $ 3,750

Note that fixed costs sometimes are relevant. However only the portion that
varies one alternative to the next ($5,000) is relevant. The other $47,000
is not relevant
 Exercise 7-2
 Should the company except the special order?
 Why or why not?
 As shown in the incremental analysis, Innova
should accept the special order because
incremental revenue exceeds incremental
expenses by $3,750.
 Exercise 7-2
 What assumptions underlie the decision made in
part b?
 It is assumed that sales of the golf discs in other
markets would not be affected by this special
order. If other sales were affected. Innova would
have to consider the lost sales in making the
decision. Second, if Innova is operating at full
capacity, it is likely that the special order would
be rejected.
 Exercise 7-5
 XYZ Company has been manufacturing his own
shades for table lamps.
 The company is currently operating at 100%
capacity, and variable overhead is charged
production at the rate of 70% of direct labor
costs.
 The direct materials and direct labor cost per
unit to make lampshades are five and six dollars
respectively.
 Exercise 7-5
 Normal production is 30,000 tables per year.
 A supplier offers to make the lampshades at a
price of $15.50 per unit.
 If XYZ accepts the suppliers offer, all variable
costs will be eliminated, but the $45,000 of fixed
manufacturing overhead currently charge to
lampshades will have to be absorbed by other
products.
 Exercise 7-5
 Prepare the incremental analysis for the
decision to make her by the lampshades.
Net Income
Make Buy Increase
(Decrease)

Direct materials (30,000 X $5.00) $150,000 $      0 $ 150,000

Direct labor (30,000 X $6.00)  180,000        0 180,000
Variable manufacturing costs  126,000        0 126,000
  ($180,000 X 70%)   45,000   45,000        0
Fixed manufacturing costs        0  465,000 ( (465,000)
Purchase price (30,000 X $15.50) $501,000 $510,000 ($ (9,000)
Total annual cost

In this case the fixed cost is not relevant since

it is not change one alternative to the next.
 Exercise 7-5
 Prepare the incremental analysis for the
decision to make her by the lampshades.
Net Income
Make Buy Increase
(Decrease)

Direct materials (30,000 X $5.00) $150,000 $      0 $ 150,000

Direct labor (30,000 X $6.00)  180,000        0 180,000
Variable manufacturing costs  126,000        0 126,000
  ($180,000 X 70%)   45,000   45,000        0
Fixed manufacturing costs        0  465,000 ( (465,000)
Purchase price (30,000 X $15.50) $501,000 $510,000 ($ (9,000)
Total annual cost

They should not purchase the lampshades

Since doing so will decrease net income by $9,000.
 Exercise 7-5
 Prepare the incremental analysis for the
decision to make her by the lampshades.
Net Income
Make Buy Increase
(Decrease)

Direct materials (30,000 X $5.00) $150,000 $      0 $ 150,000

Direct labor (30,000 X $6.00)  180,000        0 180,000
Variable manufacturing costs  126,000        0 126,000
  ($180,000 X 70%)   45,000   45,000        0
Fixed manufacturing costs        0  465,000 ( (465,000)
Purchase price (30,000 X $15.50) $501,000 $510,000 ($ (9,000)
Total annual cost

Would your answer be different if the productive capacity released by not making
the lampshades could be used to produce income of $35,000?

Of course, by purchasing the lampshades they would then save $26,000.

 Exercise 7-6
 XYZ has recently started to manufacture a product.
 The cost structure to manufacture 20,000 units is
as follows.
 Direct materials ($40 per unit) $80,000
 Direct labor ($30) $600,000
 Variable labor ($6) hundred and $20,000
 Allocated fixed overhead ($25) $500,000
 Total costs $2,020,000
 XYZ is approached by ABC which offers to make
the product for $90 per unit or $1,800,000.
 Exercise 7-6
 Using incremental analysis, determine rather
XYZ should accept the offer under each of the
following independent assumptions.
 Exercise 7-6
 Assume that $300,000 of the fixed overhead
costs can be reduced or avoided.

Net Income
Increase
     Make           Buy         (Decrease)  
Direct materials $ 800,000 $ -0-  $ 800,000

Direct labor 600,000 -0-  600,000

Variable overhead 120,000 -0-  120,000

Fixed overhead 500,000 200,000 300,000

Purchase price 0 1,800,000 (1,800,000)

Total annual cost $2,020,000 $2,000,000 $ 20,000

Accept the order!

 Exercise 7-6
 Assume that none of the fixed overhead can be avoided.
 However, if the products are purchased from ABC, XYZ can use the
release productive resources to generate additional income of
$300,000.

