Chapter 7Incremental Analysis for Short-Term Decision Making

PowerPoint Authors:Jon A. Booker, Ph.D., CPA, CIACharles W. Caldwell, D.B.A., CMASusan Coomer Galbreath, Ph.D., CPA

Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

Steps in the Decision-MakingProcess

Step 1

Identify the decision problem

Step 2

Determine the decision alternatives

Step 3

Evaluate the costs and benefits of

the alternatives

Step 5

Review the results of the

decision-making process

Step 4

Makethe

decision

Improve

future decisions

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Relevant versus Irrelevant Costsand Benefits

Relevant costs are costs thatwill change depending on the alternative selected.

Relevant costs are also called differential costs,

incremental costs, or avoidable costs.

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Relevant versus Irrelevant Costsand Benefits

Irrelevant costs areare costs thatdo not differ between

alternatives.

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An opportunity cost is a benefit that is given up when one

alternative is selected over another.

At capacity, adding additional work

requires giving up a portion of the

existing work. The benefit of the

existing work given up is an opportunity

cost.

With idle capacity, additional work may

be added without sacrificing existing work. There is no

opportunity cost to the additional work.

Opportunity Costs and Capacity Considerations

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A special order is a one-time order that is not considered part of the

company’s normal ongoing business.

A special order is a one-time order that is not considered part of the

company’s normal ongoing business.

Special-Order Decisions

When analyzing a special order, only the

incremental costs and benefits are relevant.

When analyzing a special order, only the

incremental costs and benefits are relevant.

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Special-Order Decisions

A major university has asked Mattel to make a special University Barbie, dressed in a sporty outfit with the school’s logo and colors. The

university bookstore has offered to buy 25,000 of these dolls at a price of $7.00 each. Mattel

has the capacity to fill the order without affecting production of other Barbie products,

which are normally sold to toy stores and discount chains for $9.00 each.

More Information

Special-Order Decisions

Unit CostDirect materials 3.50$ Direct labor 1.00 Variable manufacturing overhead 0.50 Fixed manufacturing overhead 2.50 Total manufacturing cost 7.50$

Mattel estimates that its unit cost to produce the University Barbie will be:

Should Mattel accept the special order?

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Per Unit Total Incremental Revenue 7.00$ 175,000$

Less Incremental Costs: Direct materials 3.50 87,500 Direct labor 1.00 25,000 Variable Overhead 0.50 12,500 Fixed Overhead - - Total Incremental Cost 5.00 125,000 Incremental Profit 2.00$ 50,000$

Incremental Analysis of the Special Orderfor 25,000 University Barbie Dolls

The special order will result in a profit of $2.00 per doll and a total profit of $50,000. Note that fixed costs are excluded because they are irrelevant to the decision.

Incremental Analysis (with Excess Capacity)

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A decision to make a part or provide a service internally rather than to buy externally from a

supplier is called a “make-or-buy” decision.

A decision to make a part or provide a service internally rather than to buy externally from a

supplier is called a “make-or-buy” decision.

Make-or-Buy Decisions

Make-or-buy decisions are also called insourcing versus outsourcing decisions. Make-or-buy decisions are also called insourcing versus outsourcing decisions.

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Annual UnitCost Cost

Packaging Materials 300,000$ 1.50$ Packaging Direct Labor 90,000 0.45 Indirect Materials 60,000 0.30 Packaging Supervision 50,000 0.25 Other Fixed MFG Overhead 200,000 1.00 Total Packaging Cost 700,000$ 3.50$

Internal Cost of Packaging200,000 American Girl Dolls

Mattel is trying to decide whether to continue packaging the American Girl doll “in-house” or outsource the packaging process to

an external supplier. Mattel’s packaging costs for the dolls are:

The outside supplier bid $3.00 per doll for the packaging work.Should Mattel outsource the packaging?

Make-or-Buy Decisions

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Make-or-Buy Decisions• The agreement with the outside supplier includes a 3-year contract for a minimum of 200,000 units per year.

• All costs directly related to the packaging activities, including all direct and indirect materials, labor, and supervision, would be avoided if the packaging is outsourced.

• Other total fixed manufacturing overhead costs would remain unchanged.

• The factory space that is now used for packaging could be used to expand production of a popular product line. The expansion would generate an additional $150,000 in profit per year.

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Internal Outsourced Costs Costs

Supplier's Price ($3.00 per unit) - $ 600,000 Packaging Materials ($1.50 per unit) 300,000$ Packaging Direct Labor ($0.45 per unit) 90,000 Indirect Materials ($0.30 per unit) 60,000 Packaging Supervisor 50,000 Profit from Expanding Another Product Line - (150,000) Total cost 500,000$ 450,000$

Relevant Costs of Packaging 200,000 Units per Year

Incremental Analysis

Outsourcing is $50,000 less.

Note that fixed costs are excluded because they are irrelevantto the decision. Mattel should outsource the packaging.

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One of the most important decisions managers make is

whether to continue or eliminate a business segment, such as a product or a store.

A segment is a candidate for elimination if its revenues are

less than its relevant (avoidable) expenses.

One of the most important decisions managers make is

whether to continue or eliminate a business segment, such as a product or a store.

A segment is a candidate for elimination if its revenues are

less than its relevant (avoidable) expenses.

Decisions to Eliminate Unprofitable Segments

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Sell-or-Process Further Decisions

Businesses are often faced with the decision to sell partially completed products or to process them to completion and hopefully sell them at a higher price.

As a general rule, , we process further only if incremental revenues

exceed incremental costs.

Costs of manufacturing the product up to the sell-or-

process decision point are sunk and therefore

irrelevant.

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Prioritizing Products with Limited ResourcesWhen a limited resource restricts a company’s ability to satisfy demand, the company is said to have a constrained resource that is referred

to as a bottleneck.To maximize profits in the short run, a

company with a bottleneck must prioritize its products or services so as to maximize

contribution margin per unit of the constrained resource.

The focus is on contribution margin instead of segment margin because fixed costs will not

change in the short run, and are not relevant.

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End of Chapter 7

Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin