In a make or buy decision relevant costs include

Cost-Volume-Profit Analysis

Incremental Analysis

 CHAPTER PREVIEW 

Companies of all sorts must make product decisions. Oral‐B Laboratories opted to produce a new, higher‐priced toothbrush. General Motors announced the closure of its Oldsmobile Division. This chapter explains management's decision‐making process and a decision‐making approach called incremental analysis. The use of incremental analysis is demonstrated in a variety of situations.

Keeping It Clean

When you think of new, fast‐growing, San Francisco companies, you probably think of fun products like smartphones, social networks, and game apps. You don't tend to think of soap. In fact, given that some of the biggest, most powerful companies in the world dominate the soap market (e.g., Proctor & Gamble, Clorox, and Unilever), starting a new soap company seems like an outrageously bad idea. But that didn't dissuade Adam Lowry and Eric Ryan from giving it a try. The long‐time friends and former roommates combined their skills (Adam's chemical engineering and Eric's design and marketing) to start Method Products. Their goal: selling environmentally friendly soaps that actually remove dirt.

Within a year of its formation, the company had products on the shelves at Target stores. Within 5 years, Method was cited by numerous business publications as one of the fastest‐growing companies in the country. It was easy—right? Wrong. Running a company is never easy, and given Method's commitment to sustainability, all of its business decisions are just a little more complex than usual. For example, the company wanted to use solar power to charge the batteries for the forklifts used in its factories. No problem, just put solar panels on the buildings. But because Method outsources its manufacturing, it doesn't actually own factory buildings. In fact, the company that does Method's manufacturing doesn't own the buildings either. Solution—Method parked old semi‐trailers next to the factories and installed solar panels on those.

Since Method insists on using natural products and sustainable production practices, its production costs are higher than companies that don't adhere to these standards. Adam and Eric insist, however, that this actually benefits them because they have to be far more careful about controlling costs and far more innovative in solving problems. Consider Method's most recently developed laundry detergent. It is 8 times stronger than normal detergent, so it can be sold in a substantially smaller package. This reduces both its packaging and shipping costs. In fact, when the cost of the raw materials used for soap production recently jumped by as much as 40%, Method actually viewed it as an opportunity to grab market share. It determined that it could offset the cost increases in other places in its supply chain, thus absorbing the cost much easier than its big competitors.

In these and other instances, Adam and Eric identified their alternative courses of action, determined what was relevant to each choice and what wasn't, and then carefully evaluated the incremental costs of each alternative. When you are small and your competitors have some of the biggest marketing budgets in the world, you can't afford to make very many mistakes.

LEARNING OBJECTIVE 1

Describe management's decision‐making process and incremental analysis.

Making decisions is an important management function. Management's decision‐making process does not always follow a set pattern because decisions vary significantly in their scope, urgency, and importance. It is possible, though, to identify some steps that are frequently involved in the process. These steps are shown in Illustration 20-1 .

ILLUSTRATION 20-1 Management's decision‐making process

Accounting's contribution to the decision‐making process occurs primarily in Steps 2 and 4—evaluating possible courses of action and reviewing results. In Step 2, for each possible course of action, relevant revenue and cost data are provided. These show the expected overall effect on net income. In Step 4, internal reports are prepared that review the actual impact of the decision.

In making business decisions, management ordinarily considers both financial and nonfinancial information. Financial information is related to revenues and costs and their effect on the company's overall profitability. Nonfinancial information relates to such factors as the effect of the decision on employee turnover, the environment, or the overall image of the company in the community. (These are considerations that we touched on in our Chapter 14 discussion of corporate social responsibility.) Although nonfinancial information can be as important as financial information, we will focus primarily on financial information that is relevant to the decision.

INCREMENTAL ANALYSIS APPROACH

Decisions involve a choice among alternative courses of action. Suppose you face the personal financial decision of whether to purchase or lease a car. The financial data relate to the cost of leasing versus the cost of purchasing. For example, leasing involves periodic lease payments; purchasing requires “upfront” payment of the purchase price. In other words, the financial information relevant to the decision are the data that vary in the future among the possible alternatives. The process used to identify the financial data that change under alternative courses of action is called incremental analysis . In some cases, you will find that when you use incremental analysis, both costs and revenues vary. In other cases, only costs or revenues vary.

Just as your decision to buy or lease a car affects your future financial situation, similar decisions, on a larger scale, affect a company's future. Incremental analysis identifies the probable effects of those decisions on future earnings. Such analysis inevitably involves estimates and uncertainty. Gathering data for incremental analyses may involve market analysts, engineers, and accountants. In quantifying the data, the accountant must produce the most reliable information available.

ALTERNATIVE TERMINOLOGY

Incremental analysis is also called differential analysis because the analysis focuses on differences.

HOW INCREMENTAL ANALYSIS WORKS

The basic approach in incremental analysis is illustrated in the following example.

ILLUSTRATION 20-2 Basic approach in incremental analysis

This example compares Alternative B with Alternative A. The net income column shows the differences between the alternatives. In this case, incremental revenue will be $15,000 less under Alternative B than under Alternative A. But a $20,000 incremental cost savings will be realized. 1 Thus, Alternative B will produce $5,000 more net income than Alternative A.

In the following pages, you will encounter three important cost concepts used in incremental analysis, as defined and discussed in Illustration 20-3 .

· Relevant cost In incremental analysis, the only factors to be considered are those costs and revenues that differ across alternatives. Those factors are called relevant costs . Costs and revenues that do not differ across alternatives can be ignored when trying to choose between alternatives.

· Opportunity cost Often in choosing one course of action, the company must give up the opportunity to benefit from some other course of action. For example, if a machine is used to make one type of product, the benefit of making another type of product with that machine is lost. This lost benefit is referred to as opportunity cost .

