INCREMENTAL ANALYSIS

1
CHAPTER 7

• INCREMENTAL ANALYSIS

Managerial Accounting, Fourth Edition
2
Incremental Analysis

• Occurs when there is more than one alternative
  choice of action.

Alternative One
Alternative Two
3
Important Definitions

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

4
Types of Incremental Analysis

• Accept an order at a special price
• Make or buy components or finished products
• Sell products or process further
• Retain or replace equipment
• Eliminate an unprofitable business segment
• Allocate limited resources

LO 2 Describe the concept of incremental
analysis.
5
McDermotts Criteria

• When can you sell a product at less than full
  cost and still make a profit? When . . .
• You can segregate the market
• You can identify fixed and variable costs
• You have a positive contribution margin
• You have excess capacity or can charge for
  opportunity cost
• The minimum price you can charge under these
  conditions is
• Variable costs of the new order plus opportunity
  cost

6
Variable Cost of the New Order

• Variable costs of the new order include
• Direct labor
• Direct materials
• Variable overhead
• Variable marketing and administrative costs
• Any other costs will be incurred to fulfill the
  new order (freight, special handling, and so on).
• Any normal costs that disappear should be
  subtracted from variable costs in this formula.

7
Opportunity Cost

• The opportunity cost is the contribution margin
  of any sales given up.
• The formula is (contribution margin per unit )
  (units of sales to existing customers given up)

8
Example Problem

• McDermott Manufacturing makes computer monitors.
• Revenue and cost data for the company are shown
  below
• Price 60
• Direct labor 10
• Direct materials 5
• Variable overhead 12
• Fixed overhead 100,000
• Variable marketing 6
• Fixed marketing and administration 50,000

9
Example Problem

• A Japanese retailer wants to purchase 5,000
  monitors.
• Assume that the purchase needs the criteria
  listed earlier by Professor McDermott.

10
Additional Information

• The company has the capacity to manufacture
  10,000 units per year.
• Currently the company is manufacturing and
  selling 8,000 units per year.
• The special order will have no marketing costs
• It will cost 3 to ship the monitors to the
  purchasers San Francisco warehouse.
• What is the minimum price for which the company
  would be willing to sell this special order?

11
Calculation of Variable Costs
Category Amount
Direct labor 10
Direct materials 5
Variable overhead 12
Variable marketing 0
Additional shipping 3
Total variable costs 30
Remember we delete any savings on the special
order. In this case we save marketing costs
(sales commissions).
12
Calculation of Variable Costs
Category Amount
Direct labor 10
Direct materials 5
Variable overhead 12
Variable marketing 0
Additional shipping 3
Total variable costs 30
Also remember We add any additional costs of
this special order, in this case shipping the
product to San Francisco.
13
Calculation of Opportunity Cost

• The company has an excess capacity of 2,000 units
  (10,000 manufacturing capacity 8,000 units
  presently manufactured and sold).
• However the customer wishes to purchase 5,000
  monitors.
• The opportunity cost in units, therefore, is
  5,000 units of demand - 2,000 units of excess
  capacity 3,000 units.
• The opportunity cost in dollars is the
  contribution margin per unit times the
  opportunity cost in units.

14
Calculation of Opportunity Cost

• The contribution margin (for existing customers)
  is
• 60 price - 10 direct labor - 5 direct
  materials - 12 variable overhead - 6 variable
  marketing 27.
• The total contribution margin lost is, therefore,
  27 3000 units 81,000.
• The opportunity cost per unit sold to the
  Japanese is 81,000/5000 units 16.20 per unit

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Minimum Price Special Order

• 30 variable costs of special order 16.20
  opportunity cost 46.20.
• Note the full cost of the product including
  fixed costs is 48.
• What if the customer is willing to pay 47.50 per
  unit?
• This is less than the full (absorption) cost of
  the product.
• Should they accept the special order?

16
Minimum Price Special Order

• The contribution margin is 47 - 30 variable
  costs of special order 17 contribution margin.
• This 17 will cover the opportunity cost of
  16.20 per unit, allowing .80 per unit to flow
  to the bottom line.
• The net impact on the bottom line will be .80 x
  5000 units 4000
• Bottom line variable revenues and costs are
  relevant, fixed costs are not relevant in
  short-term special pricing decisions.