(2)
Net Income
Increase
     Make          Buy       (Decrease) 
Direct materials $ 800,000 $ 0 $ 800,000
Direct labor 600,000 0 600,000
Variable overhead 120,000 0 120,000
Fixed overhead 500,000 500,000 0
Opportunity cost 300,000 0 300,000
Purchase price 0 1,800,000 (1,800,000)

Totals $2,320,000 $2,300,000 $ 20,000

Here the author shows the revenue as a negative (opportunity) cost which is
the same as a revenue.
 Exercise 7-6
 Describes the qualitative factors that might
affect the decision to purchase the product 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.
 Exercise 7-11
 XYZ Enterprises uses a computer to handle its
sales invoices.
 Lately, businesses has been so good that it
takes an extra three hours per night, plus every
third Saturday, to keep up with the volume of
sales invoices.
 Management is considering updating its
computer with a faster model that would
eliminate all of the overtime processing.
 Exercise 7-11

Current Machine New Machine

Original purchase cost $15,000 $25,000
Accumulated depreciation $6,000 $0
Estimated annual operating costs $24,000 $18,000
Useful life Five years Five years

If sold now, the current machine would have a salvage value of $5,000. If
operated for the remainder of its useful life, the current machine would
have a zero salvage value. The new machine is expected to have zero
salvage value after five years.

Should the current machine be replaced?

 Exercise 7-11

Net Income
Retain Replace Increase
Machine Machine (Decrease)

Operating costs $120,000  (1) ($ 90,000) (2) ( $ 30,000

New machine cost        0 (  25,000) ( (25,000)
Salvage value (old)        0 (   (5,000) (   5,000)
Total $120,000 ($110,000) ($ 10,000)

(1) $24,000 X 5.
(2) $18,000 X 5.

There are a number of formats one could use in doing this analysis, here the
author chooses to make the far right column show the impact the change
would have on operating income. He arbitrarily decides to make a positive
impact a positive number and a negative impact a negative number.
 Exercise 7-11

Net Income
Retain Replace Increase
Machine Machine (Decrease)

Operating costs $120,000  (1) ($ 90,000) (2) ( $ 30,000

New machine cost        0 (  25,000) ( (25,000)
Salvage value (old)        0 (   (5,000) (   5,000)
Total $120,000 ($110,000) ($ 10,000)

(1) $24,000 X 5.
(2) $18,000 X 5.

The current machine should be replaced. The incremental analysis shows the
net income for the five-year period will be $10,000 higher by replacing the
current machine.
 Problem 5
 Lewis Manufacturing Company has four
operating divisions.
 During the first quarter of 2008, the company
reported aggregate income from operations of
$176,000 and the following divisional results.
 Problem 5
Divisions
One Two Three Four
Sales $250,000 $200,000 $500,000 $400,000
COGS 200,000 189,000 300,000 250,000
S&A 65,000 60,000 60,000 50,000
Expense
Income (loss) -$15,000 -$49,000 $140,000 $100,000

Analysis reveals the following percentages of variable costs in each division.

Divisions
One Two Three Four
COGS 70% 90% 80% 75%
S&A Exp. 40% 70% 50% 60%
 Problem 5
 Discontinuance of any division would save 50%
of the fixed costs and expenses for that division.
 Top management is very concerned about the
unprofitable divisions (one and two).
 Consensus is that one or both of the division
should be discontinued.
 Problem 5
 Compute the contribution margin for divisions
one and two.
Division I Division II

Sales $250,000 $200,000

Variable costs  140,000  170,100
Cost of goods sold   26,000   42,000
Selling and administrative  166,000  212,100
Total variable expenses ($ 84,000) $ (12,100)
Contribution margin
Contribution margin is what is available to pay fixed costs. Eliminating
Division II gives us a negative contribution margin.

However, if we can decrease fixed cost below $12,100, the elimination

would still be a good idea.
 Problem 5
 Prepare an incremental analysis concerning the
possible discontinuance of Division I and
Division II.
(1) Net Income
Division I Continue Eliminate Increase
(Decrease)

Contribution margin (above) $(84,000) $(     0) $(84,000)

Fixed costs  (60,000)  (30,000)   30,000
Cost of goods sold  (39,000)  (19,500)   19,500
Selling and administrative  (99,000)  (49,500)   49,500
Total fixed expenses $(15,000) $(49,500) $(34,500)
Income (loss) from operations

Eliminating Division One would reduce income by $34,500 – not a good

idea!
 Problem 5

Net Income
Division II Continue Eliminate Increase
(Decrease)

Contribution margin (above) $(12,100) $(     0) $12,100

Fixed costs (18,900  ( 9,450)  ( 9,450
Cost of goods sold (  18,000  ( 9,000)  ( 9,000
Selling and administrative (  36,900  (18,450) 18,450
Total fixed expenses $(49,000) $(18,450) $30,550
Income (loss) from operations

Division II should be eliminated as income from operations would

increase by $30,500 by so doing.
The End