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Chapter 21
Incremental Analysis

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 Introduction: The Kroger Co. 1

The Kroger Co. was founded in 18 83 and incorporated in

1902. Today, the company is one of the largest retailers in
the world with annual sales in excess of $135 billion. Kroger
operates approximately 2,800 supermarkets under various
names, of which more than 2,250 properties have
pharmacies, and nearly 1,600 operate fuel centers. In
addition to selling national brand merchandise and
thousands of other items packaged under its private label,
the company also manufactures and processes of some of
the foods sold in its supermarkets nationwide.

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 Introduction: The Kroger Co. 2

Kroger managers make important decisions on a daily basis

that involve the focus of this chapter. These include
determining which foods to make versus which foods to buy,
choosing wholesale produce venders, deciding which cuts of
meat to process into hamburger and which cuts to sell as
steaks or roasts, selecting which foods to feature in its weekly
ads, etc. These decisions, and others, are short term in nature
and compatible with incremental analysis. In a later chapter,
we will exam decisions having long-term consequences, which
for Kroger would involve decisions to open new stores,
upgrade computer systems, construct a distribution center,
purchase food processing equipment, etc.

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 The Challenge of Changing Markets
Short-run business decisions are inherently different from
future-oriented, long-run strategic plans.
• Short-run decisions are made with a fixed set of resources
and must meet the demands of the current marketplace.
• There is no time to create demand or acquire a
significantly different resource base.

Costs identified as important for a particular business

decision are called relevant costs.

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 Specific Decisions
Good judgment about relevant information occurs by looking
through the lens of the particular decision under
consideration.
Specific decisions to be examined in this chapter include:

1. Special order decisions.

2. Production constraint decisions.
3. Make or buy decisions.

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 Relevant Financial Information

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 Concept of Relevant Cost Information
Kevin Anderson is a sophomore at the University of Minnesota in
Minneapolis.
Following the most brutal winter ever recorded in the state’s history,
Anderson is faced with an extremely important decision: Should he
drive to Miami for spring break, or should he fly?
• If he drives, he will leave on Saturday, stay in a roadside motel
Saturday night, and arrive in Miami late Sunday evening, allowing
him to enjoy five full days in Miami (Monday through Friday).
• However, he would have to leave the following Saturday, and
spend another Saturday night in a motel, to arrive back in
Minneapolis late Sunday evening.
• If he flies, he will simply leave on Saturday morning and arrive in
Miami late that night, allowing him to relax on the beach for seven
full days before having to fly back to Minnesota Sunday.
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 Identifying Relevant Information

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 Analyze the Information and Make a
Decision 1

Let’s help Kevin analyze this information and make a decision

regarding his vacation plans.
• If he decides to drive to Florida, he must stay a total of eight
nights in a motel (two nights on the interstate and six nights
in Miami).
• If he decides to fly, he must also stay eight nights in a motel
(from Saturday through Saturday in Miami).
• Thus, if we assume that the cost of a room in Miami does not
differ significantly from the cost of a room along the
interstate, motel charges are not relevant in deciding
between driving or flying.

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 Analyze the Information and Make a
Decision 2

• The same logic applies to the dog sitting cost and the cost of
Kevin’s meals. Regardless of how Kevin gets to Miami, he
will be away from Minneapolis a total of nine days and eight
nights. Thus the dog will require the same amount of care,
and Kevin’s total food costs will be about the same, whether
he drives or flies.
• Therefore, the costs associated with dog sitting and meals
are not relevant in deciding between driving or flying.

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 Analyze the Information and Make a
Decision 3

• How about the $800 Kevin spent for car insurance? This cost
has already been incurred and will not be affected by
whether Kevin drives or flies.
• Such past costs, which cannot be affected by future
decisions, are termed sunk costs.
• Sunk costs are not relevant to making decisions about the
future.

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 Analyze the Information and Make a
Decision 4

In financial terms, Kevin’s decision can be made by comparing the

$300 he would spend for gasoline if he drives to the $500 he would
spend for a round-trip airline ticket and taxi if he flies.
Thus we may be tempted to tell him to drive and save $200.
However, there are other nonfinancial factors Kevin may wish to
consider.
• How much does he value the two extra days he can spend on the
beach if he flies?
• What physical condition will he be in if he decides to drive?
• How much wear-and-tear must his car endure if he drives?
• Might his car break down and spoil his plans?
• Which mode of transportation is the safest?

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 Relevant Information in Business
Decisions
Identifying all of the information relevant to a particular
business decision is a challenging task, because relevance is
a broad concept.
The process requires the following:
• An understanding of quantitative and qualitative information.
• A grasp of legal issues.
• Sensitivity to ethical concerns.
• An ability to discern fact from opinion.

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 Illustration: Relevant Costs 1

Assume that Redstar Ketchup Company is closed for a labor

strike. During the strike, Redstar is incurring costs of
approximately $15,000 per week for utilities, interest, and
salaries of nonstriking employees. A major film company has
offered to rent the ketchup factory for a week at a price of
$10,000 to shoot several scenes of a new superhero action
movie. If the factory is rented, Redstar’s management
estimates that its cleanup costs will amount to nearly $2,000.
Solely on the basis of this information, would it be profitable
to rent the ketchup factory to the film company?

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 Illustration: Relevant Costs 2

If the factory is rented, Redstar’s profitability for the week

may be measured as follows.
Revenue $10,000
Cost and expenses:
Weekly factory expenses $15,000
Cleanup costs 2,000 17,000
Operating income (loss) $(7,000)

• Does an anticipated operating loss of $7,000 mean that

Redstar should refuse the film company’s offer?
• A closer examination reveals that not all of the information
in this income statement is relevant to this particular
decision.
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 Illustration: Relevant Costs 3

• The $15,000 in weekly factory expenses will continue

whether or not the factory is rented to the film company.
• Thus the relevant factors in this decision are the
differences in the costs incurred and the revenue earned
under the alternative courses of action (renting or not
renting).
• These differences are referred to often as incremental (or
differential) costs and revenues.

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 Illustration: Relevant Costs 4

Reject Accept Incremental

Offer Offer Analysis
Revenue $ 0 $10,000 $10,000
Costs and expenses:
Weekly factory expenses (15,000) (15,000) 0
Estimated cleanup costs 0 (2,000) (2,000)
Operating income (loss) $(15,000) $(7,000) $ 8,000

• Our analysis shows that accepting the film company’s offer

will result in $10,000 of incremental revenue but only
$2,000 in incremental costs.
• Thus renting the ketchup factory to the film company will
benefit Redstar by reducing its operating loss for the week
by $8,000.
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 Opportunity Costs
An opportunity cost is the benefit that could have been
obtained by pursuing an alternative course of action.
• For example, assume that you pass up a summer job that
pays $4,000 and instead attend summer school. The
$4,000 may be viewed as an opportunity cost of attending
summer school.

Although opportunity costs are not recorded in a company’s

accounting records, they are important factors to consider in
many business decisions.

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 Sunk Costs versus Out-of-Pocket Costs

A sunk cost is one that has already been incurred and cannot
be changed by future actions.
An out-of-pocket cost describes a cost that has not yet been
incurred and that may vary among the possible courses of
action.

Key Point
The only costs relevant to a decision are those that vary
among the courses of action being considered. Sunk costs
are not relevant because they cannot be changed,
regardless of what decision is made.

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 Special Order Decisions 1

Assume that Par Four manufactures golf balls that it

distributes exclusively through professional golf shops in the
United States. Although the company has the capacity to
manufacture two million balls per month, its current sales
volume requires that only 800,000 units be produced. At this
level of output, monthly manufacturing costs average
approximately $480,000, or $0.60 per ball as follows.

Manufacturing costs:
Variable ($0.20 per ball × 800,000 balls ) $160,000
Fixed 320,000
Total cost of manufacturing 800,000 balls per month $480,000
Average manufacturing cost per ball ($480,000 ÷ 800,000 balls) $ 0.60

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 Special Order Decisions 2

• Assume that Par Four receives a special order from N GC,

a company that sells golf products in Japan, for 500,000
“special label” golf balls per month.
• The balls would be imprinted with the N GC name and logo
and would not in any way be identified with Par Four.
• To avoid direct competition with Par Four’s regular
customers, NGC has agreed not to sell these balls outside
of Japan.
• However, it is willing to pay Par Four only $250,000 per
month for the special order, which amounts to $0.50 per
ball.
• Would it be profitable for Par Four to accept this order?