· Sunk cost Costs that have already been incurred and will not be changed or avoided by any present or future decisions are referred to as sunk costs . For example, the amount you spent in the past to purchase or repair a laptop should have no bearing on your decision whether to buy a new laptop. Sunk costs are not relevant costs.

ILLUSTRATION 20-3 Key cost concepts in incremental analysis

Incremental analysis sometimes involves changes that at first glance might seem contrary to your intuition. For example, sometimes variable costs do not change under the alternative courses of action. Also, sometimes fixed costs do change. For example, direct labor, normally a variable cost, is not an incremental cost in deciding between two new factory machines if each asset requires the same amount of direct labor. In contrast, rent expense, normally a fixed cost, is an incremental cost in a decision whether to continue occupancy of a building or to purchase or lease a new building.

It is also important to understand that the approaches to incremental analysis discussed in this chapter do not take into consideration the time value of money. That is, amounts to be paid or received in future years are not discounted for the cost of interest. Time value of money is addressed in Chapter 24 and Appendix G .

SERVICE COMPANY INSIGHT

American Express

That Letter from AmEx Might Not Be a Bill

No doubt every one of you has received an invitation from a credit card company to open a new account—some of you have probably received three in one day. But how many of you have received an offer of $300 to close out your credit card account? American Express decided to offer some of its customers $300 if they would give back their credit card. You could receive the $300 even if you hadn't paid off your balance yet, as long as you agreed to give up your credit card.

Source: Aparajita Saha‐Bubna and Lauren Pollock, “AmEx Offers Some Holders $300 to Pay and Leave,” Wall Street Journal Online (February 23, 2009).

What are the relevant costs that American Express would need to know in order to determine to whom to make this offer? (Go to WileyPLUS for this answer and additional questions.)

DECISION TOOLS

Incremental analysis helps managers choose the alternative that maximizes net income.

QUALITATIVE FACTORS

In this chapter, we focus primarily on the quantitative factors that affect a decision—those attributes that can be easily expressed in terms of numbers or dollars. However, many of the decisions involving incremental analysis have important qualitative features. Though not easily measured, they should not be ignored.

Consider, for example, the potential effects of the make‐or‐buy decision or of the decision to eliminate a line of business on existing employees and the community in which the plant is located. The cost savings that may be obtained from outsourcing or from eliminating a plant should be weighed against these qualitative attributes. One example would be the cost of lost morale that might result. Al “Chainsaw” Dunlap was a so‐called “turnaround” artist who went into many companies, identified inefficiencies (using incremental analysis techniques), and tried to correct these problems to improve corporate profitability. Along the way, he laid off thousands of employees at numerous companies. As head of Sunbeam, it was Al Dunlap who lost his job because his Draconian approach failed to improve Sunbeam's profitability. It was reported that Sunbeam's employees openly rejoiced for days after his departure. Clearly, qualitative factors can matter.

RELATIONSHIP OF INCREMENTAL ANALYSIS AND ACTIVITY‐BASED COSTING

In Chapter 17 , we noted that many companies have shifted to activity‐based costing to allocate overhead costs to products. The primary reason for using activity‐based costing is that it results in a more accurate allocation of overhead. The concepts presented in this chapter are completely consistent with the use of activity‐based costing. In fact, activity‐based costing results in better identification of relevant costs and, therefore, better incremental analysis.

TYPES OF INCREMENTAL ANALYSIS

A number of different types of decisions involve incremental analysis. The more common types of decisions are whether to:

1. Accept an order at a special price.

2. Make or buy component parts or finished products.

3. Sell products or process them further.

4. Repair, retain, or replace equipment.

5. Eliminate an unprofitable business segment or product.

We consider each of these types of decisions in the following pages.

DO IT! 1

Incremental Analysis

Owen T Corporation is comparing two different options. The company currently follows Option 1, with revenues of $80,000 per year, maintenance expenses of $5,000 per year, and operating expenses of $38,000 per year. Option 2 provides revenues of $80,000 per year, maintenance expenses of $12,000 per year, and operating expenses of $32,000 per year. Option 1 employs a piece of equipment that was upgraded 2 years ago at a cost of $22,000. If Option 2 is chosen, it will free up resources that will increase revenues by $3,000.

Complete the following table to show the change in income from choosing Option 2 versus Option 1. Designate any sunk costs with an “S.”

 

Option 1

 

Option 2

 

Net Income Increase (Decrease)

 

Sunk (S)

Revenues

 

 

 

 

Maintenance expenses

 

 

 

 

Operating expenses

 

 

 

 

Equipment upgrade

 

 

 

 

Opportunity cost

 

 

 

 

Action Plan

✓ Past costs that cannot be changed are sunk costs.

✓ Benefits lost by choosing one option over another are opportunity costs.

SOLUTION

 

Option 1

 

Option 2

 

Net Income Increase (Decrease)

 

Sunk (S)

Revenues

 

$80,000

 

$80,000

 

$     0

 

Maintenance expenses

 

  5,000

 

 12,000

 

  (7,000)

 

Operating expenses

 

 38,000

 

 32,000

 

  6,000

 

Equipment upgrade

 

 22,000

 

      0

 

      0

 

S

Opportunity cost

 

  3,000

 

      0

 

  3,000

 

 

 

 

$ 2,000

 

Related exercise material: BE20-1, BE20-2, E20-1, E20-18, and DO IT! 20-1.

LEARNING OBJECTIVE 2

Analyze the relevant costs in accepting an order at a special price.