17
Another example the authors

• Example
• Mexico Co. offers to buy a special order of 2,000
  blenders at 11 per unit from Sunbelt.
• No effect on normal sales sufficient plant
  capacity
• Operating at 80 percent capacity 100,000 units
• Current fixed manufacturing costs 400,000 or
  4 per unit
• Variable manufacturing cost 8 per unit
• Normal selling price 20 per unit
• Based strictly on total cost of 12 per unit (8
  4), reject offer as cost exceeds selling price
  of 11

LO 3 Identify the relevant costs in accepting
an order at a special price.
18
Accept an Order at a Special Price

• Within existing capacity, no change in fixed
  costs - they are not relevant for this decision
• Total variable costs change they are relevant
• Revenue increases 22,000 variable costs
  increase 16,000
• Income increases by 6,000
• Accept the Special Order

LO 3 Identify the relevant costs in accepting
an order at a special price.
19
Lets Review

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

a. Decrease 6,000. b. Increase 6,000. c.
Increase 12,000. d. Increase 9,000.
LO 3 Identify the relevant costs in accepting an
order at a special price.
20
Make or Buy

• Management must decide whether to make or buy
  components.
• The decision to buy parts or services rather than
  making them is called outsourcing.
• Example Costs to produce 25,000 switches

LO 4 Identify the relevant costs in a
make-or-buy decision.
21
Make or Buy Example Continued

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

LO 4 Identify the relevant costs in a
make-or-buy decision.
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Make or Buy Example Continued

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

LO 4 Identify the relevant costs in a
make-or-buy decision.
23
Make or Buy Example Continued

• The relevant costs for incremental analysis are
• Baron Company will incur 25,000 additional cost
  if switches are purchased
• Continue to make switches

LO 4 Identify the relevant costs in a
make-or-buy decision.
24
Make or Buy

• Opportunity Costs
• Definition The potential benefits that may be
  obtained from following an alternative course of
  action.
• New assumption
• Now assume Baron Company can use the newly
  available productive capacity from buying the
  switches to generate additional income of 28,000
  by making another product.
• If Baron makes the switches, this possible income
  is lost.

LO 4 Identify the relevant costs in a
make-or-buy decision.
25
Make or Buy Opportunity Cost Example

• This opportunity cost, the lost income, is
  added to the Make column as an additional
  cost for comparative purposes
• It is now advantageous to buy the switches
  Baron Company will be 3,000 better off

LO 4 Identify the relevant costs in a
make-or-buy decision.
26
Lets Review

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

a. Manufacturing costs that will be saved. b.
The purchase price of the units. c.
Opportunity costs. d. All of the above.
LO 4 Identify the relevant costs in a
make-or-buy decision.
27
Sell or Process Further

• Many manufacturers have the option of selling a
  product now or continuing to process the product
  hoping to sell the refined product at a higher
  price
• Decision Rule
• Process further as long as
• the incremental revenue from
• such processing exceeds the
• incremental processing costs

LO 5 Identify the relevant costs in determining
whether to sell or process materials further.
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Sell or Process Further - Example

• Single-Product Case
• Cost to manufacture one unfinished table
• Selling price of unfinished unit is 50 unused
  capacity can be used to finish the tables to sell
  for 60
• Relevant unit costs of finishing tables
• Direct materials increase 2 Direct labor
  increases 4
• Variable manufacturing overhead costs increase
  by 2.40 (60 percent of direct labor increase)
• Fixed manufacturing costs will not increase

LO 5 Identify the relevant costs in determining
whether to sell or process materials further.
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Sell or Process Further

• Incremental revenues (10) exceed incremental
  costs (8.40) Income increases 1.60 per unit
• Process further

LO 5 Identify the relevant costs in determining
whether to sell or process materials further .
30
Sell or Process Further

• Multiple-Product Case
• In many industries, a number of end-products are
  produced from a single raw material and a common
  production process
• Multiple end-products are commonly called joint
  products
• Petroleum gasoline, lubricating oil, kerosene
• Meat Packing meat, hides, bones

LO 5 Identify the relevant costs in determining
whether to sell or process materials further.
31
Sell or Process Further

• Multiple-Product Case
• All costs incurred prior to the point at which
  the products are separately identifiable (the
  split-off point) are called joint costs
• Joint costs are (for purposes of determining
  product cost) allocated to individual products on
  the basis of relative sales value
• Joint costs are not relevant for any
  sell-or-process-further decisions
• Joint product costs are sunk costs.
• They have already been incurred and cannot be
  changed

LO 5 Identify the relevant costs in determining
whether to sell or process materials further.
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Sell or Process Further - Example

