Accounting Principles

Fourteenth Edition
Weygandt Kimmel Mitchell

Chapter 23
Incremental Analysis
This slide deck contains animations. Please disable animations if they cause issues with your device.
This deck contains equations authored in Math Type. For the full experience, please download the Math Type software plug-in.

Copyright ©2021 John Wiley & Sons, Inc.

Chapter Outline
Learning Objectives
LO 1 Describe management’s decision-making process and incremental
analysis.
LO 2 Analyze the relevant costs in accepting an order at a special price.
LO 3 Analyze the relevant costs in a make-or-buy decision.
LO 4 Analyze the relevant costs and revenues in determining whether to
sell or process materials further.
LO 5 Analyze the relevant costs to be considered in repairing, retaining,
or replacing equipment.

Copyright ©2021 John Wiley & Sons, Inc. 2

Decision-Making
LEARNING OBJECTIVE 1
Describe management’s decision-making process and
incremental analysis.
Making decisions is an important management function.
• Does not always follow a set pattern
• Decisions vary in scope, urgency, and importance
• Steps usually involved in process include:
Illustration 23.1

LO 1 Copyright ©2021 John Wiley & Sons, Inc. 3

Decision-Making Process
In making business decisions,
• Considers financial and non-financial information
• Financial information
o Revenues and costs, and
o Effect on overall profitability
• Nonfinancial information
o Effect on employee turnover
o The environment
o Overall company image

LO 1 Copyright ©2021 John Wiley & Sons, Inc. 4

Incremental Analysis Approach

• Decisions involve a choice among alternative actions

• Process used to identify the financial data that change
under alternative courses of action
o Both costs and revenues may vary or
o Only revenues may vary or
o Only costs may vary

LO 1 Copyright ©2021 John Wiley & Sons, Inc. 5

How Incremental Analysis Works
Basic approach in incremental analysis
Illustration 23.2

• Incremental revenue is $15,000 less under Alternative B

• Incremental cost savings of $20,000 is realized
• Alternative B produces $5,000 more net income

LO 1 Copyright ©2021 John Wiley & Sons, Inc. 6

 How Incremental Analysis Works
Important concepts used in incremental analysis
• Relevant costs and revenues
• Opportunity cost
• Sunk cost
Relevant cost: The only factors to be considered are those costs and
revenues that differ across alternatives.

Opportunity cost: Choosing one course of action, the company must give
up the opportunity to benefit from some other course of action.

Sunk cost: Costs that have already been incurred and will not be changed
or avoided by any present or future decisions are referred to as sunk costs
(are not relevant costs).
LO 1 Copyright ©2021 John Wiley & Sons, Inc. 7
How Incremental Analysis Works
Other items to consider

• Sometimes involves changes that seem contrary to

intuition
• Variable costs sometimes do not change under
alternatives
• Fixed costs sometimes change between alternatives

LO 1 Copyright ©2021 John Wiley & Sons, Inc. 8

Types of Incremental Analysis

Common types of decisions involving incremental

analysis:
1. Accept an order at a special price
2. Make or buy component parts or finished products
3. Sell products or process them further
4. Repair, retain, or replace equipment
5. Eliminate an unprofitable business segment or product

LO 1 Copyright ©2021 John Wiley & Sons, Inc. 9

Incremental Analysis
Review Question (1 of 2)

Incremental analysis is the process of identifying the

financial data that
a. do not change under alternative courses of action.
b. change under alternative courses of action.
c. are mixed under alternative courses of action.
d. None of the above

LO 1 Copyright ©2021 John Wiley & Sons, Inc. 10

Incremental Analysis
Review Answer (1 of 2)

Incremental analysis is the process of identifying the

financial data that
a. do not change under alternative courses of action.
b. Answer: change under alternative courses of action.
c. are mixed under alternative courses of action.
d. None of the above

LO 1 Copyright ©2021 John Wiley & Sons, Inc. 11

DO IT! 1: Incremental Analysis
Owen T Corporation is comparing two different options. The
company currently operates under Option 1, with revenues of
$80,000 per year, maintenance expenses of $5,000 per year, and
operating expenses of $38,000 per year. Option 2 provides
revenues of $80,000 per year, maintenance expenses of $12,000
per year, and operating expenses of $32,000 per year. Option 1
employs a piece of equipment that was upgraded 2 years ago at a
cost of $22,000. If Option 2 is chosen, it will free up resources that
will increase revenues by $3,000.
Complete the following table to show the change in income from
choosing Option 2 versus Option 1. Designate any sunk costs with
an “S.”

LO 1 Copyright ©2021 John Wiley & Sons, Inc. 12

DO IT! 1: Incremental Analysis
Solution
Complete the following table to show the change in income from
choosing Option 2 versus Option 1. Designate any sunk costs with
an “S.”

Option 2 is better
LO 1 Copyright ©2021 John Wiley & Sons, Inc. 13
Special Orders
LEARNING OBJECTIVE 2
Analyze the relevant costs in accepting an order at a
special price.

• To obtain additional business by making a major price

concession to a specific customer
• Assumes that sales of products in other markets are
not affected by special order
• Assumes that company is not operating at full
capacity

LO 2 Copyright ©2021 John Wiley & Sons, Inc. 14

Special Orders
Sunbelt Company produces 100,000 Smoothie blenders per
month, which is 80% of factory capacity. Variable
manufacturing costs are $8 per unit. Fixed manufacturing
costs are $400,000, or $4 per unit. The Smoothie blenders are
normally sold directly to retailers at $20 each. Kensington Co.
(a foreign wholesaler) has offered to purchase an additional
2,000 blenders from Sunbelt at $11 per unit. Management
has determined that acceptance of the offer would not affect
normal sales of the product, and the additional units can be
manufactured without increasing factory capacity. What
should management do?

LO 2 Copyright ©2021 John Wiley & Sons, Inc. 15

Special Orders
Solution
Illustration 23.3

• Fixed costs do not change since within existing capacity –

thus fixed costs are not relevant
• Variable manufacturing costs and expected revenues
change – thus both are relevant to the decision
LO 2 Copyright ©2021 John Wiley & Sons, Inc. 16
DO IT! 2: Special Orders
Cobb Company incurs costs of $28 per unit ($18 variable and $10 fixed) to
make a product that normally sells for $42. A foreign wholesaler offers to
buy 5,000 units at $25 each. The special order results in additional
shipping costs of $1 per unit. Compute the increase or decrease in net
income Cobb realizes by accepting the special order, assuming Cobb has
excess operating capacity.
Should Cobb Company accept the special?
Net Income Increase
Reject Accept (Decrease)
Revenues $─0─ $125,000* $125,000
Costs ─0─ 95,000** (95,000)
Net income $─0─ $ 30,000 $ 30,000

*5,000 × $25
**(5,000 × $18) + (5,000 × $1)

The analysis indicates net income increases by $30,000; therefore,

Cobb Company should accept the special order.
LO 2 Copyright ©2021 John Wiley & Sons, Inc. 17
Make or Buy
LEARNING OBJECTIVE 3

Analyze the relevant costs in a make-or-buy decision.

Illustration: Baron Company incurs the following annual costs in

producing 25,000 ignition switches for motorcycles.
Illustration 23.4
Direct materials $ 50,000
Direct labor 75,000
Variable manufacturing overhead 40,000
Fixed manufacturing overhead 60,000
Total manufacturing costs $225,000
Total cost per unit ($225,000 ÷ 25,000) $9.00

Instead of making switches, Baron might purchase ignition switches

at a price of $8 per unit. If they do this, all variable costs and
$10,000 of fixed costs will be eliminated. What should Baron do?
LO 3 Copyright ©2021 John Wiley & Sons, Inc. 18
Make or Buy
Illustration 23.5

• Manufacturing cost is $1 higher per unit than purchase price

• Must absorb at least $50,000 of fixed costs under either
option
LO 3 Copyright ©2021 John Wiley & Sons, Inc. 19
Make or Buy Decision
Review Question
In a make-or-buy decision, relevant costs are:
a. Manufacturing costs that will be saved
b. The purchase price of the units
c. Opportunity costs
d. All of the above

LO 3 Copyright ©2021 John Wiley & Sons, Inc. 20

Make or Buy Decision
Review Answer
In a make-or-buy decision, relevant costs are:
a. Manufacturing costs that will be saved
b. The purchase price of the units
c. Opportunity costs
d. Answer: All of the above

LO 3 Copyright ©2021 John Wiley & Sons, Inc. 21

Opportunity Cost

The lost potential benefit that could have been obtained

from following an alternative course of action.
If there is an opportunity to use this productive capacity
in some other manner, then this opportunity cost must be
considered.