Sometimes a company has an opportunity to obtain additional business if it is willing to make a price concession to a specific customer. To illustrate, assume that Sunbelt Company produces 100,000 Smoothie blenders per month, which is 80% of plant capacity. Variable manufacturing costs are $8 per unit. Fixed manufacturing costs are $400,000, or $4 per unit. The Smoothie blenders are normally sold directly to retailers at $20 each. Sunbelt has an offer from Kensington Co. (a foreign wholesaler) to purchase an additional 2,000 blenders at $11 per unit. Acceptance of the offer would not affect normal sales of the product, and the additional units can be manufactured without increasing plant capacity. What should management do?

If management makes its decision on the basis of the total cost per unit of $12 ($8 variable+$4 fixed)$12 ($8 variable+$4 fixed), the order would be rejected because costs per unit ($12) exceed revenues per unit ($11) by $1 per unit. However, since the units can be produced within existing plant capacity, the special order will not increase fixed costs. Let's identify the relevant data for the decision. First, the variable manufacturing costs increase $16,000 ($8×2,000)$16,000 ($8×2,000). Second, the expected revenue increases $22,000 ($11×2,000)$22,000 ($11×2,000). Thus, as shown in Illustration 20-4 , Sunbelt increases its net income by $6,000 by accepting this special order.

ILLUSTRATION 20-4 Incremental analysis—accepting an order at a special price

Two points should be emphasized. First, we assume that sales of the product in other markets would not be affected by this special order. If other sales were affected, then Sunbelt would have to consider the lost sales in making the decision. Second, if Sunbelt is operating at full capacity, it is likely that the special order would be rejected. Under such circumstances, the company would have to expand plant capacity. In that case, the special order would have to absorb these additional fixed manufacturing costs, as well as the variable manufacturing costs.

DO IT! 2

Special Orders

Cobb Company incurs costs of $28 per unit ($18 variable and $10 fixed) to make a product that normally sells for $42. A foreign wholesaler offers to buy 5,000 units at $25 each. The special order results in additional shipping costs of $1 per unit. Compute the increase or decrease in net income Cobb realizes by accepting the special order, assuming Cobb has excess operating capacity. Should Cobb Company accept the special order?

Action Plan

✓ Identify all revenues that change as a result of accepting the order.

✓ Identify all costs that change as a result of accepting the order, and net this amount against the change in revenues.

SOLUTION

 

Reject

 

Accept

 

Net Income Increase (Decrease)

Revenues

 

$–0–

 

$125,000 *  

 

$125,000 

Costs

 

 –0–

 

  95,000 **

 

 (95,000)

Net income

 

$–0–

 

$ 30,000 

 

$ 30,000 

* 5,000 × $25

** (5,000 × $18) + (5,000 × $1)

The analysis indicates net income increases by $30,000; therefore, Cobb Company should accept the special order.

Related exercise material: BE20-3, E20-2, E20-3, E20-4, and DO IT! 20-2.

▼ HELPFUL HINT

This is a good example of different costs for different purposes. In the long run all costs are relevant, but for this decision only costs that change are relevant.

LEARNING OBJECTIVE 3

Analyze the relevant costs in a make‐or‐buy decision.

When a manufacturer assembles component parts in producing a finished product, management must decide whether to make or buy the components. The decision to buy parts or services is often referred to as outsourcing. For example, as discussed in the Feature Story, a company such as Method Products may either make or buy the soaps used in its products. Similarly, Hewlett‐Packard Corporation may make or buy the electronic circuitry, cases, and printer heads for its printers. Boeing recently sold some of its commercial aircraft factories in an effort to cut production costs and focus on engineering and final assembly rather than manufacturing. The decision to make or buy components should be made on the basis of incremental analysis.

Baron Company makes motorcycles and scooters. It incurs the following annual costs in producing 25,000 ignition switches for scooters.

Direct materials

$  50,000

Direct labor

75,000

Variable manufacturing overhead

40,000

Fixed manufacturing overhead

  60,000

Total manufacturing costs

$225,000

Total cost per unit ($225,000 ÷ 25,000)

$9.00

ILLUSTRATION 20-5 Annual product cost data

Instead of making its own switches, Baron Company might purchase the ignition switches from Ignition, Inc. at a price of $8 per unit. What should management do?

At first glance, it appears that management should purchase the ignition switches for $8 rather than make them at a cost of $9. However, a review of operations indicates that if the ignition switches are purchased from Ignition, Inc., all of Baron's variable costs but only $10,000 of its fixed manufacturing costs will be eliminated (avoided). Thus, $50,000 of the fixed manufacturing costs remain if the ignition switches are purchased. The relevant costs for incremental analysis, therefore, are as shown below.

ILLUSTRATION 20-6 Incremental analysis—make or buy

This analysis indicates that Baron Company incurs $25,000 of additional costs by buying the ignition switches rather than making them. Therefore, Baron should continue to make the ignition switches even though the total manufacturing cost is $1 higher per unit than the purchase price. The primary cause of this result is that, even if the company purchases the ignition switches, it will still have fixed costs of $50,000 to absorb.

ETHICS NOTE

In the make‐or‐buy decision, it is important for management to take into account the social impact of its choice. For instance, buying may be the most economically feasible solution, but such action could result in the closure of a manufacturing plant that employs many good workers.

OPPORTUNITY COST

The foregoing make‐or‐buy analysis is complete only if it is assumed that the productive capacity used to make the ignition switches cannot be converted to another purpose. If there is an opportunity to use this productive capacity in some other manner, then this opportunity cost must be considered. As indicated earlier, opportunity cost is the potential benefit that may be obtained by following an alternative course of action.

To illustrate, assume that through buying the switches, Baron Company can use the released productive capacity to generate additional income of $38,000 from producing a different product. This lost income is an additional cost of continuing to make the switches in the make‐or‐buy decision. This opportunity cost is therefore added to the “Make” column for comparison. As shown in Illustration 20-7 , it is now advantageous to buy the ignition switches. The company's income would increase by $13,000.

