Chapter 5

Incremental
Analysis-
Relevant Costs for Decision
Making
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INTRODUCTION
1. The Challenge of changing markets
2. The concept of relevant information
[Link] Analysis in common business
decisions
-Special order decisions
-Make-or-buy decisions
-Add or Drop decision
-Production constraint decision
-Joint product decisions
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Use differential analysis to analyze decisions.

Differential Analysis
The process of estimating revenues and
costs
of alternative actions available to decision
makers

Short Run
The period of time over which capacity will be
unchanged, usually one year

3
Are costs that change in response to an alternative
course of action

Differential costs differ between actions.

Alternative A Alternative B

4
 Information presented to management can
show the detailed costs that are included for
making a decision, or it can show just the
differences between alternatives, as follows.

Status Quo Alternative Difference

Sales revenue Br.750 Br.900 Br.150

Less: Variable costs 250 300 50
Contribution margin Br.500 Br.600 Br.100
Less: Fixed costs 350 350 -0-
Operating profit Br.150 Br.250 Br.100

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Costs incurred in the past that cannot be change

A sunk cost is NOT relevant for making decisions.

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 Product markets can change quickly due to
competitor price cuts, changing
customers preferences, and introduction
of new products by competitors.

 Managers must make short-run decisions

with fixed set of resources, to react to the
changing market place.

Production Decisions:

Special • Make or buy Joint

• Add or drop product Others
Order
• Product Choices decisions
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 Common costs:
 Are costs which will be identical for all alternatives. e.g.
rent or rates on a factory.
 Sunk costs:
 Also called past costs. e.g. dedicated fixed assets,
development costs already incurred.
 Committed costs:
 Is a future cash outflow that will be incurred anyway,
whatever decision is taken now. e.g. contracts already
entered into which cannot be altered.
 Which of these costs are relevant costs?
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 Two criteria are important:
1. Bearing on the future:
 The consequence of the decisions are born in the
future, not in the past.
2. Different under competing alternatives
 Must involve costs or benefits that differ among
the alternatives

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12
Year 0 Year 1

Short-run pricing decision: Less Long-run

than one year
pricing decision:
Longer than one year

Pricing a one-time special order.

Pricing a new product.

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• XYZ Co. has received a one-time offer for 500 prints
at a special price of Br. 0.40 per print (Br.200).

• The regular price is Br. 0.50. should the offer be

accepted or rejected.

Sales for the week (5,000 prints at Br. 0.50) Br.2,500

Less: Variable costs, including paper, maintenance,
and etc (5,000 copies at Br. 0.20) 1,000
Total contribution margin Br.
1,500 Less: Fixed costs (supplies, plus allocated costs
of the print shop) 1,200
Operating profit for the week Br. 300
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 Condition I: Analysis of Special Order: Idle capacity
Status
Quo: Alternative:
(Without (with
Special Special
Offer) Offer) Difference
Comparison of Totals
Sales revenue Br.2,500 Br.2,700 Br.200
Variable costs (1,000) (1,100) (100)
Total contribution Br.1,500 Br.1,600 Br.100
Fixed costs (1,200) (1,200) -0-
Operating profit Br. 300 Br. 400 Br.100

Alternative Presentation: Differential Analysis

Differential sales, 500 at Br. 0.40 Br. 200
Less: Differential costs, 500 at Br. 0.20 100
Differential operating profit (before taxes) Br. 100

The special order should be accepted 15

Condition II: Analysis of Special Order: No Idle capacity
Status
Quo: Alternative:
(Without (with
Special Special
Offer) Offer) Difference
Comparison of Totals
Sales revenue Br.2,500 Br.2,450 Br.(50)
Less: Variable costs 1,000 1,000 -0-
Total contribution Br.1,500 Br.1,450 Br.(50)
Less: Fixed costs 1,200 1,200 -0-
Operating profit Br. 300 Br. 250 Br.(50)

Alternative Presentation: Differential Analysis

Differential sales, 500 at Br. (0.10) Br. (50)
Less: Differential costs, -0-
Differential operating profit (before taxes) Br. (50)

The special order should be rejected 16

 Understand how to apply differential analysis to production decisions.

Decision to make goods or services

Make or buy
internally or purchase them externally

Add or drop Decision to add or drop a product

a segment line or close a business unit

Produc Decision on what products or

t services to offer (product mix)
choice
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 XYZ company’s current costs of developing prints:

100,000
Per unit prints
Costs directly traceable:
Direct materials Br.0.05 Br. 5,000
Direct labor 0.12 12,000
Variable manufacturing overhead 0.03 3,000
Fixed manufacturing overhead 4,000
Common costs allocated to this product line 10,000
Total costs Br.34,000

This year’s expected volume is 100,000 prints, so the full cost of

processing a print is:
Br. 34,000 ÷ 100,000 = Br. 0.34

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The Co. has received an offer from an outside developer to
process any number of prints for Br. 0.25 each.

Should XYZ Co. accept this

offer?

The accounting department

prepared cost analyses at volume
levels of 50,000 and 100,000 prints
per year.

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 Condition
I 100,000
prints
100,000 Process Outsource
prints prints processing Difference

Direct costs:
Direct materials Br. 5,000 Br.25,000a Br.20,000 higher
Labor 12,000 -0- 12,000 lower
Variable overhead 3,000 -0- 3,000 lower
Fixed overhead 4,000 -0- 4,000 lower
Common costs 10,000b 10,000b -0-
Total costs Br.34,000 Br.35,000 Br. 1,000 higher
a
100,000 units purchased at Br.0.25 = Br.25,000
b
These common costs remain unchanged for these volumes.
Because they do not change, they could be omitted from the analysis.

