:‫محاضرات لها عالقة بالوحدة‬

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 Making decisions is an important management function.
o Does not always follow a set pattern because decisions vary significantly
in their scope, urgency, and importance.

o Steps usually involved in process include:

 In making business decisions, management ordinarily considers both financial
and nonfinancial information.
o Financial information
 Revenues and costs
 Effect on overall profitability.
o Nonfinancial information
 Effect on employee turnover,
 The environment,
 Overall image of the company in the community.

Financial information ‫التركيز في هذه الوحد على ال‬

Incremental Analysis Approach

 Decisions involve a choice among alternative actions.

 The process used to identify the financial data that change under alternative
courses of action is called incremental analysis.

 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.

How Incremental Analysis Works

Basic approach in incremental analysis

Comparison of Alternative B with Alternative A:

 Incremental revenue is $15,000 less under Alternative B
 Incremental cost savings of $20,000 is realized
 Thus, Alternative B produces $5,000 more net income than Alternative A
 Three important cost concepts used in incremental analysis
 o Relevant Cost
o Opportunity Cost
o Sunk Cost
 https://www.youtube.com/watch?v=RijZDMI2hqI&t=20s&ab_channel=Inte
rmediateFinancialAccountingI

In other meaning:
Relevant costs Those costs and revenues that differ across alternatives.
Opportunity cost The potential benefit that is lost when one course of action is chosen
rather than an alternative course of action.
Sunk cost A cost that cannot be changed or avoided by any present or future decision.
  Incremental analysis sometimes involves changes that at first glance might
seem contrary to your intuition.

Variable costs, sometimes, do not change under the alternative

courses of action.
Fixed costs, sometimes, do change, between alternatives.

For example, direct labor, normally a variable cost, is not an

incremental cost in deciding between two new factory machines if
each asset requires the same amount of direct labor. In contrast, rent
expense, normally a fixed cost, is an incremental cost in a decision
whether to continue occupancy of a building or to purchase or lease a
new building.

Types of Incremental Analysis

A number of different types of decisions involve incremental analysis. The more
common types of decisions are whether to:
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.
We consider each of these types of decisions in the following pages.
Sometimes a company has an opportunity to obtain additional business if it is
willing to make a price concession to a specific customer.
Example: assume that Sunbelt Company produces 100,000 Smoothie blenders per
month, which is 80% of plant 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. Sunbelt has an offer
from Kensington Co. (a foreign wholesaler) to purchase an additional 2,000
blenders at $11 per unit. Acceptance of the offer would not affect normal sales of
the product, and the additional units can be manufactured without increasing
plant capacity.

What should management do?

 Sunbelt increases its net income by $6,000 by accepting this special order.

Two points should be emphasized.

First, we assume that sales of the product in other markets would not be
affected by this special order. If other sales were affected, then Sunbelt
would have to consider the lost sales in making the decision.

Second, if Sunbelt is operating at full capacity, it is likely that the special

order would be rejected. Under such circumstances, the company would
have to expand plant capacity. In that case, the special order would have
to absorb these additional fixed manufacturing costs, as well as the
variable manufacturing costs.
Answer
When a manufacturer assembles component parts in producing a finished product,
management must decide whether to make or buy the components. The decision
to buy parts or services is often referred to as outsourcing.

The decision to make or buy components should be made on the basis of

incremental analysis.

EXAMPLE: Baron Company makes motorcycles and scooters. It incurs the

following annual costs in producing 25,000 ignition switches for scooters.

Instead of making its own switches, Baron Company might purchase the ignition
switches from Ignition, Inc. at a price of $8 per unit.

What should management do?

At first glance, it appears that management should purchase the ignition switches
for $8 rather than make them at a cost of $9. However, a review of operations
indicates that if the ignition switches are purchased from Ignition, Inc., all of
Baron’s variable costs but only $10,000 of its fixed manufacturing costs will be
eliminated (avoided). Thus, $50,000 of the fixed manufacturing costs remain if the
ignition switches are purchased. The relevant costs for incremental analysis,
therefore, are as shown below.

 Manufacturing cost is $1 higher per unit than purchase price.

 Must absorb at least $50,000 of fixed costs under either option.
Opportunity Cost

The foregoing make-or-buy analysis is complete only if it is assumed that the

productive capacity used to make the ignition switches cannot be converted to
another purpose. If there is an opportunity to use this productive capacity in some
other manner, then this opportunity cost must be considered. As indicated earlier,
opportunity cost is the potential benefit that may be obtained by following an
alternative course of action.

Example, 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. This opportunity cost is
therefore added to the “Make” column for comparison. As shown in Illustration 7-
7, it is now advantageous to buy the ignition switches. The company’s income
would increase by $13,000.

The qualitative factors in this decision include the possible loss of jobs for employees who
produce the ignition switches. In addition, management must assess the supplier’s ability
to satisfy the company’s quality control standards at the quoted price per unit.
Answer
Answer
4

Many manufacturers have the option of selling products at a given point in the
production cycle or continuing to process with the expectation of selling them at a
later point at a higher price.
For example, a bicycle manufacturer could sell its bicycles to retailers either
unassembled or assembled. A furniture manufacturer could sell its dining room sets
to furniture stores either unfinished or finished. The sell or-process-further
decision should be made on the basis of incremental analysis. The basic decision
rule is: Process further as long as the incremental revenue from such processing
exceeds the incremental processing costs.