LO 3 Copyright ©2021 John Wiley & Sons, Inc. 22

Opportunity Cost
Illustration

Assume that through buying the switches, Baron Company can

use the released productive capacity to generate additional
income of $38,000 from producing a different product. This lost
income is an additional cost of continuing to make the switches in
the make-or-buy decision.
Illustration 23.6

LO 3 Copyright ©2021 John Wiley & Sons, Inc. 23

DO IT! 3: Make or Buy
Juanita Company must decide whether to make or buy some
of its components for the appliances it produces. The costs of
producing 166,000 electrical cords for its appliances are as
follows.
Direct materials $90,000 Variable overhead $32,000
Direct labor 20,000 Fixed overhead 24,000

Instead of making the electrical cords at an average cost per unit of

$1.00 ($166,000 ÷ 166,000), the company has an opportunity to
buy the cords at $0.90 per unit. If the company purchases the
cords, all variable costs and one-fourth of the fixed costs are
eliminated.
Make or Buy?
LO 3 Copyright ©2021 John Wiley & Sons, Inc. 24
DO IT! 3: Make or Buy
Part a. solution
a. Prepare an incremental analysis showing whether the
company should make or buy the electrical cords.
Net Income Increase
Make Buy (Decrease)
Direct materials $90,000 $ ─0─ $ 90,000
Direct labor 20,000 ─0─ 20,000
Variable manufacturing costs 32,000 ─0─ 32,000
Fixed manufacturing costs 24,000 18,000* 6,000
Purchase price ─0─ 149,400** (149,400)
Total cost $166,000 $167,400 $ (1,400)

*$24,000 × .75
**166,000 × $0.90

Juanita Company should make the components.

LO 3 Copyright ©2021 John Wiley & Sons, Inc. 25
DO IT! 3: Make or Buy
Part b. solution
b. Will your answer be different if the released productive
capacity of the production facility will generate additional
income of $5,000?
Make Buy Net Income Increase (Decrease)
Total cost $166,000 $167,400 $(1,400)
Opportunity cost 5,000 ─0─ 5,000
Total cost $171,000 $167,400 $ 3,600

Yes, the answer is different. The analysis shows that net

income increases by $3,600 if Juanita Company purchases the
electrical cords rather than making them.
Juanita Company should buy the components.

LO 3 Copyright ©2021 John Wiley & Sons, Inc. 26

 Sell or Process Further
LEARNING OBJECTIVE 4

Analyze the relevant costs and revenues in determining whether to

sell or process materials further.

May have option to sell product at a given point in

production or continuing to process and sell later at a
higher price.
Decision Rule:
• Process further as long as the incremental revenue
from such processing exceeds the incremental
processing costs.

LO 4 Copyright ©2021 John Wiley & Sons, Inc. 27

Single-Product Case
Illustration: Woodmasters Inc. makes tables. The cost to manufacture an
unfinished table is $35. The selling price per unfinished unit is $50.
Woodmasters has unused capacity that can be used to finish the tables
and sell them at $60 per unit. For a finished table, direct materials will
increase $2 and direct labor costs will increase $4. Variable
manufacturing overhead costs will increase by $2.40 (60% of direct
labor). No increase is anticipated in fixed manufacturing overhead.
Illustration 23.7

Direct materials $15

Direct labor 10
Variable manufacturing overhead 6
Fixed manufacturing overhead 4
Manufacturing cost per unit $35

LO 4 Copyright ©2021 John Wiley & Sons, Inc. 28

Single-Product Case
Solution (1 of 2)
Illustration 23.8

Should Woodmasters sell or process further?

LO 4 Copyright ©2021 John Wiley & Sons, Inc. 29
Single-Product Case
Solution (2 of 2)
Illustration 23.8

Woodmasters should process further.

LO 4 Copyright ©2021 John Wiley & Sons, Inc. 30
Sell or Process Further
Review Question

Process further as long as the incremental revenue from

processing exceeds:
a. Incremental processing costs
b. Variable processing costs
c. Fixed processing costs
d. No correct answer is given

LO 4 Copyright ©2021 John Wiley & Sons, Inc. 31

Sell or Process Further
Review Answer

Process further as long as the incremental revenue from

processing exceeds:
a. Answer: Incremental processing costs
b. Variable processing costs
c. Fixed processing costs
d. No correct answer is given

LO 4 Copyright ©2021 John Wiley & Sons, Inc. 32

DO IT! 4: Sell or Process Further

Easy Does It manufactures unpainted furniture for the do-

it-yourself (DIY) market. It currently sells a child’s rocking
chair for $25. Production costs per unit are $12 variable
and $8 fixed. Easy Does It is considering painting the
rocking chair and selling it for $35. Variable costs to paint
each chair are expected to be $9, and fixed costs are
expected to be $2.
Prepare an analysis showing whether Easy Does It should
sell unpainted or painted chairs.