ILLUSTRATION 20-7 Incremental analysis—make or buy, with opportunity cost

The qualitative factors in this decision include the possible loss of jobs for employees who produce the ignition switches. In addition, management must assess the supplier's ability to satisfy the company's quality control standards at the quoted price per unit.

SERVICE COMPANY INSIGHT

Amazon.com

Giving Away the Store?

In an earlier chapter, we discussed Amazon.com's incredible growth. However, some analysts have questioned whether some of the methods that Amazon uses to increase its sales make good business sense. For example, a few years ago, Amazon initiated a “Prime” free‐shipping subscription program. For a $79 fee per year, Amazon's customers get free shipping on as many goods as they want to buy. At the time, CEO Jeff Bezos promised that the program would be costly in the short‐term but benefit the company in the long‐term. Six years later, it was true that Amazon's sales had grown considerably. It was also estimated that its Prime customers buy two to three times as much as non‐Prime customers. But, its shipping costs rose from 2.8% of sales to 4% of sales, which is remarkably similar to the drop in its gross margin from 24% to 22.3%. Perhaps even less easy to justify is a proposal by Mr. Bezos to start providing a free Internet movie‐streaming service to Amazon's Prime customers. Perhaps some incremental analysis is in order?

Source: Martin Peers, “Amazon's Prime Numbers,” Wall Street Journal Online (February 3, 2011).

What are the relevant revenues and costs that Amazon should consider relative to the decision whether to offer the Prime free‐shipping subscription? (Go to WileyPLUS for this answer and additional questions.)

DO IT! 3

Make or Buy

Juanita Company must decide whether to make or buy some of its components for the appliances it produces. The costs of producing 166,000 electrical cords for its appliances are as follows.

Direct materials

 

$90,000

 

Variable overhead

 

$32,000

Direct labor

 

$20,000

 

Fixed overhead

 

$24,000

Instead of making the electrical cords at an average cost per unit of $1.00 ($166,000 ÷ 166,000)$1.00 ($166,000 ÷ 166,000), the company has an opportunity to buy the cords at $0.90 per unit. If the company purchases the cords, all variable costs and one‐fourth of the fixed costs are eliminated.

(a) Prepare an incremental analysis showing whether the company should make or buy the electrical cords. (b) Will your answer be different if the released productive capacity will generate additional income of $5,000?

Action Plan

✓ Look for the costs that change.

✓ Ignore the costs that do not change.

✓ Use the format in the chapter for your answer.

✓ Recognize that opportunity cost can make a difference.

SOLUTION

1.

2.

 

Make

 

Buy

 

Net Income Increase (Decrease)

Direct materials

 

$ 90,000

 

$   –0–  

 

$  90,000 

Direct labor

 

20,000

 

  –0–  

 

  20,000

Variable manufacturing costs

 

32,000

 

  –0–  

 

  32,000

Fixed manufacturing costs

 

24,000

 

  18,000 *  

 

   6,000

Purchase price

 

     –0–

 

 149,400 **

 

 (149,400)

  Total cost

 

$166,000

 

$167,400  

 

$  (1,400)

3. * $24,000 × .75

4. ** 166,000 × $0.90

5. This analysis indicates that Juanita Company will incur $1,400 of additional costs if it buys the electrical cords rather than making them.

6.

7.

 

Make

 

Buy

 

Net Income Increase (Decrease)

Total cost

 

$166,000

 

$167,400

 

$(1,400)

Opportunity cost

 

   5,000

 

   –0–  

 

  5,000 

  Total cost

 

$171,000

 

$167,400

 

$ 3,600

8. Yes, the answer is different. The analysis shows that net income increases by $3,600 if Juanita Company purchases the electrical cords rather than making them.

Related exercise material: BE20-4, E20-5, E20-6, E20-7, E20-8, and DO IT! 20-3.

LEARNING OBJECTIVE 4

Analyze the relevant costs in determining whether to sell or process materials 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 higher price. For example, a bicycle manufacturer such as Trek could sell its bicycles to retailers either unassembled or assembled. A furniture manufacturer such as Ethan Allencould sell its dining room sets to furniture stores either unfinished or finished. The sell‐or‐process‐further decision should be made on the basis of incremental analysis. The basic decision rule is: Process further as long as the incremental revenue from such processing exceeds the incremental processing costs.

SINGLE‐PRODUCT CASE

Assume, for example, that Woodmasters Inc. makes tables. It sells unfinished tables for $50. The cost to manufacture an unfinished table is $35, computed as follows.

Direct materials

 

$15

Direct labor

 

10

Variable manufacturing overhead

 

6

Fixed manufacturing overhead

 

  4

Manufacturing cost per unit

 

$35

ILLUSTRATION 20-8 Per unit cost of unfinished table

Woodmasters currently has unused productive capacity that is expected to continue indefinitely. Some of this capacity could be used to finish the tables and sell them at $60 per unit. For a finished table, direct materials will increase $2 and direct labor costs will increase $4. Variable manufacturing overhead costs will increase by $2.40 (60% of direct labor). No increase is anticipated in fixed manufacturing overhead.

Should the company sell the unfinished tables, or should it process them further? The incremental analysis on a per unit basis is as follows.

ILLUSTRATION 20-9 Incremental analysis—sell or process further

It would be advantageous for Woodmasters to process the tables further. The incremental revenue of $10.00 from the additional processing is $1.60 higher than the incremental processing costs of $8.40.

▼ HELPFUL HINT

Current net income is known. Net income from processing further is an estimate. In making its decision, management could add a “risk” factor for the estimate.

