Managerial Accounting Chapter 7: Incremental Analysis for Short-Term Decision Making

Segment Margin

calculated as sales revenue less all costs that are directly attributable to the segment, including variable costs and direct fixed costs

What does incremental analysis involve?

comparing the relevant costs and benefits of alternative decision choices

costs that differ between alternatives are also called

differential costs or incremental costs. Example: In Exhibit 7.1, the difference in monthly rent between the house and the apartment was $200. Only the difference in cost was relevant to the decision of whether to rent the house or the apartment.

two important cautions with qualitative analysis

should only be used for one-time or special orders. Managers would not want to use it to make long-term pricing decisions because revenues must cover all costs, including fixed costs, if the company is to be profitable in the long run. Managers should also consider whether accepting the special order will impact the price that other customers are willing to pay for sales made through regular channels.

We can use incremental analysis to determine whether the company should sell the product as it is currently designed or move forward with the enhanced design. The first step is to compare the incremental revenues and costs of the two alternatives as summarized in the following table.

study table and paragraph after

What is the goal of incremental analysis?

to make decisions that will maximize the company's short-term accounting profit

Steps in the decision making process

1. identify the decision problem 2. determine the decision alternatives 3. Evaluate the costs and benefits of the alternatives 4. make the decision 5. review the results of the decision

Qualitative Analysis

Before making a final decision, IKEA's managers would want to consider many other qualitative factors, such as the following: Will the quality of the food service be as good, or even better, than IKEA could provide internally? Sometimes quality can be improved by outsourcing because the supplier specializes in that function. Is the function a critical part of the company's business strategy? Many companies choose to outsource functions that are less critical to their business success and for Page 300 which they do not have a strategic advantage or core competency. Since IKEA's core competency is the design of innovative furniture, it may make sense to outsource less critical activities to others. Are there any safety or liability issues to consider? For example, what happens if a customer gets sick from eating the food? Even if the supplier is legally responsible, IKEA could bear some of the costs and its reputation and brand could be severely impacted. This happened a few years ago when horse meat was detected in a few batches of Swedish meatballs. IKEA quickly took action to remove the product (donating more than 3.5 million servings to European food banks) and has since implemented new procedures and supplier policies to strengthen the traceability of food in its supply chain. How will outsourcing impact employees and other critical stakeholders? What will happen to employees who are let go? Will the supplier hire them? How will it impact the local community? How does the decision impact the triple bottom line? The incremental analysis only focuses on the economic aspect of the triple bottom line. Are there environmental or social impacts to consider?

incremental analysis or differential analysis

Decision-making approach that focuses on the differential costs and benefits of alternate decision choices. expenses that are the same under both options like rent do not matter what matters is the difference in costs and benefits between the two options

IMPORTANT TO REMEMBER

Fixed costs are excluded from the incremental analysis because they will be incurred regardless of whether or not the company accepts the special order. In the short term, fixed costs will not change, so any price that exceeds the variable costs of filling the order will yield an incremental profit. Notice that fixed costs, such as rent, supervision, and insurance, are excluded from the incremental analysis because they will be incurred regardless of whether the special order is accepted or rejected. In other words, fixed costs are not relevant to this decision. only costs that are relevant to this decision are the variable costs of filling the special order.

Managers should ask the following questions when analyzing make-or-buy decisions:

How much will costs and revenue change depending on whether the company makes or buys the product or service? Are there opportunity costs associated with either alternative? For example, what else could the company do with the resources that are currently devoted to an in-house function? Could the resources be deployed to some better use? Are there other qualitative factors to consider, such as corporate strategy, sustainability goals, employee morale, risk, quality, and reliability? When you see fixed costs stated on a per-unit basis, be careful. What really counts is the total fixed cost and whether that total cost will change depending on the decision.