• Multiple-Product Case
• Marais Creamery must decide whether to
• Sell cream and skim milk now
• or
• Process each further before selling

LO 5 Identify the relevant costs in determining
whether to sell or process materials further.
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Sell or Process Further Example Continued

• The daily cost and revenue data for Marais
  Creamery are

LO 5 Identify the relevant costs in determining
whether to sell or process materials further.
34
Sell or Process Further Example Continued

• Sell cream or process further into cottage
  cheese?
• Do not process cream further
• To do so will incur an incremental loss of 2,000

LO 5 Identify the relevant costs in determining
whether to sell or process materials further.
35
Sell or Process Further

• Sell skim milk or process further into condensed
  milk?
• Marais should process the skim milk
• To do so will increase net income by 7,000

LO 5 Identify the relevant costs in determining
whether to sell or process materials further.
36
Lets Review

• The decision rule in a sell-or-process-further
  decision is
• process further as long as the incremental
  revenue from processing exceeds

a. Incremental processing costs. b. Variable
processing costs. c. Fixed processing costs. d.
No correct answer is given.
LO 5 Identify the relevant costs in determining
whether to sell or process materials further.
37
Retain or Replace Equipment

• Management must decide whether a company should
  continue to use an asset or replace it
• Example Assessment of replacement of a factory
  machine
• Variable costs
• Decrease from 160,000
• to 125,000 annually

• Old Machine New Machine
• Book value
  40,000
• Cost 120,000
• Remaining useful life four years
  four years
• Scrap value -
  0 - - 0 -

LO 6 Identify the relevant costs to be
considered in retaining or replacing equipment.
38
Retain or Replace Equipment - Example

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

LO 6 Identify the relevant costs to be
considered in retaining or replacing equipment.
39
Lets Review

• In a decision to retain or replace equipment, the
  book value of the old equipment is a(an)

a. Opportunity cost. b. Sunk cost. c.
Incremental cost. d. Marginal cost.
LO 6 Identify the relevant costs to be
considered in retaining or replacing equipment.
40
Eliminate an Unprofitable Segment

• Should the company eliminate an unprofitable
  segment?
• Key Focus on relevant costs
• Consider effect on related product lines
• Fixed costs allocated to the unprofitable segment
  must be absorbed by the other segments
• Net income may decrease when an unprofitable
  segment is eliminated
• Decision Rule
• Retain the segment unless fixed costs
  eliminated
• exceed the contribution margin lost

LO 7 Identify the relevant costs in deciding
whether to eliminate an unprofitable segment.
41
Eliminate an Unprofitable Segment - Example

• Martina Company manufactures three models of
  tennis racquets Profitable lines Pro and
  Master
  Unprofitable line Champ
• Condensed Income Statement data
• Should the Champ line be eliminated?

LO 7 Identify the relevant costs in deciding
whether to eliminate an unprofitable segment.
42
Eliminate an Unprofitable Segment - Example

• If Champ is eliminated, must allocate its 30,000
  share of fixed costs 2/3 to Pro and 1/3 to
  Master
• Revised Income Statement data
• Total income has decreased by 10,000 (220,000 -
  210,000)

LO 7 Identify the relevant costs in deciding
whether to eliminate an unprofitable segment.
43
Eliminate an Unprofitable Segment - Example

• Incremental analysis of Champ provides the same
  results
• Decision Do not eliminate Champ

LO 7 Identify the relevant costs in deciding
whether to eliminate an unprofitable segment.
44
Lets Review

• If an unprofitable segment is eliminated

a. Net income will always increase. b. Variable
expenses of the eliminated segment will have to
be absorbed by other segments. c. Fixed
expenses allocated to the eliminated segment will
have to be absorbed by other segments. d. Net
income will always decrease.
LO 7 Identify the relevant costs in deciding
whether to eliminate an unprofitable segment .
45
Other Considerations in Decision Making

• Many decisions involving incremental analysis
  have important qualitative features that must be
  considered in addition to the quantitative
  factors.
• Example cost of lost morale due to outsourcing
  or eliminating a plant
• Incremental analysis is completely consistent
  with activity-based costing (ABC)
• ABC often results in better identification of
  relevant costs and, thus, better incremental
  analysis

46
All About You

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

47
All About You

• What is a Degree Worth?
• You are working two jobs, your grades are
  suffering, you feel depressed Should you drop
  out of school?
• Is it better to stay in school even if you only
  take one class each semester?