MULTIPLE‐PRODUCT CASE

Sell‐or‐process‐further decisions are particularly applicable to processes that produce multiple products simultaneously. In many industries, a number of end‐products are produced from a single raw material and a common production process. These multiple end‐products are commonly referred to as joint products . For example, in the meat‐packing industry, Armour processes a cow or pig into meat, internal organs, hides, bones, and fat products. In the petroleum industry, ExxonMobil refines crude oil to produce gasoline, lubricating oil, kerosene, paraffin, and ethylene.

Illustration 20-10 presents a joint product situation for Marais Creamery involving a decision to sell or process further cream and skim milk. Cream and skim milk are joint products that result from the processing of raw milk.

ILLUSTRATION 20-10 Joint production process—Creamery

Marais incurs many costs prior to the manufacture of the cream and skim milk. All costs incurred prior to the point at which the two products are separately identifiable (the split‐off point) are called joint costs . For purposes of determining the cost of each product, joint product costs must be allocated to the individual products. This is frequently done based on the relative sales value of the joint products. While this allocation is important for determination of product cost, it is irrelevant for any sell‐or‐process‐further decisions. The reason is that these joint product costs are sunk costs. That is, they have already been incurred, and they cannot be changed or avoided by any subsequent decision.

Illustration 20-11 provides the daily cost and revenue data for Marais Creamery related to cream and cottage cheese.

Costs (per day)

Joint cost allocated to cream

 

$ 9,000

Cost to process cream into cottage cheese

 

10,000

Revenues from Products (per day)

Cream

 

$19,000

Cottage cheese

 

27,000

ILLUSTRATION 20-11 Cost and revenue data per day for cream

From this information, we can determine whether the company should simply sell the cream or process it further into cottage cheese. Illustration 20-12 shows the necessary analysis. Note that the joint cost that is allocated to the cream is not included in this decision. It is not relevant to the decision because it is a sunk cost. It has been incurred in the past and will remain the same no matter whether the cream is subsequently processed into cottage cheese or not.

ILLUSTRATION 20-12 Analysis of whether to sell cream or process into cottage cheese

From this analysis, we can see that Marais should not process the cream further because it will sustain an incremental loss of $2,000.

Illustration 20-13 (page 986) provides the daily cost and revenue data for the company related to skim milk and condensed milk.

Costs (per day)

Joint cost allocated to skim milk

  

$ 5,000

Cost to process skim milk into condensed milk

  

8,000

Revenues from Products (per day)

Skim milk

 

$11,000

Condensed milk

 

26,000

ILLUSTRATION 20-13 Cost and revenue data per day for skim milk

Illustration 20-14 shows that Marais Company should process the skim milk into condensed milk, as it will increase net income by $7,000.

ILLUSTRATION 20-14 Analysis of whether to sell skim milk or process into condensed milk

Again, note that the $5,000 of joint cost allocated to the skim milk is irrelevant in deciding whether to sell or process further. Why? The joint cost remains the same, whether or not further processing is performed.

These decisions need to be reevaluated as market conditions change. For example, if the price of skim milk increases relative to the price of condensed milk, it may become more profitable to sell the skim milk rather than process it into condensed milk. Consider also oil refineries. As market conditions change, the companies must constantly re‐assess which products to produce from the oil they receive at their plants.

DO IT! 4

Sell or Process Further

Easy Does It manufactures unpainted furniture for the do‐it‐yourself (DIY) market. It currently sells a child's rocking chair for $25. Production costs are $12 variable and $8 fixed. Easy Does It is considering painting the rocking chair and selling it for $35. Variable costs to paint each chair are expected to be $9, and fixed costs are expected to be $2.

Prepare an analysis showing whether Easy Does It should sell unpainted or painted chairs.

Action Plan

✓ Identify the revenues that change as a result of painting the rocking chair.

✓ Identify all costs that change as a result of painting the rocking chair, and net the amount against the revenues.

SOLUTION

Sell

Process Further

Net Income Increase (Decrease)

Revenues

$25

$35 

$10 

Variable costs

 12

 21 a

 (9)

Fixed costs

  8

 10 b

 (2)

Net income

$ 5

$ 4 

$(1)

a $12 + $9

b $8 + $2

The analysis indicates that the rocking chair should be sold unpainted because net income per chair will be $1 greater.

Related exercise material: BE20-5, BE20-6, E20-9, E20-10, E20-11, E20-12, and DO IT! 20-4.

LEARNING OBJECTIVE 5

Analyze the relevant costs to be considered in repairing, retaining, or replacing equipment.

Management often has to decide whether to continue using an asset, repair, or replace it. For example, Delta Airlines must decide whether to replace old jets with new, more fuel‐efficient ones. To illustrate, assume that Jeffcoat Company has a factory machine that originally cost $110,000. It has a balance in Accumulated Depreciation of $70,000, so the machine's book value is $40,000. It has a remaining useful life of four years. The company is considering replacing this machine with a new machine. A new machine is available that costs $120,000. It is expected to have zero salvage value at the end of its four‐year useful life. If the new machine is acquired, variable manufacturing costs are expected to decrease from $160,000 to $125,000 annually, and the old unit could be sold for $5,000. The incremental analysis for the four‐year period is as follows.

ILLUSTRATION 20-15 Incremental analysis—retain or replace equipment

In this case, it would be to the company's advantage to replace the equipment. The lower variable manufacturing costs due to replacement more than offset the cost of the new equipment. Note that the $5,000 received from the sale of the old machine is relevant to the decision because it will only be received if the company chooses to replace its equipment. In general, any trade‐in allowance or cash disposal value of existing assets is relevant to the decision to retain or replace equipment.

One other point should be mentioned regarding Jeffcoat's decision: The book value of the old machine 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. Sunk costs are not relevant in incremental analysis. In this example, if the asset is retained, book value will be depreciated over its remaining useful life. Or, if the new unit is acquired, book value will be recognized as a loss of the current period. Thus, the effect of book value on cumulative future earnings is the same regardless of the replacement decision.

