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INCREMENTAL ANALYSIS

Chapter 21. INCREMENTAL ANALYSIS. Special order decisions. Product mix decisions. Make or buy decisions. Joint product decisions. The Challenge of Changing Markets.

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INCREMENTAL ANALYSIS

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  1. Chapter21 INCREMENTAL ANALYSIS

  2. Specialorderdecisions Productmixdecisions Makeor buydecisions Jointproductdecisions The Challenge ofChanging Markets • Product markets can change quickly due to competitor pricecuts, changing customer preferences, and introduction ofnew products by competitors. • Managers must make short-run decisions, with a fixed setof resources, to react to the changing market place.

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

  4. The Concept ofRelevant Cost Information 8 days @ $80 8 days @ $20 8 days @ $5

  5. The Concept ofRelevant Cost Information Costs do not differ,so they are notrelevant to decision. Also, car insuranceis not relevant tothe decision as itis a past cost.

  6. The Concept ofRelevant Cost Information Are the extra twodays in Floridaworth the $300extra cost to fly? Transportationcosts differ betweenthe two alternatives,so they are relevantto your decision

  7. 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. Decision Making

  8. Information that varies among the possible courses of action being considered. — Incremental costs and revenues — Important cost concepts forbusiness decisions. Opportunity costs. Sunk costs. Out-of-pocket costs. 1 2 Relevant Informationin Business Decisions

  9. 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. Youropportunity cost of attending college for one year includes the $20,000. Opportunity Cost Opportunity costs are not recorded in the accounting records, but are relevant to decisions because they are a real sacrifice.

  10. All costs incurred in the past that cannot be changed by any decision made now or in the future. Sunk costs should not be considered in decisions. Example: You bought an automobile that cost $10,000 two years ago. The $10,000 cost is sunk because whether you drive it, park it, trade it, or sell it, you cannot change the $10,000 cost. Sunk Costs VersusOut-of-Pocket Costs

  11. Sunk Costs VersusOut-of-Pocket Costs Trade ? Cost = $10,000two years ago Cost = $25,000today The dealer will trade for $20,000 plus your car.What amount is relevant to your decision, the $10,000 sunk cost of your car or the$20,000 out-of-pocket cash differential?

  12. The decision to accept additional business should be based on incremental costs andincremental revenues. Incremental amounts are those that occur only if the company decides to acceptthe new business. Special Order Decisions

  13. View Co. currently sells 100,000 units of its product. The company has revenue and costs as shown below: Special Order Decisions

  14. View Co. is approached by an overseascompany that offers to purchase10,000 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 increaseby $1,000. Should View Co.accept the offer? Special Order Decisions

  15. Special Order Decisions First let’s look at incorrect reasoningthat leads to an incorrect decision. Our cost is $9.00per unit. I can’t sell for $8.50 per unit.

  16. Special Order Decisions This analysis leads to the correct decision.

  17. 10,000 new units × $8.50 selling price = $85,000 Special Order Decisions

  18. 10,000 new units × $3.50 = $35,000 Special Order Decisions

  19. 10,000 new units × $2.20 = $22,000 Special Order Decisions

  20. Even though the $8.50 selling price is less than the normal $10 selling price, View Co. should accept theoffer because net income will increase by $20,000. Special Order Decisions

  21. We can also look at this decisionusing contribution margin. Special Order Decisions

  22. Production Constraint Decisions Managers often face the problem of deciding how scarce resources are going to be utilized. Usually, fixed costs are not affected by this particular decision, so management can focus on maximizing total contribution margin. Let’s look at the Kaiser Company example.

  23. Kaiser Company produces two products and selected data is shown below: Production Constraint Decisions

  24. Machine A1 is the scarce resource because there is excess capacity on other machines. Machine A1 is being used at 100% of its capacity. Machine A1 capacity is 2,400 minutes per week. Should Kaiser focus its efforts on Product 1 or 2? Production Constraint Decisions

  25. Let’s calculate the contribution margin per unit of the scarce resource, machine A1. Production Constraint Decisions

  26. Production Constraint Decisions Let’s calculate the contribution margin per unit of the scarce resource, machine A1. Product 2 should be emphasized. It is the more valuable use of the scarce resource, machine A1, yielding a contribution margin of $30 per minute as opposed to $24 for Product 1.

  27. Production Constraint Decisions Let’s calculate the contribution margin per unit of the scarce resource, machine A1. If there are no other considerations, the best plan would be to produce to meet current demand for Product 2 and then use any capacity that remains to make Product 1.