Differential costs increase by Br.1,000, so reject

alternative to buy.

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 Condition II
50,000
50,000 Process Outsource
prints prints processing Difference

Direct costs:
Direct materials Br. 2,500 Br.12,500a Br.10,000 higher
Labor 6,000 -0- 6,000 lower
Variable overhead 1,500 -0- 1,500 lower
Fixed overhead 4,000 -0- 4,000 lower
Common costs 10,000b 10,000b -0-
Total costs Br.24,000 Br.22,500 Br. 1,500 lower
a
50,000 units purchased at Br.0.25 = Br.12,500
b
These common costs remain unchanged for these volumes.
Because they do not change, they could be omitted from the analysis.

Differential costs decrease by Br.1,500, so

accept
alternative to buy.
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22
 XYZ Co.
Product Line Income Statement

Total Prints Cameras Frames

Sales revenue Br.80,000 Br.10,000 Br.50,000 Br.20,000

Cost of sales (all variable) 53,000 8,000 30,000 15,000
Contribution margin Br.27,000 Br. 2,000 Br.20,000 Br. 5,000
Less fixed costs:
Rent 4,000 1,000 2,000 1,000
Salaries 5,000 1,000 2,500 1,500
Marketing and administrative* 3,000 500 1,500 1,000
Operating profit (loss) Br.15,000 Br. (500) Br.14,000 Br. 1,500

*Half of the Marketing and Administrative cost is fixed.

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 Keep discontinue prints
 Sales 80,000 70,000
 Cost of sales 53,000 45,000
 Contribution m27,000 25,000
 Fixed costs
 Salaries 5,000 4,000
 Rent 4,000 4,000
 S& Admin 3,000 2,750
 Operating profit 15,000 14,250

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 XYZ Co.
Differential Analysis
Status quo: Alternative:
Keep prints Drop prints Difference

Sales revenue Br.80,000 Br.70,000 Br.10,000 decrease

Cost of sales (all variable) 53,000 45,000 8,000 decrease
Contribution margin Br.27,000 Br.25,000 Br. 2,000 decrease
Less fixed costs:
Rent 4,000 4,000 -0-
Salaries 5,000 4,000 1,000 decrease
Marketing and administrative 3,000 2,750 250 decrease
Operating profit (loss) Br. 15,000 Br. 14,250 Br. 750 decrease

Profits decrease Br.750, so keep

prints.
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 Constraints
urces, or policies that limit the attainment of an objective are c

Contribution Margin per Unit of Scarce

Resource Contribution margin per unit of a
particular input with limited availability.

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 XYZ Co
Revenue and Cost Information
Metal Wood
frames frames
Price
Less: Variable costs per unit Br.50 Br.80
Material 8 22
Labor 8 24
Overhead 4 4
Contribution margin per unit Br.30 Br.30
Fixed costs
Manufacturing Br.3,000
Marketing and administrative 1,500
Total Br.4,500

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 XYZ Co.
Revenue and Cost Information
Metal Wood
frames frames

Per unit:
Contribution margin Br. 30 Br. 30
Machine hours required ÷ 0.5 ÷ 1.0
Contribution margin per machine hour Br. 60 Br. 30

Metal Frames have a higher contribution margin

per machine hour.

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 Suppose XYZ Co. has 200 machine hours per month
available.
Metal Wood
frames frames
Capacity 400 200
Contribution margin per unit × Br.30 × Br.30
Total contribution margin Br.12,000 Br.6,000
Less: Fixed manufacturing costs 3,000 3,000
Less: Fixed marketing and admin. costs 1,500 1,500
Operating profit Br. 7,500 Br.1,500

Selling metal frames will result in higher profits than

selling wooden frames.

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32
 Two or more products produced from a common

Product A
Joint costs are the costs of
Joint Costs processing prior to the split-off p
Product B

Product C
The split-off point is the point in a process where joint produ

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 Firms 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 if incremental revenues > increm

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 Addis Mfg Co. produces two products, X and Y, from this process.

X Revenue
Br.
Further
Processin
Final
Sale
80,000 g Br. Br.120,000
50,000
Joint Common
Cost Production
Br. 120,000
Process

Y Further Final
Sale
Revenue Processin
Br. g Br. Br.115,000
Split-Off
Point 70,000 40,000

Should the products be sold at split-off or processed further? 35

 Incremental Incremental
Product Revenue Cost Difference
X Br. 40,000 Br. 50,000 Br.(10,000)
Y 45,000 40,000 5,000

Product X incremental revenue = Br. 120,000 - 80,000

Product Y incremental revenue = Br. 115,000 - 70,000

Decision:
Process product Y, but sell product X at the split-off
point.
Note that the Br.120,000 joint cost is irrelevant to the
processing decision. 37
 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.

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 Joint costs are not relevant
in decisions regarding what to do with
a 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.

End of the
chapter
39
Chapter 6
Performance Evaluation and Balanced
Scorecard
6.1. Financial and Non-Financial Performance
Measures
6.2. Balanced Scorecard and Strategic Cost
Management
6.3. Corporate Governance and Sustainability
Reporting
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