Sometimes, decisions regarding whether to replace equipment are clouded by behavioral decision‐making errors. For example, suppose a manager spent $90,000 repairing a machine two months ago. Suppose that the machine now breaks down again. The manager might be inclined to think that because the company recently spent a large amount of money to repair the machine, the machine should be repaired again rather than replaced. However, the amount spent in the past to repair the machine is irrelevant to the current decision. It is a sunk cost.

Similarly, suppose a manager spent $5,000,000 to purchase a machine. Six months later, a new machine comes on the market that is significantly more efficient than the one recently purchased. The manager might be inclined to think that he or she should not buy the new machine because of the recent purchase. In fact, the manager might fear that buying a different machine so quickly might call into question the merit of the previous decision. Again, the fact that the company recently bought a machine is not relevant. Instead, the manager should use incremental analysis to determine whether the savings generated by the efficiencies of the new machine would justify its purchase.

DO IT! 5

Repair or Replace Equipment

Rochester Roofing is faced with a decision. The company relies very heavily on the use of its 60‐foot extension lift for work on large homes and commercial properties. Last year, the company spent $60,000 refurbishing the lift. It has just determined that another $40,000 of repair work is required. Alternatively, Rochester Roofing has found a newer used lift that is for sale for $170,000. The company estimates that both the old and new lifts would have useful lives of 6 years. However, the new lift is more efficient and thus would reduce operating expenses by about $20,000 per year. The company could also rent out the new lift for about $2,000 per year. The old lift is not suitable for rental. The old lift could currently be sold for $25,000 if the new lift is purchased. Prepare an incremental analysis that shows whether the company should repair or replace the equipment.

Action Plan

✓ Those costs and revenues that differ across the alternatives are relevant to the decision.

✓ Past costs that cannot be changed are sunk costs.

SOLUTION

Retain Equipment

Replace Equipment

Net Income Increase (Decrease)

Operating expenses

$120,000 *

$120,000 

Repair costs

 40,000

  40,000 

Rental revenue

 $(12,000) **

  12,000 

New machine cost

 170,000 

(170,000)

Sale of old machine

         

 (25,000)

  25,000 

Total cost

$160,000 

$133,000 

$ 27,000 

* (6 years × $20,000)

** (6 years × $2,000)

The analysis indicates that purchasing the new machine would increase net income for the 6‐year period by $27,000.

Related exercise material: BE20-7, E20-13, E20-14, and DO IT! 20-5.

LEARNING OBJECTIVE 6

Analyze the relevant costs in deciding whether to eliminate an unprofitable segment or product.

Management sometimes must decide whether to eliminate an unprofitable business segment or product. For example, in recent years, many airlines quit servicing certain cities or cut back on the number of flights. Goodyear quit producing several brands in the low‐end tire market. Again, the key is to focus on the relevant costs—the data that change under the alternative courses of action. To illustrate, assume that Venus Company manufactures tennis racquets in three models: Pro, Master, and Champ. Pro and Master are profitable lines. Champ (highlighted in red in the table below) operates at a loss. Condensed income statement data are as follows.

Pro

Master

Champ

Total

Sales

$800,000

$300,000

$100,000 

$1,200,000

Variable costs

 520,000

 210,000

   90,000  

  820,000

Contribution margin

280,000

90,000

10,000 

380,000

Fixed costs

  80,000

  50,000

   30,000  

   160,000

Net income

$200,000

$ 40,000

$(20,000)

$  220,000

ILLUSTRATION 20-16 Segment income data

▼ HELPFUL HINT

A decision to discontinue a segment based solely on the bottom line—net loss—is inappropriate.

You might think that total net income will increase by $20,000 to $240,000 if the unprofitable Champ line of racquets is eliminated. However, net income may actually decrease if the Champ line is discontinued. The reason is that if the fixed costs allocated to the Champ racquets cannot be eliminated, they will have to be absorbed by the other products. To illustrate, assume that the $30,000 of fixed costs applicable to the unprofitable segment are allocated ⅔ to the Pro model and ⅓ to the Master model if the Champ model is eliminated. Fixed costs will increase to $100,000 ($80,000+$20,000)$100,000 ($80,000+$20,000) in the Pro line and to $60,000 ($50,000+$10,000)$60,000 ($50,000+$10,000) in the Master line. The revised income statement is as follows.

Pro

Master

Total

Sales

$800,000

$300,000

$1,100,000

Variable costs

  520,000

  210,000

   730,000

Contribution margin

  280,000

   90,000

   370,000

Fixed costs

 100,000

  60,000

   160,000

Net income

$180,000

$ 30,000

$ 210,000

ILLUSTRATION 20-17 Income data after eliminating unprofitable product line

Total net income has decreased $10,000 ($220,000−$210,000)$10,000 ($220,000−$210,000). This result is also obtained in the following incremental analysis of the Champ racquets.

ILLUSTRATION 20-18 Incremental analysis—eliminating unprofitable segment with no reduction in fixed costs

The loss in net income is attributable to the Champ line's contribution margin ($10,000) that will not be realized if the segment is discontinued.

Assume the same facts as above, except now assume that $22,000 of the fixed costs attributed to the Champ line can be eliminated if the line is discontinued. Illustration 20-19 presents the incremental analysis based on this revised assumption.

ILLUSTRATION 20-19 Incremental analysis—eliminating unprofitable segment with reduction in fixed costs

In this case, because the company is able to eliminate some of its fixed costs by eliminating the division, it can increase its net income by $12,000. This occurs because the $22,000 savings that results from the eliminated fixed costs exceeds the $10,000 in lost contribution margin by $12,000 ($22,000−$10,000)$12,000 ($22,000−$10,000).