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 Special Order Decisions 3

• At first glance, the order appears to be unprofitable.

• Not only is NGC’s offer of $0.50 per ball much less than
the regular sales price of $1.25, it is even less than Par
Four’s $0.60 per-unit manufacturing cost.
• However, before we decide to reject N GC’s order, let us
first perform an incremental analysis of the costs and
revenue relevant to this decision.

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 Special Order Decisions 4

Production Level:
Production Level: Production Level:
Without Special
With Special order Incremental
Order (800,000
(1,300,000 balls) Analysis
balls)
Sales:

Regular sales @ $1.25 $1,000,000 $1,000,000 $ –0–

Special order @ $0.50 –0– 250,000 250,000

Manufacturing costs:

Variable @ $0.20 per ball (160,000) (260,000) (100,000)

Fixed manufacturing
(320,000) (320,000) –0–
costs per month
Gross profit on sales $ 520,000 $ 670,000 $ 150,000

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 Special Order Decisions 5

• The relevant factors in this type of decision are the

incremental (additional) revenue that will be earned and
the incremental costs that will be incurred by accepting the
order.
• Only the additional variable costs of $0.20 per unit are
relevant to this decision, because the fixed costs remain
$320,000 regardless of whether the order is accepted or
not.
• The special order should increase operating income
by $150,000 per month (500,000 balls × $0.30 per unit).

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 Your Turn: You as a Sales Representative

Assume that you are a sales representative for Par Four.

One of your best customers, Clubs & Caddies, a chain of
retail golf shops, has heard about the special order shipment
to NGC in Japan. Clubs & Caddies has been paying $0.80
per ball and would like the same special order price given to
NGC. In fact, the purchasing manager at Clubs & Caddies
says it is unethical for you not to sell at the same price per
ball that you are charging NGC. How should you respond?

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 Production Constraint Decisions 1

Assume that Fran’s Studio creates three products: (1)

watercolor paintings, (2) oil paintings, and (3) custom frames.
Total output, however, is limited to what can be produced in
6,000 hours of direct labor. The contribution margin per direct
labor hour required to complete each of the studio’s products
is as follows.
Unit Unit Unit Direct Labor
Contribution
Selling − Variable = Contribution ÷ Hours Required =
Margin per hour
Product Price costs Margin per Unit
Watercolor
$ 90 $30 $ 60 2 $30
paintings
Oil paintings 160 60 100 4 25

Custom frames 35 15 20 1 20

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 Production Constraint Decisions 2

• Notice that oil paintings generate the highest contribution

margin on a per-unit basis ($100).
• However, watercolors are the studio’s most profitable
product in terms of their contribution margin per direct
labor hour.
• In general, when capacity is constrained by the limited
availability of a particular input, a company should attempt
to maximize its contribution margin per unit of that input.

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 Production Constraint Decisions 3

The table below shows the total contribution margin Fran’s

Studio would earn if it used all 6,000 of its annual labor hours
to create a single product line. The studio can maximize its
total contribution margin and, therefore, its operating income,
by creating only watercolor paintings.

Contribution Total Contribution

Total Capacity
× Margin per Hour of = Margin if Only One
(Hours)
Direct Labor Product Is Created
Watercolors 6,000 $30 $180,000

Oil paintings 6,000 25 150,000

Custom frames 6,000 20 120,000

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 Production Constraint Decisions 4

In most cases, however, a company cannot simply

manufacture the single product that is most profitable.
For example, the demand for watercolors may not be
sufficient to allow Fran’s Studio to sell all of the watercolor
paintings it is capable of producing.
• In this case, operating income would be maximized by
creating oil paintings once the demand for watercolors is
satisfied.
• If the demand for oil paintings is also met, any remaining
direct labor hours would be devoted to producing custom
frames.