LO 4 Copyright ©2021 John Wiley & Sons, Inc. 33

DO IT! 4: Sell or Process Further
Solution

Prepare an analysis showing whether Easy Does It should

sell unpainted or painted chairs.
Net Income Increase
Sell Process Further (Decrease)
Revenues $25 $35 $10
Variable costs 12 21a (9)
Fixed costs 8 10b (2)
Net income $ 5 $ 4 $ (1)
a
$12 + $9; b$8 + $2

LO 4 Copyright ©2021 John Wiley & Sons, Inc. 34

Repair, Retain, or Replace Equipment
LEARNING OBJECTIVE 5

Analyze the relevant costs to be considered in repairing, retaining,

or replacing equipment.

Illustration: Jeffcoat Company has a factory machine that originally cost

$110,000. It has a balance in Accumulated Depreciation of $70,000, so
the machine’s book value is $40,000. It has a remaining useful life of four
years. The company is considering replacing this machine with a new
machine.
A new machine is available that costs $120,000. It is expected to have
zero salvage value at the end of its four-year useful life. If the new
machine is acquired, variable manufacturing costs are expected to
decrease from $160,000 to $125,000 annually, and the old unit could be
sold for $5,000.
Prepare the incremental analysis for the four-year period.
LO 5 Copyright ©2021 John Wiley & Sons, Inc. 35
Repair, Retain, or Replace Equipment
Incremental analysis-retain or replace equipment
(1 of 2)
Prepare the incremental analysis for the four-year period.
Illustration 23.14

Retain or Replace?
LO 5 Copyright ©2021 John Wiley & Sons, Inc. 36
Repair, Retain, or Replace Equipment
Incremental analysis-retain or replace equipment (2 of 2)

Prepare the incremental analysis for the four-year period.

Illustration 23.14

Jeffcoat Company should replace the machine.

LO 5 Copyright ©2021 John Wiley & Sons, Inc. 37
Repair, Retain, or Replace Equipment
Additional Considerations
• Suppose that the manager spent $90,000 repairing a
machine two months ago
o The amount spent to repair the machine is irrelevant to
the current decision
o Costs which cannot be changed by future decisions
(sunk cost) are not relevant in incremental analysis
• Any trade-in allowance or cash disposal value of the
existing asset is relevant

LO 5 Copyright ©2021 John Wiley & Sons, Inc. 38

DO IT! 5: Repair or Replace

Rochester Roofing is faced with a decision. The company relies very

heavily on the use of its 60-foot extension lift for work on large homes
and commercial properties. Last year, the company spent $60,000
refurbishing the lift. It has just determined that another $40,000 of repair
work is required. Alternatively, Rochester Roofing has found a newer used
lift that is for sale for $170,000. The company estimates that both the old
and new lifts would have useful lives of 6 years. However, the new lift is
more efficient and thus would reduce operating expenses from $70,000
to $50,000 each year. The company could also rent the new lift for about
$2,000 per year. The old lift is not suitable for rental. The old lift could
currently be sold for $25,000 if the new lift is purchased. Prepare an
incremental analysis that shows whether the company should repair or
replace the equipment.

LO 5 Copyright ©2021 John Wiley & Sons, Inc. 39

DO IT! 5: Repair or Replace
Prepare an incremental analysis that shows whether the company
should repair or replace the equipment.
Solution:
Retain Replace Net Income Increase
Equipment Equipment (Decrease)
Operating expenses $420,000* $300,000** $120,000
Repair costs 40,000 40,000
Rental revenue $(12,000)*** 12,000
New machine cost 170,000 (170,000)
Sale of old machine (25,000) 25,000
Total cost $460,000 $433,000 $27,000

*6 Years × $70,000
**6 Years × $50,000
***6 Years × $2,000

The analysis indicates that purchasing the new machine would increase
net income for the 6-year period by $27,000.
LO 5 Copyright ©2021 John Wiley & Sons, Inc. 40
Copyright
Copyright © 2021 John Wiley & Sons, Inc.
All rights reserved. Reproduction or translation of this work beyond that permitted in
Section 117 of the 1976 United States Act without the express written permission of the
copyright owner is unlawful. Request for further information should be addressed to the
Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies
for his/her own use only and not for distribution or resale. The Publisher assumes no
responsibility for errors, omissions, or damages, caused by the use of these programs or
from the use of the information contained herein.

Copyright ©2021 John Wiley & Sons, Inc. 41