In deciding on the future status of an unprofitable segment, management should consider the effect of elimination on related product lines. It may be possible for continuing product lines to obtain some or all of the sales lost by the discontinued product line. In some businesses, services or products may be linked—for example, free checking accounts at a bank, or coffee at a donut shop. In addition, management should consider the effect of eliminating the product line on employees who may have to be discharged or retrained.

MANAGEMENT INSIGHT

Buck Knives

Time to Move to a New Neighborhood?

If you have ever moved, then you know how complicated and costly it can be. Now consider what it would be like for a manufacturing company with 260 employees and a 170,000‐square‐foot facility to move from southern California to Idaho. That is what Buck Knives did in order to save its company from financial ruin. Electricity rates in Idaho were half those in California, workers' compensation was one‐third the cost, and factory wages were 20% lower. Combined, this would reduce manufacturing costs by $600,000 per year. Moving the factory would cost about $8.5 million, plus $4 million to move key employees. Offsetting these costs was the estimated $11 million selling price of the California property. Based on these estimates, the move would pay for itself in three years.

Ultimately, the company received only $7.5 million for its California property, only 58 of 75 key employees were willing to move, construction was delayed by a year which caused the new plant to increase in price by $1.5 million, and wages surged in Idaho due to low unemployment. Despite all of these complications, though, the company considers the move a great success.

Source: Chris Lydgate, “The Buck Stopped,” Inc. Magazine (May 2006), pp. 87–95.

What were some of the factors that complicated the company's decision to move? How should the company have incorporated such factors into its incremental analysis? (Go to WileyPLUS for this answer and additional questions.)

DO IT! 6

Unprofitable Segments

Lambert, Inc. manufactures several types of accessories. For the year, the knit hats and scarves line had sales of $400,000, variable expenses of $310,000, and fixed expenses of $120,000. Therefore, the knit hats and scarves line had a net loss of $30,000. If Lambert eliminates the knit hats and scarves line, $20,000 of fixed costs will remain. Prepare an analysis showing whether the company should eliminate the knit hats and scarves line.

Action Plan

✓ Identify the revenues that change as a result of eliminating a product line.

✓ Identify all costs that change as a result of eliminating a product line, and net the amount against the revenues.

SOLUTION

 

Continue

 

Eliminate

 

Net Income Increase (Decrease)

Sales

 

$400,000 

 

$      0 

 

$(400,000)

Variable costs

 

 310,000 

 

       0 

 

  310,000 

Contribution margin

 

90,000 

 

0 

 

  (90,000)

Fixed costs

 

 120,000 

 

  20,000 

 

  100,000 

Net income

 

$ (30,000)

 

$(20,000)

 

$  10,000 

The analysis indicates that Lambert should eliminate the knit hats and scarves line because net income will increase $10,000.

Related exercise material: BE20-8, E20-15, E20-16, E20-17, and DO IT! 20-6.

USING DECISION TOOLS—METHOD PRODUCTS

Method Products faces many situations where it needs to apply the decision tool learned in this chapter. For example, assume that in order to have control over the creative nature of its packaging, Method decides to manufacture (instead of outsourcing) some of its more creative soap dispensers. Suppose that the company has been approached by a plastic container manufacturer with a proposal to provide 500,000 Mickey and Minnie Mouse hand wash dispensers. Assume Method's cost of producing 500,000 of the dispensers is $110,000, broken down as follows.

Direct materials

 

$60,000

 

Variable manufacturing overhead

 

$12,000

Direct labor

 

$30,000

 

Fixed manufacturing overhead

 

$ 8,000

Instead of making the dispensers at an average cost per unit of $0.22 ($110,000 ÷ 500,000), Method has an opportunity to buy the dispensers at $0.215 per unit. If the dispensers are purchased, all variable costs and one‐half of the fixed costs will be eliminated.

INSTRUCTIONS

(a) Prepare an incremental analysis showing whether Method should make or buy the dispensers.

(b) Will your answer be different if the released productive capacity resulting from the purchase of the dispensers will generate additional income of $25,000?

(c) What additional qualitative factors might Method need to consider?

SOLUTION

1.

 

Make

 

Buy

 

Net Income Increase (Decrease)

Direct materials

 

$ 60,000

 

$ –0–

 

$  60,000 

Direct labor

 

  30,000

 

  –0–

 

   30,000 

Variable manufacturing costs

 

  12,000

 

  –0–

 

   12,000 

Fixed manufacturing costs

 

   8,000

 

   4,000 *

 

    4,000 

Purchase price

 

  –0–   

 

 107,500 **

 

 (107,500)

Total cost

 

$110,000

 

$111,500 

 

$  (1,500)

2. * $8,000 × .50

3. ** $0.215 × 500,000

4. This analysis indicates that Method will incur $1,500 of additional costs if it buys the dispensers. Method therefore would choose to make the dispensers.

5.

 

Make

 

Buy

 

Net Income Increase (Decrease)

Total cost

 

$110,000

 

$111,500

 

$ (1,500)

Opportunity cost

 

  25,000

 

  –0–   

 

 25,000

Total cost

 

$135,000

 

$111,500

 

$23,500

6. Yes, the answer is different. The analysis shows that if additional capacity is released, net income will be increased by $23,500 if the dispensers are purchased. In this case, Method would choose to purchase the dispensers.

7. Method is very concerned about the image of its products. It charges a higher price for many of its products than those of its larger competitors. It therefore wants to ensure that the functionality of the dispenser, as well as the appearance, are up to its standards. Also, because of Method's commitment to sustainability, it would consider numerous qualitative issues. For example, is this supplier going to use sustainable manufacturing practices? Method currently requires that its suppliers meet its expectations regarding sustainability.

