Veronica mars a recent graduate of bell's accounting program

20

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.