CH.10 Incremental Analysis: The Key to Decision-Making

Joint Cost

Describe costs that are incurred up to the split-off point -CAUTION: NOT relevant to the decision to process further Decision Rule: IF Incremental Revenue > Incremental Cost then process further

Sunk Cost

A cost that has already been incurred -CANNOT be changed, thus relevant!! EX: Q-drop

To make a decision using incremental analysis

1.) Eliminate costs and benefits that do not differ, in total, between alternatives. 2.)Base the decision on the remaining costs and benefits.

Managing Constraints

1.) Work overtime 2.) Hire subcontractors 3.)Shift more workers to processes that are bottlenecks 4.) Invest in additional equipment 5.) Process improvements

Decisions Based On Incremental Analysis

1.)Special Orders 2.)Add or Drop a Segment 3.)Further Processing of Joint Product Costs 4.) Make or Buy Decision 5.) Utilization of Constrained Resource:Product Mix Decision 6.) Managing Constraints

Make or Buy Decisions

A company must decide whether to make a component part or buy it from an external supplier (outsourcing) -Be sure to consider opportunity cost if facilities could be used to manufacture another product. -If part is made: VC will generally change,FC may or may not (choose lowest cost)

Avoidable Costs

A cost that can be eliminated( in whole or in part)by choosing one alternative over another.(Avoidable costs are relevant)

Opportunity Cost

Benefits foregone(income) by choosing the best alternative EX: Not working full-time

Add or Drop a Segment

Focus on RELEVANT info. If any segment is eliminated: Total Revenues will decrease by amount of that division's revenues, Total variable costs will be reduced by that division's VC, but only avoidable Fixed Costs can be eliminated - Focus on short run -Beware of common fixed costs -Decision Rule: Retain the segment unless fixed costs eliminated exceed the CM lost -Consider effect on related product lines

Relevant Costs

Future costs that differ among the alternatives (also applies to revenues) EX: Tuition, Textbooks,Fees

Special Orders

Occur when a customer orders a product that differs from standard output or offers a price lower than usual sales price 1.) Special order accepted if incremental revenues exceed incremental costs 2.) Typically, revenues and VC will increase;FC may or may not depends on if idle capacity exists(fixed cost same) - Revenue> Incremental Cost

Split-off point

Is the point in the manufacturing process at which the joint products can be recognized as separate products.

Utilization Of A Constrained Resource: Product Mix Decisions

Management must decide which products to make and sell(product mix) to maximize net income -If resources are NOT limited, simply rank product lines according to the CM/unit and CM ratio -Examples of constraints: floor space for retail firm; raw material,direct labor hours, or machine capacity for a manufacturing firm -If resources are limited,emphasize products with the greatest contribution margin per unit of scarce resource.

Management's Decision-making Process

Managers must make decisions regarding which products to offer, whether to make or buy a part,what prices to charge etc.

Why use the Incremental Analysis Approach?

Saves time and places focus on what's relevant

Further Processing of Joint Product Costs

Some companies make a number of end products from a single raw material. Such end products are know as joint products!! EX:Crude Oil -gasoline -kerosene -other

Incremental(or differential) Analysis Approach

The process in which managers identify data that change under alternative actions to allow managers to chose among alternatives(compare to Total cost approach) -Must identify which revenues and costs are relevant to the decision -Every decision involves choosing from among at least two alternatives.

Incremental Revenues/Costs

Total differences in revenues/costs among two alternatives.