Incremental Analysis (when Capacity is Limited)

Now assume that IKEA is operating at full production capacity and cannot fill the special order for 5,000 sit-or-stand desks without reducing production and sale of desks sold through normal channels. The desks normally sell in IKEA stores, catalogs, and the company website for $300 each. Should IKEA's managers accept the university's offer to pay $200 per desk? imited production capacity creates an opportunity cost because filling the special order would mean passing up the opportunity to sell to normal customers. The opportunity cost can be measured as the contribution margin that would have been earned on sales made through regular channels. Again, we can focus on contribution margin because fixed costs will not change in the short run. The net result of accepting the special order would be a $500,000 decrease in profit. Notice that the incremental cost associated with the special order is $300 when the opportunity cost of lost sales is considered, compared to an offer price of $200. When a company is operating at full capacity, managers should not accept a special order for less than the price they could get through normal channels. This analysis assumes that capacity cannot be increased in the short-run and that it is not possible to back-order or defer the sales to a future period. It is also possible that some existing customers would decide to purchase a different type of IKEA desk, which would potentially offset some of the opportunity costs. Finally, there may be other strategic reasons for accepting the special order, such as the opportunity to enter a new market or region, or to increase brand awareness by partnering with a major university. As always, the numerical analysis must be balanced against these qualitative factors.

Substitute Products

Products where one good can be used instead of another. Examples include butter and margarine, or sugar and artificial sweeteners. In this example, IKEA customers might choose to buy the Bojgsjö bookcase if the Finnby bookcase is not available. In that scenario, eliminating one product could boost sales of another product line.

Step 2: Determine the Decision Alternatives

This is a critical step because the remainder of the decision process hinges on the decision alternatives identified here. If a potential alternative is not included in this initial stage, it will not be considered in later phases of the analysis. For the decision about where to live, assume you have narrowed it down to two options: lease a house with two roommates or rent a one-bedroom apartment on your own. This rules out other potential alternatives such as living with your parents or buying your own home; thus, these alternatives will not be considered further.

Turning Unused Capacity into Revenue

Travel providers such as airlines, hotels, and car rental agencies often use special pricing to fill unused capacity. Online travel sites like priceline.com and hotwire.com provide discounted prices to consumers who are willing to travel at off-peak times, stay at any hotel within a certain class, or rent any car that is available. The airline, hotel, or car rental company generates extra revenue from the unused capacity; consumers get a bargain price for travel; and the online travel site generates advertising revenue from related travel services such as dining, entertainment, and tourist attractions. What is the incremental cost to an airline of one extra passenger on a flight? If there is an empty seat on the plane, it is literally peanuts and a soft drink. The incremental cost of filling an empty hotel room is the cost of cleaning the room and incidental supplies like toiletries. Because fixed costs are going to be incurred anyway, any price that exceeds these variable costs will generate extra profit. But this approach to pricing only works in the short run. To make money in the long run, companies need a solid base of customers who are willing to pay full price for their services.

The third question is whether any opportunity costs should be considered.

Would the elimination of the Finnby bookcase free resources (people, space, or machines) that could be used in another way? Perhaps another product could be developed that would contribute more to profit than the Finnby bookcase. For the following incremental analysis, we assume that there are no alternative uses for the resources and thus no opportunity costs. read about incremental analysis and elimination of finnby book case example

another term for relevant cost is avoidable cost and what is that?

a cost that can be avoided by choosing one alternative instead of another Example: the costs of fuel and on-campus parking could be avoided if you lived in an apartment near campus and could ride your bike to class. This cost was relevant to the decision because it differed between the two alternatives.

what do special-order decisions require managers to do?

decide whether to accept or reject an order that is outside the scope of normal sales. These one-time orders, or special orders, are often offered at a lower price than customers normally pay for the product or service. The decision that managers must make is whether to accept or reject the offer. We can analyze this decision by comparing the incremental costs and benefits of accepting (versus rejecting) the special order.

relevant cost

has the potential to influence a specific decision and should therefore be considered in the analysis. To be relevant, it must meet both of the following criteria: Occurs in the future. Differs between decision alternatives.

Third step of the decision-making process

involves comparing the costs and benefits of the decision alternatives. One of the most important parts of this process is determining which costs (and benefits) are relevant to the decision at hand.

direct fixed cost

is a fixed cost that can be attributed to a specific segment of the business. Examples include a machine used to produce only one type of product, a supervisor who is responsible for a specific division, and advertising aimed at a specific region or product line. Even though these costs are fixed, or independent of the number of units produced or sold, they relate to only one segment and could be avoided if the segment were eliminated.