48
Chapter Review - Exercise 7-1
Identify each of the following statements as true
or false.

• 1. The first step in managements
  decision-making process is Determine and
  evaluate possible courses of action.
• 2. The final step in managements decision-making
  process is to actually make the decision.
• 3. Accountings contribution to managements
  decision- making process occurs primarily in
  evaluating possible courses of action and in
  reviewing the results.
• 4. In making business decisions, management
  ordinarily considers only financial information
  because it is objectively determined.

False
False
True
False
49
Chapter Review - Exercise 7-1 Continued
Identify each of the following statements as true
or false.

• 5. Decisions involve a choice among alternative
  courses of action.
• 6. The process used to identify the financial
  data that change under alternative courses of
  action is called incremental analysis.
• 7. Costs that are the same under all alternative
  courses of action sometimes affect the decision.
• 8. When using incremental analysis, some costs
  will always change under alternative courses of
  action, but revenues will not.
• 9. Variable costs will change under alternative
  courses of action, but fixed costs will not.

True
True
False
False
False
50
Problems Come Next!
51
Brief Exercise One

• The steps in management decision-making process
  are listed in random order below. Indicate the
  order in which the step should be executed.
• Identify the problem and assign responsibility.
• Determine and evaluate possible courses of
  action.
• Make a decision.
• Review results of the decision.
•  

52
Exercise One

• Given the following list of statements about
  decision making and incremental analysis,
  determine which are true and which are false.
• If false, correct the statement.

53
Statements

• The first step in management s decision-making
  process is Determine and evaluate possible
  courses of action.
• False. The first step in management decision
  making process is identified the problem and
  assign responsibility
• The final step in managements decision-making
  process is to actually make the decision.
• False. The final step in managements
  decision-making process is to review the results
  of the decision.

54
Statements

• Accountings contribution to managements
  decision-making process occurs primarily in
  evaluating possible courses of action and in
  reviewing the results.
• True
• In making business decisions, management
  ordinarily considers only financial information
  because it is objectively determined.
• False. In making business decisions, management
  ordinarily considers both financial and
  nonfinancial information.

55
Statements

• Decisions involve a choice among alternative
  courses of action.
• True
• The process used to identify the financial data
  that changes under alternative courses of action
  is called incremental analysis.
• True
• Costs that are the same under all alternative
  courses of action sometimes affect the decision.
• False. Costs that are the same are not relevant.

56
Statements

• When using incremental analysis, some costs will
  always change under alternative courses of
  actions, but revenues will not.
• False. When using incremental analysis, either
  costs or revenues or both will change under
  alternative courses of action.
• Variable costs will change under variable
  courses of action, but fixed costs will not.
• False. Sometimes variable costs will not change
  under alternative courses of action, but fixed
  costs will.

57
Exercise 7-2

• A company produces golf discs which normally
  sellto retailers for seven dollars each.
• The cost of manufacturing 20,000 golf discs is.
• Materials 10,000
• Labor 30,000
• Variable overhead 20,000
• Fixed overhead 40,000
• Total cost 100,000
• The company incurs a 5 sales commission (0.35)
  on each disc sold.

58
Exercise 7-2

• An outside firm offers 4.75 per disc for 5,000
  discs.
• This company would sell the discs under its own
  brand in foreign markets yet not served.
• If the manufacturer accepts the offer, its fixed
  overhead will increase from 40,000 to 45,000
  due to the purchase of a new printing machine.
• No sales commissions will result from the special
  order.

59
Exercise 7-2

• Prepare an incremental analysis for the special
  order.

(a) Reject Order Accept Order Net Income Effect

Revenues Materials (0.50) Labor (1.50) Variable overhead (1.00) Fixed overhead Sales commissions Net income -0- -0- -0- -0- -0- -0- -0- 23,750 (2,500) (7,500) (5,000) (5,000) -0-     3,750 23,750 (2,500) (7,500) (5,000) (5,000) -0-     3,750
Note that fixed costs sometimes are relevant.
However only the portion that varies one
alternative to the next (5,000) is relevant. The
other 47,000 is not relevant
60
Exercise 7-2

• Should the company except the special order?
• Why or why not?
• As shown in the incremental analysis, Innova
  should accept the special order because
  incremental revenue exceeds incremental expenses
  by 3,750.

61
Exercise 7-2

• What assumptions underlie the decision made in
  part b?
• It is assumed that sales of the golf discs in
  other markets would not be affected by this
  special order. If other sales were affected.
  Innova would have to consider the lost sales in
  making the decision. Second, if Innova is
  operating at full capacity, it is likely that the
  special order would be rejected.

62
Exercise 7-5

• XYZ Company has been manufacturing his own shades
  for table lamps.
• The company is currently operating at 100
  capacity, and variable overhead is charged
  production at the rate of 70 of direct labor
  costs.
• The direct materials and direct labor cost per
  unit to make lampshades are five and six dollars
  respectively.

63
Exercise 7-5

• Normal production is 30,000 tables per year.
• A supplier offers to make the lampshades at a
  price of 15.50 per unit.
• If XYZ accepts the suppliers offer, all variable
  costs will be eliminated, but the 45,000 of
  fixed manufacturing overhead currently charge to
  lampshades will have to be absorbed by other
  products.

64
Exercise 7-5

• Prepare the incremental analysis for the decision
  to make her by the lampshades.

Make Buy Net Income Increase (Decrease)

Direct materials (30,000 X 5.00) Direct labor (30,000 X 6.00) Variable manufacturing costs (180,000 X 70) Fixed manufacturing costs Purchase price (30,000 X 15.50) Total annual cost 150,000 180,000 126,000 45,000 0 501,000 0 0 0 45,000 465,000 510,000 150,000 180,000 126,000 0 ( (465,000) ( (9,000)
In this case the fixed cost is not relevant
since it is not change one alternative to the
next.
65
Exercise 7-5

• Prepare the incremental analysis for the decision
  to make her by the lampshades.

Make Buy Net Income Increase (Decrease)

Direct materials (30,000 X 5.00) Direct labor (30,000 X 6.00) Variable manufacturing costs (180,000 X 70) Fixed manufacturing costs Purchase price (30,000 X 15.50) Total annual cost 150,000 180,000 126,000 45,000 0 501,000 0 0 0 45,000 465,000 510,000 150,000 180,000 126,000 0 ( (465,000) ( (9,000)
They should not purchase the lampshades Since
doing so will decrease net income by 9,000.
66
Exercise 7-5

• Prepare the incremental analysis for the decision
  to make her by the lampshades.

Make Buy Net Income Increase (Decrease)

Direct materials (30,000 X 5.00) Direct labor (30,000 X 6.00) Variable manufacturing costs (180,000 X 70) Fixed manufacturing costs Purchase price (30,000 X 15.50) Total annual cost 150,000 180,000 126,000 45,000 0 501,000 0 0 0 45,000 465,000 510,000 150,000 180,000 126,000 0 ( (465,000) ( (9,000)
Would your answer be different if the productive
capacity released by not making the lampshades
could be used to produce income of 35,000? Of
course, by purchasing the lampshades they would
then save 26,000.
67
Exercise 7-6

• XYZ has recently started to manufacture a
  product.
• The cost structure to manufacture 20,000 units is
  as follows.
• Direct materials (40 per unit) 80,000
• Direct labor (30) 600,000
• Variable labor (6) hundred and 20,000
• Allocated fixed overhead (25) 500,000
• Total costs 2,020,000
• XYZ is approached by ABC which offers to make the
  product for 90 per unit or 1,800,000.

68
Exercise 7-6

• Using incremental analysis, determine rather XYZ
  should accept the offer under each of the
  following independent assumptions.

69
Exercise 7-6

• Assume that 300,000 of the fixed overhead costs
  can be reduced or avoided.

     Make           Buy       Net Income Increase  (Decrease)  
Direct materials 800,000 -0-  800,000
Direct labor 600,000 -0-  600,000
Variable overhead 120,000 -0-  120,000
Fixed overhead 500,000 200,000 300,000
Purchase price 0 1,800,000 (1,800,000)
Total annual cost 2,020,000 2,000,000 20,000
Accept the order!
70
Exercise 7-6

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

(2)
     Make          Buy      Net Income Increase (Decrease) 
Direct materials 800,000 0 800,000
Direct labor 600,000 0 600,000
Variable overhead 120,000 0 120,000
Fixed overhead 500,000 500,000 0
Opportunity cost 300,000 0 300,000
Purchase price 0 1,800,000 (1,800,000)
Totals 2,320,000 2,300,000 20,000
Here the author shows the revenue as a negative
(opportunity) cost which is the same as a revenue.
71
Exercise 7-6

• Describes the qualitative factors that might
  affect the decision to purchase the product from
  an outside supplier.
• Qualitative factors include the possibility of
  laying off those employees that produced the
  robot and the resulting poor morale of the
  remaining employees, maintaining quality
  standards, and controlling the purchase price in
  the future.