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 Your Turn: You as a Store Manager
Assume that you are the store manager of Fran’s Studio.
Fran would like you to expand the store by selling posters
and prints in addition to the watercolors and oil paintings
currently produced by the studio. Do you think the posters
and prints are complementary with the other products sold at
Fran’s Studio? Explain why or why not.

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 Make or Buy Decisions 1

• In many manufacturing operations, a company must

decide whether to produce a certain part required in the
assembly of its finished products or to buy the part from
outside suppliers.
• If the company is currently producing a part that could be
purchased at a lower cost from outsiders, profits may be
increased by a decision to buy the part and utilize the
company’s own manufacturing resources for other
purposes.

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 Make or Buy Decisions 2

If a company can buy for $5 per unit a part that costs the company
$6 per unit to produce, the choice seems to be clearly in favor of
buying. But the astute reader will quickly raise the question, “What
is included in the cost of $6 per unit?” Assume that the $6 unit cost
of producing a normal required volume of 10,000 units per month
was determined as follows.
Manufacturing costs:
Direct materials $ 8,000
Direct labor 12,500
Variable overhead 10,000
Fixed overhead per month 29,500
Total cost of manufacturing 10,000 per month $60,000
Average manufacturing cost per unit ($60,000 ÷ 10,000 units) $6

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 Make or Buy Decisions 3

Assume that a review of operations indicates that if the production

of this part were discontinued, all of the cost of direct materials and
direct labor plus $9,000 of variable overhead would be eliminated.
In addition, $2,500 of the fixed overhead would be eliminated.
These, then, are the relevant costs in producing the 10,000 units
of the component part.
Make the Part Buy the Part Incremental Analysis
Manufacturing costs for 10,000 units:
Direct materials $ 8,000 $ 8,000
Direct labor 12,500 12,500
Variable overhead 10,000 $1,000 9,000
Fixed overhead 29,500 27,000 2,500
Purchase price of part, $5 per unit - 50,000 (50,000)
Total cost to acquire part $60,000 $78,000 $(18,000)

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 Make or Buy Decisions 4

• Our analysis shows that making the part will cost $60,000 per
month, while buying the part will cost $78,000.
• Thus the company will save $18,000 per month by continuing to
make the part.
Key Point
In addition to evaluating the opportunity costs associated with a
make or buy decision, managers must evaluate other important
concerns that are nonfinancial in nature including:
• Product quality.
• Production scheduling and flexibility.
• Product availability.
• Supplier relationships.

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 Decision-Focused Judgment

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 Learning Objective Summary LO21-1
LO21-1: Explain what makes information relevant to a
particular business decision. Only information that varies
among the alternative courses of action being considered is
relevant to the decision. Costs or revenue that does not vary
among the alternative courses of action is not relevant to the
decision.

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 Learning Objective Summary LO21-2
LO21-2: Discuss the relevance of opportunity costs,
sunk costs, and out-of-pocket costs in making business
decisions. An opportunity cost is the benefit that could have
been obtained by pursuing another course of action.
Opportunity costs often are subjective, but they are important
considerations in any business decision. Sunk costs, on the
other hand, have already been incurred as a result of past
actions. These costs cannot be changed regardless of the
action taken and are not relevant to the decision at hand.
Out-of-pocket costs will be incurred in the future and are
relevant if they will vary among the possible courses of
action.

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 Learning Objective Summary LO21-3
LO21-3: Use incremental analysis in common business
decisions. Incremental analysis is the technique of
comparing one course of action to another by determining
the differences expected to arise in revenue and in costs.

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 Learning Objective Summary LO21-4
LO21-4: Discuss how contribution margin can be
maximized when one factor limits productive capacity.
Identify the production input factor that limits the amount of
output. Then determine the output mix that maximizes the
contribution margin per unit of the limiting factor.

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 Learning Objective Summary LO21-5
LO21-5: Identify nonfinancial considerations and
creatively search for better courses of action. Examples
of relevant nonfinancial information include legal and ethical
considerations and the long-run effects of decisions on
company image, employee morale, and the environment.
Also, managers should search creatively for alternative
courses of action. Unless a company selects the best
possible course of action, it incurs an opportunity cost.
Opportunity costs are not recorded in the accounting
records, but they may determine the success or failure of a
business enterprise.

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