Step 3: Evaluate the Costs and Benefits of the Alternatives

main focus will be on step 3 of the decision making process involves comparing the costs and benefits of the decision alternatives identified in Step 2. The approach we use is called incremental analysis or differential analysis because it focuses on the factors that will change, or differ, between the decision alternatives. In managerial accounting, this approach is sometimes called relevant costing because only those costs that change or differ between the decision alternatives are relevant for decision making.

idle or excess capacity

means the company has more than enough resources to satisfy demand. Because it has not yet reached the limit on its resources, opportunity costs are not relevant.

capacity

measure of the limit placed on a specific resource. Example: the number of people who will fit in a restaurant or an airplane, the number of employees who are available to serve clients, the amount of machine time that is available to make a product, or the amount of shelving space that is available for merchandise.

complementary products

or products that are used together. examples include Brother printers and cartridges, Apple iPods and iTunes, and Page 303Nintendo game systems and games eliminating one product can have a negative effect on the related product. When choosing to discontinue products, managers must carefully anticipate the effect on other related product lines.direckeke

Global Reporting Initiative (GRI)

provides the most widely-accepted standards for sustainability reporting, including guidelines, definitions and examples of performance indicators that capture economic, social, and environmental measures of performance. The following represent just a few of the performance indicators that might be included in an organization's sustainability report: Total number and rates of new employee hires and employee turnover by age group, gender, and region. Proportion of spending on local suppliers at significant locations of operation. Percentage of new suppliers that were screened using labor practices criteria.

Assume the company has only 300,000 feet of acacia wood available. Which products should managers produce in order to maximize this month's profit? To answer this question, we need to determine how much contribution margin is generated per unit of the constrained resource. Because raw materials (acacia wood) is the constrained resource, we need to divide the unit contribution margin by the amount of raw materials required to make each unit, as follows:

study chart

Full capacity

the limit on one or more of its resources has been reached, and making the choice to do one thing means giving up the opportunity to do something else. At full capacity, opportunity costs become relevant and should be incorporated into the analysis.

Irrelevant costs

those that will not influence a decision, either because they have already been incurred or because they do not differ between the decision alternatives. Sunk costs, or costs that were incurred in the past, are not relevant because they will not change based on a future decision. Sunk costs may be used to evaluate the outcome of previous decisions (Step 5 of the decision process). However, they are not relevant for future decisions, which is the focus of this chapter. Future costs that remain the same across decision alternatives are also irrelevant. In the housing example, the monthly utility costs were estimated to be $150 regardless of whether you share the rental house or rent the apartment. You can either ignore this cost altogether, or include the same amount in both options so that the net effect is zero.

make-or-buy decisions or outsourcing decisions

whether to perform an activity or function in-house or purchase it from an outside supplier, d make-or-buy decisions Application of incremental analysis that requires managers to decide whether to perform a particular activity or function in-house or to purchase it from an outside supplier. Almost any business function can be outsourced, including production activities and support functions such as payroll, information technology, distribution, and technical support. The key question is whether the organization wants to perform the activities with its own resources and employees, or hire a third party to perform the activities.

The second question that managers must address is whether the elimination of one product or segment will affect the costs and revenues of other segments. Example?

will customers who were planning to buy the Finnby bookcase purchase one of the other models instead? Let's assume that the elimination of the Finnby bookcase will increase sales of the Bojgsjö bookcase by 10 percent, with no effect on the Billy bookcase. Remember that variable costs change in direct proportion to changes in sales, so both the sales revenue and variable costs of the Bojgsjö bookcase would increase by 10 percent. The net effect will be a 10 percent increase in the contribution margin of the Bojgsjö bookcase.

opportunity cost

Another type of cost that must be considered in decision making the forgone benefit (lost opportunity) of choosing one decision alternative over another We all face opportunity costs anytime we make a choice about what to do with our limited time or money business managers face opportunity costs when they are forced to choose one alternative over another because of limited resources such as cash, employee time, equipment availability, or space. Opportunity costs are relevant for decision making, but they only come into play when the capacity of a critical resource is limited.

Special-Order Decisions

Application of incremental analysis that requires managers to decide whether to accept or reject an order that is outside the scope of normal sales.

keep-or-drop decisions or continue-or-discontinue decisions

Application of incremental analysis that requires managers to decide whether to retain or eliminate a business segment or product.

Step 5: Review the Results of the Decision

review the results of the decision to determine if you made the right choice or whether you should do something different the next time you are faced with a similar decision. With any decision, there are likely to be Page 293 unexpected costs and benefits that you did not foresee that will influence how you make decisions in the future. Managerial accounting provides feedback to managers about the results of previous decisions so that they can take corrective action or make adjustments going forward. The role of managerial accounting information in performance evaluation and control is discussed in more detail in other chapters

This segmented income statement is based on the contribution margin approach introduced in Chapter 5. However, it has been expanded to include a new line item called

segment margin

In deciding whether to eliminate a business segment, managers should ask the following questions:

How much will total revenue and total costs change if the segment is eliminated? Will other segments or product lines be affected? Are there opportunity costs associated with keeping the segment? For example, could resources be deployed to more profitable uses if the segment were eliminated? Are there other qualitative factors to consider, such as the impact on employees and the company's reputation in the community?