72
Exercise 7-11

• XYZ Enterprises uses a computer to handle its
  sales invoices.
• Lately, businesses has been so good that it takes
  an extra three hours per night, plus every third
  Saturday, to keep up with the volume of sales
  invoices.
• Management is considering updating its computer
  with a faster model that would eliminate all of
  the overtime processing.

73
Exercise 7-11
Current Machine New Machine
Original purchase cost 15,000 25,000
Accumulated depreciation 6,000 0
Estimated annual operating costs 24,000 18,000
Useful life Five years Five years
If sold now, the current machine would have a
salvage value of 5,000. If operated for the
remainder of its useful life, the current machine
would have a zero salvage value. The new machine
is expected to have zero salvage value after five
years. Should the current machine be replaced?
74
Exercise 7-11
Retain Machine Replace Machine Net Income Increase (Decrease)

Operating costs New machine cost Salvage value (old) Total 120,000 0 0 120,000  (1) ( 90,000) ( 25,000) ( (5,000) (110,000) (2) ( 30,000 ( (25,000) ( 5,000) ( 10,000)
(1) 24,000 X 5. (2) 18,000 X 5.
There are a number of formats one could use in
doing this analysis, here the author chooses to
make the far right column show the impact the
change would have on operating income. He
arbitrarily decides to make a positive impact a
positive number and a negative impact a negative
number.
75
Exercise 7-11
Retain Machine Replace Machine Net Income Increase (Decrease)

Operating costs New machine cost Salvage value (old) Total 120,000 0 0 120,000  (1) ( 90,000) ( 25,000) ( (5,000) (110,000) (2) ( 30,000 ( (25,000) ( 5,000) ( 10,000)
(1) 24,000 X 5. (2) 18,000 X 5.
The current machine should be replaced. The
incremental analysis shows the net income for
the five-year period will be 10,000 higher by
replacing the current machine.
76
Problem 5

• Lewis Manufacturing Company has four operating
  divisions.
• During the first quarter of 2008, the company
  reported aggregate income from operations of
  176,000 and the following divisional results.

77
Problem 5
Divisions Divisions Divisions Divisions
One Two Three Four
Sales 250,000 200,000 500,000 400,000
COGS 200,000 189,000 300,000 250,000
S A Expense 65,000 60,000 60,000 50,000
Income (loss) -15,000 -49,000 140,000 100,000
Analysis reveals the following percentages of
variable costs in each division.
Divisions Divisions Divisions Divisions
One Two Three Four
COGS 70 90 80 75
SA Exp. 40 70 50 60
78
Problem 5

• Discontinuance of any division would save 50 of
  the fixed costs and expenses for that division.
• Top management is very concerned about the
  unprofitable divisions (one and two).
• Consensus is that one or both of the division
  should be discontinued.

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Problem 5

• Compute the contribution margin for divisions one
  and two.

Division I Division II

Sales Variable costs Cost of goods sold Selling and administrative Total variable expenses Contribution margin 250,000 140,000 26,000 166,000 ( 84,000) 200,000 170,100 42,000 212,100 (12,100)
Contribution margin is what is available to pay
fixed costs. Eliminating Division II gives us a
negative contribution margin. However, if we can
decrease fixed cost below 12,100, the
elimination would still be a good idea.
80
Problem 5

• Prepare an incremental analysis concerning the
  possible discontinuance of Division I and
  Division II.

(1) Division I Continue Eliminate Net Income Increase (Decrease)

Contribution margin (above) Fixed costs Cost of goods sold Selling and administrative Total fixed expenses Income (loss) from operations (84,000) (60,000) (39,000) (99,000) (15,000) ( 0) (30,000) (19,500) (49,500) (49,500) (84,000) 30,000 19,500 49,500 (34,500)
Eliminating Division One would reduce income by
34,500 not a good idea!
81
Problem 5
Division II Continue Eliminate Net Income Increase (Decrease)

Contribution margin (above) Fixed costs Cost of goods sold Selling and administrative Total fixed expenses Income (loss) from operations (12,100) (18,900 (  18,000 (  36,900 (49,000) ( 0) ( 9,450) ( 9,000) (18,450) (18,450) 12,100 ( 9,450 ( 9,000 18,450 30,550
Division II should be eliminated as income from
operations would increase by 30,500 by so doing.
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The End