Download Incremental Analysis: A Comprehensive Study Guide for Accounting Principles II and more Study Guides, Projects, Research Principles of Accounting in PDF only on Docsity!
Accounting Principles II: Incremental
Analysis
Complete Study Guide
Introduction to Incremental Analysis
Managerial decisions are choices made based on financial and nonfinancial information. Typically, financial information serves as the first hurdle in identifying a possible course of action as an alternative. If the financial hurdle is met, then management must consider the impact of the alternative on the environment, the company's employees, its image, the community, its partners or alliances, and so on before making a final decision. Incremental analysis , sometimes called marginal or differential analysis, is used to analyze the financial information needed for decision making. It identifies the relevant revenues and/or costs of each alternative and the expected impact of the alternative on future income. To illustrate the concept, think about the decision to lease or buy a car. Leasing involves a regular payment and the return of the vehicle at the end of the lease unless a one‐ time payment is made. This arrangement means the car does not legally belong to the person leasing it. To buy a car requires payment of the purchase price. The payment may be made in cash or by signing a note payable for the amount owed. If you were to prepare financial statements under each alternative, they would look very different. An operating lease for a car with payments of $300 per month would result in the annual cost of the lease, $3,600, being reported as an expense on the income statement. The purchase of a car results in an asset — and a liability, if a note was signed — being recorded on the company's balance sheet. Another example is the choice between alternatives A and B, given the following relevant revenues and expenses:
This example shows alternative B generates $23,000 more net income than alternative A. Management must now consider the nonfinancial information to determine whether alternative B should be accepted. Several concepts are incorporated into incremental analysis and need to be defined before discussing some specific applications of incremental analysis. Relevant cost. Those revenues and costs that differ among alternatives, as opposed to revenues and costs that stay the same, which are ignored when analyzing alternatives. Note: Some texts refer to the revenues that change as relevant benefits. Sunk cost. A cost that has already been incurred and, therefore, has no impact on future decisions because the cost will not change or go away in the future. The book value of a previously purchased and currently owned asset will not change whether or not a new asset is purchased to replace it. Opportunity cost. A potential benefit that is lost when a company chooses another alternative.
Examples of Incremental Analysis
Incremental analysis , sometimes called marginal or differential analysis, is used to analyze the financial information needed for decision making. It identifies the relevant revenues and/or costs of each alternative and the expected impact of the alternative on future income. Here are some examples of incremental analysis: Accepting additional business.
company's current business. If 84,000 packets is 75% of capacity, 112,000 packets would be 100% of capacity. The Party Connection has the capacity to prepare the 15,000 packets requested without changing its existing operations. Should the Party Connection accept this special order? Using its current cost information, the answer would be no because accepting the order would generate a $7,500 loss. However, this is not the proper way to analyze the alternative. Incremental analysis, which identifies only those revenues and costs that change if the order were accepted, should be used to analyze the alternative. This requires a review of the costs. Suppose the following information is discovered with further analysis: Accepting this order would not impact current sales. To manufacture 15,000 packets would require $12.00 of direct materials and $6.00 of direct labor. The per unit overhead cost of $0.50 is 50% variable ($0.25) and 50% fixed ($0.25). Selling costs (includes commissions and delivery costs) for the 15,000 packets would be $7,000.
Administrative expenses would not change. Under this scenario, $300,000 of additional revenues would be created with additional costs of $280,750, so operating income would increase by $19,250 if the order were accepted. Given the available capacity, this opportunity would not result in additional costs to expand capacity. If the current capacity were unable to handle the special request, any new costs for expanding capacity would be included in the analysis. Also, if current sales were impacted by this order, then the lost contribution margin would be considered an opportunity cost for this alternative. With additional operating income of $19,250, this order could be accepted. Making or buying component parts or products The decision to make or buy component parts also uses incremental analysis to determine the relevant costs. Opportunity costs must also be considered. Toyland Treasures uses part #56 in several of its products. Toyland Treasures currently produces 50,000 of part #56 using $0.30 of direct materials, $0.20 of direct labor, and $0.10 of overhead. The purchase of parts is under review by the company's management. Purchasing has determined it would cost $0.75 per unit to purchase
Selling products or processing further Some companies' product can be sold at different stages in their production cycle. For example, the DGK Company manufactures children's play gyms. It can sell the gyms assembled or unassembled. Incremental analysis is used in the decision to sell unassembled products. A general guideline DGK should consider when deciding how to sell its units is that if the incremental revenues generated from assembling the gyms are greater than the incremental assembly costs, DGK should assemble the gyms (process further). DGK sells an unassembled gym for $1,000. Its costs to manufacture a gym are $550, which consist of direct materials of $300, direct labor of $150, and overhead of $100. It is estimated that assembling a gym would take additional labor of $100 and overhead of $25, and once assembled, the gym could be sold for $1,500.
On a per unit basis, the incremental analysis shows that DGK should process further and assemble the gyms. Qualitative factors such as loss of business if unassembled gyms were not offered (an opportunity cost) and customers' willingness to pay the additional $500 for an assembled gym need to be considered. An alternative way of analyzing this decision is:
To prepare the quantitative analysis for its decision whether to eliminate the deluxe segment, the fixed expenses must be separated into avoidable and unavoidable costs. It has been determined that unavoidable costs will be allocated 45% to economy and 55% to standard. If all the fixed expenses are unavoidable, the company would experience an operating loss of $130,000 if the deluxe segment was discontinued, split as follows:
If $300,000 of the fixed expenses are avoidable costs and $200,000 are unavoidable costs, the company's operating income would remain unchanged at $170,000. The deluxe model has a contribution margin of $300,000, which helps cover some but not all of the fixed expenses generated by its production and the fixed corporate expenses that are allocated to it. If the unavoidable expenses (variable and fixed) are more than the segment's revenues, a decision should be made as to whether to discontinue the segment. If the avoidable expenses are less than the segment's revenues, discontinuing the segment could result in a loss to the company. Although a segment may be unprofitable, it may be contributing to the overall income of the company. This and other factors should be considered before discontinuing the segment. Allocating scarce resources (sales mix) When a company sells more than one product and has limited capacity for production of its products, it should optimize its production to produce the highest net income possible. To maximize profit, a calculation of the contribution margin for each product is required. In addition, the amount of the limited capacity each product uses must be determined. For example, if Golfers Paradise produces two different sets of golf clubs, it is limited by its machine capacity of 4,200 hours per month. The relevant data needed to determine production requirements are contribution margin and machine hours required to produce the standard and the deluxe set of golf