Single-Product Case

Assume, for example, that Woodmasters Inc. makes tables. It sells unfinished tables
for $50. The cost to manufacture an unfinished table is $35, computed as follows.
Woodmasters currently has unused productive capacity that is expected to
continue indefinitely. Some of this capacity could 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.

Should the company sell the unfinished tables, or should it process them
further? The incremental analysis on a per unit basis is as follows.

It would be advantageous for Woodmasters to process the tables further. The

incremental revenue of $10.00 from the additional processing is $1.60 higher than
the incremental processing costs of $8.40.
Multiple-Product Case

Joint costs are the costs of a production process that yields multiple products
simultaneously.
Split-off point is the juncture in a joint production process when two or more
products become separately identifiable.
Separable costs are all costs— manufacturing, marketing, distribution, and so on
incurred beyond the splitoff point that are assignable to each of the specific
products identified at the splitoff point.

 The outputs of a joint production process can be classified into two general
categories:
1 - outputs with a positive sales value
2- outputs with a zero sales value (we don’t call it product)

 Three types of products

• Main product: when a joint production process yields one product with a
high total sales value, compared with the total sales values of other products
of the process.
• Joint products: when a joint production process yields two or more products
with high total sales values relative to the total sales values of other
products.
• Byproducts: products of a joint production process that have low total sales
values relative to the total sales value of the main product or of joint
products.

Reminder: we classify them into based on their selling value

For example,
In the meat-packing industry, the companies could process a cow or pig into meat,
internal organs, hides ‫جلود‬, bones, and fat products.
In the petroleum industry, the companies could refine crude oil to produce
gasoline, lubricating oil, kerosene, paraffin, and ethylene.

Illustration 7-10 presents a joint product situation for Marais Creamery involving a
decision to sell or process further cream and skim milk. Cream and skim milk are
joint products that result from the processing of raw milk.
 All costs incurred prior to the point at which the two products are separately
identifiable (the split-off point) are called joint costs.
 For purposes of determining the cost of each product, joint product costs must
be allocated to the individual products. This is frequently done based on the
relative sales value of the joint products.
o While this allocation is important for determination of product cost, it is
irrelevant for any sell-or-process-further decisions. The reason is that
these joint product costs are sunk costs.

Illustration 7-11 provides the daily cost and revenue data for Marais
Creamery related to cream and cottage cheese.

Note that the joint cost that is allocated to the cream is not included in this decision. It is not
relevant to the decision because it is a sunk cost. It has been incurred in the past and will remain
the same no matter whether the cream is subsequently processed into cottage cheese or not.
  From this analysis, we can see that Marais should not process the cream
further because it will sustain an incremental loss of $2,000.

Illustration 7-13 provides the daily cost and revenue data for the company related
to skim milk and condensed milk.

 Marais Company should process the skim milk into condensed milk, as it
will increase net income by $7,000.
Note: These decisions need to be reevaluated as market conditions change. For example, if the
price of skim milk increases relative to the price of condensed milk, it may become more
profitable to sell the skim milk rather than process it into condensed milk. Consider also oil
refineries. As market conditions change, the companies must constantly re-assess which
products to produce from the oil they receive at their plants.
Answer:
Answer
Answer
Management often has to decide whether to *continue using an asset,
*repair, or *replace it.

For example, Delta Airlines must decide whether to replace old jets with
new, more fuel efficient ones.

To illustrate, assume that 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.
The incremental analysis for the four-year period is as follows.

Replace it
Notes:
 The $5,000 received from the sale of the old machine is relevant to the
decision because it will only be received if the company chooses to
replace its equipment. In general, any trade-in allowance or cash
disposal value of existing assets is relevant to the decision to retain or
replace equipment.

 The book value of the old machine does not affect the decision.
Book value is a sunk cost, which is a cost that cannot be changed by
any present or future decision. Sunk costs are not relevant in
incremental analysis.

Refer to the book (Page 219) – Important notes available in this decision

Your notes:
Management sometimes must decide whether to eliminate an unprofitable
business segment or product.

Example: Assume that Venus Company manufactures tennis racquets in

three models: Pro, Master, and Champ. Pro and Master are profitable lines.
Champ (highlighted in red in the table below) operates at a loss. Condensed
income statement data are as follows.

You might think that total net income will increase by $20,000 to $240,000 if
the unprofitable Champ line of racquets is eliminated. However, net income
may actually decrease if the Champ line is discontinued.

Why?

The reason is that if the fixed costs allocated to the Champ racquets cannot
be eliminated, they will have to be absorbed by the other products.

Let’s assume that $30,000 of the fixed costs applicable to the unprofitable
segment are allocated 2/3 to Pro model and 1/3 to master model if the
Champ model is eliminated.
The Above result is also obtained in the following incremental analysis
Illustration 7-18

Assume the same facts as above, except now assume that $22,000 of the
fixed costs attributed to the Champ line can be eliminated if the line is
discontinued. Illustration 7-19 presents the incremental analysis based on
this revised assumption.
Illustration 7-19

In this case, because the company is able to eliminate some of its fixed costs
by eliminating the division, it can increase its net income by $12,000. This
occurs because the $22,000 savings that results from the eliminated
fixed costs exceeds the $10,000 in lost contribution margin by $12,000
($22,000 - $10,000).