As in the other decision scenarios, the quantitative analysis is only a starting point for making the decision. Managers must always consider other important factors, including the effect of the decision on customer loyalty and employee morale.

Managers must also think about the likely impact of discontinuation on other products and customers.

Step 4: Make the Decision

Once you have evaluated the costs and benefits of the decision alternatives, the next step is to use the information to make a decision. business, managers face similar trade-offs between financial considerations and qualitative factors such as strategic issues, quality considerations, legal and ethical concerns, and the like. For all of the decisions that we analyze throughout this chapter, we first perform a quantitative analysis to determine which alternative is "best" based strictly on the numbers. We then discuss other qualitative factors that might come into play to influence managers' decisions.

Bottleneck

Most constrained resource or the process that limits a system's output. limits the total number of units that can be produced and therefore determines how much contribution margin can be earned given the limited resource. We focus on contribution margin because fixed costs do not change in the short-run and are therefore irrelevant for this type of decision.

tip

Opportunity costs occur any time capacity is limited and accepting one option means giving up something else. For a special order, it is measured as the lost contribution margin from a regular sale. study self study

constrained resource

Resource that is unable to meet the demand placed on it. could be anything that is needed to operate the business, such as cash, employees, raw materials, machines, or facilities When any of these resources are in limited supply and the company is unable to meet customer demand, managers must decide which products to produce or which customers to serve long term, companies can manage constrained resources by eliminating non-value-added activities, such as rework and waiting, or by increasing the capacity of the constrained resources by hiring more workers, buying bigger or faster machines, or leasing additional space. takes time could result in higher costs short run, managers can maximize profit by prioritizing products or customers based on the amount of contribution margin generated by the most constrained resource, called the bottleneck

how to use incremental analysis to analyze four common managerial decisions:

Special-order decisions. Make-or-buy decisions. Keep-or-drop decisions. Sell-or-process-further decisions.

SUMMARY OF INCREMENTAL ANALYSIS

This chapter applied incremental or relevant cost analysis to a number of short-term decisions. Although the decision problems were different, the same basic approach was used to analyze each decision. In all cases, we focused only on the relevant or incremental costs and benefits of the decision alternatives. Some common rules for analyzing relevant costs and benefits are summarized here: Relevant costs and benefits occur in the future and differ between the decision alternatives. Relevant costs are also sometimes called avoidable or differential costs—costs that will change based on the decision made. Variable costs are usually relevant to the decision because they vary with the number of units produced or sold. Page 305 Fixed costs may not be relevant because they do not change with the number of units produced or sold. Fixed costs that are directly related to the decision, also called direct fixed costs, may be avoidable and thus relevant. Common or allocated fixed costs are shared by multiple products or services and are generally not relevant. Opportunity costs are the lost benefit of choosing one alternative over another. These costs are relevant and occur when capacity is reached or resources are constrained. Opportunity costs can be treated either as a benefit of one option, or as a cost of the other, but not both. The quantitative analysis provides a starting point for making decisions but must be balanced against other qualitative factors such as quality considerations, customer loyalty, employee morale, sustainability goals, and many other important factors.

Step 1: Identify the Decision Problem

Whether conscious or unconscious, we go through the same basic process when making all decisions: identifying the problem, determining our options, weighing the costs and benefits of those options, making the decision, and getting feedback about the wisdom of our decisions.

tip

You may notice that the format of the incremental analysis changes somewhat from decision to decision, and there is more than one way to work each problem. Unfortunately, there is no set format for doing incremental analysis. The key is to focus on what is the same in each analysis: the comparison of relevant, or differential, costs and benefits.

common fixed costs

are shared by multiple segments and thus will be incurred even if a segment is eliminated. In evaluating segment profitability, managers should focus on the segment margin rather than the bottom-line profit margin. segment margin tells managers how much incremental profit a segment generates to help cover common fixed costs and contribute to company-wide profit. Although the Finnby bookcase is not profitable in terms of net operating income, it generates $100,000 in segment margin, which helps cover the common fixed costs.