Chapter Six

1
Chapter Six

• Incremental Analysis

2
Special Orders

• Only costs that change should be analyzed.
• Variable costs
• A per unit, incremental, cost that will cause
  change with a production change.
• Additional fixed costs
• A change in production level will normally not
  change TOTAL fixed costs.
• If the relevant range for fixed costs changes,
  then additional fixed costs are incremental.

3
Special Order Example

• Cloudy Days Incorporated
• Income Statement
• For the Month Ended August 31, 2004
• Sales (12,000 units) 240,000
• Variable Expenses
• Manufacturing Costs 120,000
• Operating Costs 48,000 168,000
• Contribution Margin 72,000
• Fixed Expenses
• Manufacturing Costs 15,000
• Operating Costs 45,000 60,000
• Net Income 12,000

4
Special Order Decision

• Would Cloudy Days accept or reject a special
  offer for 2,500 units at a price of 16 per unit
  from Beau Monday?
• Plant capacity is 15,000 units per month.
• What is the current excess capacity?
• 3,000 units
• What costs need to be considered for this
  decision?
• Variable manufacturing costs
• Variable operating costs

5
Incremental Analysis-Special Order

• COST TO PRODUCE
• Variable cost/unit
• Manufacturing
• 120,000/12,000units10/unit
• Operating
• 48,000/12,000units4/unit
• Total variable cost/unit is 14/unit
• Fixed costs
• Do not change since the production is in the
  relevant range.

• SELLING PRICE
• 16/unit
• ADDITIONAL NET INCOME
• 2/unit 2,500 units
• 5,000
• Cloudy Days should accept the special order.

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Make or Buy Decisions(without a change in fixed
costs)

• Only analyze incremental costs (variable costs
  and additional fixed costs).
• If you can make the product for an incremental
  cost of 14/unit, would you buy it for 15/unit?
• NO!
• Fixed costs have not changed and will be the same
  whether you make or buy the product.

7
Make or Buy Decisions(with a change in fixed
costs)

• The 13,000 reduction in fixed costs is called an
  opportunity cost.
• This will affect your incremental analysis.
• Make
  Buy
• Total Cost(12,000 units) 228,000 240,000
• Opportunity Cost -0-
  13,000
• Total Cost 228,000
  227,000
• Buy product since the reduction in fixed costs
  brings total costs to an amount lower than making
  the product.

8
Sell Now or Process Further

• If we sell now, the net income will be 12,000.
• If we process further
• Sales (12,000 units25/unit)
  300,000
• Variable Costs (12,000 units16/unit)
  192,000
• Fixed Costs (48,00045,000)
  93,000
• Net Income
  15,000
• Process further since a larger net income will be
  obtained.

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To Keep or Replace Equipment

• Incremental costs
• Cost of the new machine
• Trade-in value of the old machine
• Annual cost to operate each of the machines
• For the remaining life of the old machine, not
  entire life.
• Sunk cost
• A cost that cannot be changed and is therefore
  irrelevant to the current decision.
• Cost of the old machine
• Accumulated depreciation of old machine

10
To Keep of Replace Machine Example
-0-
(20,000)
20,000
Trade-in
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Sales Mix-Contribution Margin
12
Sales Mix(additional information)

• Fixed costs total 240,240
• This is the total fixed cost to produce all types
  of chocolates.
• In order to compute breakeven with more than one
  product, a weighted average must be computed.
• It is a weighted average since the individual
  products are not sold at the same rate.

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Sales MixWeighted Average Contribution Margin

• Proportion of sales
• MCMPC
• 800003000040000
• Simplify to 834
• Weighted Average Contribution Margin
• (4/MC8MC)(6/M3M)(7/PC4PC)
• 78 total CM for selling a set proportion that
  has a total of 15 boxes per set
• Weighted Average CM78/15 units5.20/unit

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Sales Mix-Breakeven

• Fixed Costs/Weighted CMBreakeven (units)
• 240,240/(5.20/unit) 46,200 units
• Units to be sold
• MC 46,200 8/15 24,640 units
• M 46,200 3/15 9,240 units
• PC 46,200 4/15 12,320 units
• Double check that the total units of the
  individuals products equal the total units to be
  sold.
• 24640 9240 12320 46,200

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Sales Mix-Limited Resource

• Production time limits the number of units to be
  manufactured.
• Time should be allocated to the product that has
  the greatest contribution margin after taking the
  limiting factor into consideration.

16
Sales MixContribution Margin with a Limited
Resource
17
Sales Mix-Demand Constraints

• Given the contribution margin with the limited
  resource, all production time would be allotted
  to milk chocolates (highest CM at 2.00/limited
  resource).
• If consumer demand does not meet these same
  expectations, production must shift the limited
  resource to the other products.

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Sales Mix Production

• Without limited demand
• Produce all milk chocolate candies
• Contribution Margin
• 300,0004/unit 1,200,000

• With limited demand
• Contribution Margin
• MC150,0004/unit
• M 30,0003/unit
• PC120,0003.5/unit
• 1,110,000
• The excess demand is awarded to the product with
  the highest CM/limited resource.

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