  28. Let’s see how this plan would work. Production Constraint Decisions

  29. Production Constraint Decisions Let’s see how this plan would work.

  30. Production Constraint Decisions Let’s see how this plan would work.

  31. According to the plan, we will produce 2,200 units of Product 2 and 1,300 of Product 1. Our contribution margin looks like this. Production Constraint Decisions The total contribution margin for Kaiser is $64,200.

  32. Should Icontinue to makethe part, or shouldI buy it? I suppose Ishould comparethe outside purchaseprice with the additionalcosts to manufacturethe part. What will I do with myidle facilities ifI buy the part? Make or Buy Decisions

  33. Incremental costs also are important in the decision to make a product or buy it from a supplier. The cost to produce an item must include(1) direct materials, (2) direct labor and (3)incremental overhead. We should not use the predetermined overhead rate to determine product cost. Make or Buy Decisions

  34. Excel makes computer chips used inone of its products. Unit costs, based on production of 20,000 chips per year, are: Make or Buy Decisions

  35. An outside supplier has offered to provide the 20,000 chips at a cost of $25 per chip. Fixed overhead costswill not be avoided if the chips are purchased. Excel has no alternative use for the facilities. Should Excel accept the offer? Make or Buy Decisions

  36. Make or Buy Decisions Differential costs of making (costs avoided if bought from outside supplier) Excel should not pay $25 per unit to an outside supplier to avoid the $15 per unit differential cost of making the part. Fixed costs are irrelevant to decision.

  37. If Excel buys the chips from the outside supplier, the idle facilities could be leased to another company for $250,000 per year. Should Excel buy the chips andlease the facilities? Make or Buy Decisions

  38. Make or Buy Decisions The opportunity cost of facilities changes the decision. The real question to answer is, “What is the best use of Excel’s facilities?”

  39. Costs incurred in manufacturing units of product that do not meet quality standards aresunk costs and cannot be recovered. As long asrebuild costs are recovered through sale of the product, and rebuilding does not interfere with normal production, we should rebuild. Sell, Scrap, or Rebuild Decisions

  40. Servo has 10,000 defective units that cost $1.00 each to make. The units can be scrapped now for $.40 each or rebuilt at an additional cost of $.80 per unit.If rebuilt, the units can be sold for the normal selling price of $1.50 each. Rebuilding the 10,000 defective units will prevent the production of 10,000 new units that would also sell for $1.50. Should Servo scrap or rebuild? Sell, Scrap, or Rebuild Decisions

  41. Sell, Scrap, or Rebuild Decisions 10,000 units × $0.40 per unit 10,000 units × $1.50 per unit

  42. Sell, Scrap, or Rebuild Decisions 10,000 units × $0.80 per unit 10,000 units × ($1.50 - $1.00) per unit

  43. Sell, Scrap, or Rebuild Decisions Servo should scrap the units now. If Servo fails to include the opportunity cost,the rework option would show a return of $7,000,mistakenly making rebuild appear more favorable.

  44. Joint Product Decisions Two or more products produced from acommon input are calledjoint products. Product 1 Joint costs arethe costs ofprocessing prior to the split-off point. Joint Costs Product 2 Product 3 Thesplit-off point is the point in a process where joint products can be recognized as separate products.

  45. Businesses are often faced with the decision to sell partially completed products at the split-off point or to process them to completion. General rule:Process further only ifincremental revenues > incremental costs. Joint Product Decisions

  46. Final Sale$120,000 Additional Processing$40,000 Revenue$70,000 A Common Production Process Joint Cost$100,000 Final Sale$65,000 Additional Processing$20,000 Revenue$50,000 B Split-Off Point Joint Product Decisions Ames Co. produces two products, A and B, from this process. Should the products besold at split-off orprocessed further?

  47. Joint Product Decisions Product A incremental revenue = $120,000 - $70,000 Product B incremental revenue = $65,000 - $50,000 Decision: Process product A, but sell product B at the split-off point.Note that the $100,000 joint cost is irrelevant to the processing decision.

  48. Joint Product Decisions Joint costs are really common costs incurred to simultaneously produce a variety of end products. Joint costs are commonly allocated to end products on the basis of the relative sales value of each product or on some other basis.

  49. Joint costs are not relevantin decisions regarding what to do witha product after the split-off point. As a general rule . . . It is always profitable to continue processing a joint product after the split-off point so long as the incremental revenue exceeds the incremental processing costs. Joint Product Decisions

  50. End of Chapter 21

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