REVIEW AND PRACTICE

LEARNING OBJECTIVES REVIEW

1. Describe management's decision‐making process and incremental analysis. Management's decision‐making process consists of (a) identifying the problem and assigning responsibility for the decision, (b) determining and evaluating possible courses of action, (c) making the decision, and (d) reviewing the results of the decision. Incremental analysis identifies financial data that change under alternative courses of action. These data are relevant to the decision because they vary across the possible alternatives.

2. Analyze the relevant costs in accepting an order at a special price. The relevant costs are those that change if the order is accepted. The relevant information in accepting an order at a special price is the difference between the variable manufacturing costs to produce the special order and expected revenues. Any changes in fixed costs, opportunity cost, or other incremental costs or savings (such as additional shipping) should be considered.

3. Analyze the relevant costs in a make‐or‐buy decision. In a make‐or‐buy decision, the relevant costs are (a) the variable manufacturing costs that will be saved as well as changes to fixed manufacturing costs, (b) the purchase price, and (c) opportunity cost.

4. Analyze the relevant costs in determining whether to sell or process materials further. The decision rule for whether to sell or process materials further is: Process further as long as the incremental revenue from processing exceeds the incremental processing costs.

5. Analyze the relevant costs to be considered in repairing, retaining, or replacing equipment. The relevant costs to be considered in determining whether equipment should be repaired, retained, or replaced are the effects on variable costs and the cost of the new equipment. Also, any disposal value of the existing asset must be considered.

6. Analyze the relevant costs in deciding whether to eliminate an unprofitable segment or product. In deciding whether to eliminate an unprofitable segment or product, the relevant costs are the variable costs that drive the contribution margin, if any, produced by the segment or product. Opportunity cost and reduction of fixed expenses must also be considered.

DECISION TOOLS REVIEW

DECISION CHECKPOINTS

INFO NEEDED FOR DECISION

TOOL TO USE FOR DECISION

HOW TO EVALUATE RESULTS

Which alternative should the company choose?

All relevant costs including opportunity cost

Compare the relevant cost of each alternative

Choose the alternative that maximizes net income.

GLOSSARY REVIEW

· Incremental analysis  The process of identifying the financial data that change under alternative courses of action.

· Joint costs  For joint products, all costs incurred prior to the point at which the two products are separately identifiable (known as the split‐off point).

· Joint products  Multiple end‐products produced from a single raw material and a common production process.

· Opportunity cost  The potential benefit that is lost when one course of action is chosen rather than an alternative course of action.

· Relevant costs  Those costs and revenues that differ across alternatives.

· Sunk costs  A cost that cannot be changed or avoided by any present or future decision.

PRACTICE MULTIPLE-CHOICE QUESTIONS

(LO 1)

1. Three of the steps in management's decision‐making process are (1) review results of decision, (2) determine and evaluate possible courses of action, and (3) make the decision. The steps are prepared in the following order:

(a) (1), (2), (3).

(b) (3), (2), (1).

(c) (2), (1), (3).

(d) (2), (3), (1).

(LO 1)

2. Incremental analysis is the process of identifying the financial data that:

(a) do not change under alternative courses of action.

(b) change under alternative courses of action.

(c) are mixed under alternative courses of action.

(d) No correct answer is given.

(LO 1)

3. In making business decisions, management ordinarily considers:

(a) quantitative factors but not qualitative factors.

(b) financial information only.

(c) both financial and nonfinancial information.

(d) relevant costs, opportunity cost, and sunk costs.

(LO 1)

4. A company is considering the following alternatives:

 

Alternative A

 

Alternative B

Revenues

 

$50,000

 

$50,000

Variable costs

 

 24,000

 

 24,000

Fixed costs

 

 12,000

 

 15,000

Which of the following are relevant in choosing between these alternatives?

(a) Revenues, variable costs, and fixed costs.

(b) Variable costs and fixed costs.

(c) Variable costs only.

(d) Fixed costs only.

(LO 2)

5. 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.

(b) increase $6,000.

(c) increase $12,000.

(d) increase $9,000.

(LO 2)

6. It costs a company $14 of variable costs and $6 of fixed costs to produce product Z200. Product Z200 sells for $30. A buyer offers to purchase 3,000 units at $18 each. The seller will incur special shipping costs of $5 per unit. If the special offer is accepted and produced with unused capacity, net income will:

(a) increase $3,000.

(b) increase $12,000.

(c) decrease $12,000.

(d) decrease $3,000.

(LO 3)

7. Jobart Company is currently operating at full capacity. It is considering buying a part from an outside supplier rather than making it in‐house. If Jobart purchases the part, it can use the released productive capacity to generate additional income of $30,000 from producing a different product. When conducting incremental analysis in this make‐or‐buy decision, the company should:

(a) ignore the $30,000.

(b) add $30,000 to other costs in the “Make” column.

(c) add $30,000 to other costs in the “Buy” column.

(d) subtract $30,000 from the other costs in the “Make” column.

(LO 3)

8. In a make‐or‐buy decision, relevant costs are:

(a) manufacturing costs that will be saved.

(b) the purchase price of the units.

(c) the opportunity cost.

(d) All of the above.

(LO 3)

9. Derek is performing incremental analysis in a make‐or‐buy decision for Item X. If Derek buys Item X, he can use its released productive capacity to produce Item Z. Derek will sell Item Z for $12,000 and incur production costs of $8,000. Derek's incremental analysis should include an opportunity cost of:

(a) $12,000.

(b) $8,000.

(c) $4,000.

(d) $0.

(LO 4)

10. 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.

(b) variable processing costs.

(c) fixed processing costs.

(d) No correct answer is given.