Chap007_PPT

Chapter 7
Incremental Analysis for

Short-Term Decision Making
© McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC. 7-1
Learning Objective 7-1
Describe the five steps in the decision-making

process.
Steps in the Decision-Making
Process (1 of 2)
Managerial Decision-Making Framework
Steps in the Decision-Making
Process (2 of 2)
Define and identify relevant costs and benefits.
Relevant versus Irrelevant Costs
and Benefits (1 of 2)
Relevant costs have the potential to influence
a decision. Two criteria for a relevant cost:
1. Occurs in the future (after making the
decision).
2. Differs between decision alternatives.
Relevant costs are also called:

• Differential costs
• Incremental costs
• Avoidable costs
Relevant versus Irrelevant Costs
and Benefits (2 of 2)
Irrelevant costs are those that will not
influence a decision.
• Costs that have been incurred in the past
(sunk costs).
• Costs that are the same regardless of the
alternative chosen.
Opportunity Costs and Capacity
Considerations
An opportunity cost is the foregone benefit that
is given up when one alternative is selected
over another.
• At full capacity, adding additional work
requires giving up a portion of the existing
work. The benefit of the existing work given
up is an opportunity cost.
• With idle capacity, additional work may be
added without sacrificing existing work.
There is no opportunity cost to the additional
work.
Exercise 1
Assume you need to buy a new car. The existing car that you
paid $5,000 for two years ago has a current value of $1,500.
You have narrowed the choice down to a used Jeep selling at
$8,000 and a new Ford with selling price of $12,995. You plan
to drive the car for at least 5 years.
Indicate whether each of the following factors would be relevant
or irrelevant to your decision:
a. The $5,000 you paid for your existing car.
b. The $1,500 your car is worth today.
c. The selling price of the Jeep.
d. The selling price of the Ford.
e. The difference in fuel economy for the Jeep and Ford.
f. The cost of parking
g. The difference in insurance cost for the Jeep and Ford.
h. The difference in resale value 5 years from now for the Jeep and Ford.
i. The fact that the Ford (being a new car) comes with a warranty while
the Jeep does not. Qualitative factors to consider
Exercise 1
Assume you need to buy a new car. The existing car that you
paid $5,000 for two years ago has a current value of $1,500.
You have narrowed the choice down to a used Jeep selling at
$8,000 and a new Ford with selling price of $12,995. You plan
to drive the car for at least 5 years.
Indicate whether each of the following factors would be relevant
or irrelevant to your decision:
a. The $5,000 you paid for your existing car.
b. The $1,500 your car is worth today.
c. The selling price of the Jeep.
d. The selling price of the Ford.
e. The difference in fuel economy for the Jeep and Ford.
f. The cost of parking
g. The difference in insurance cost for the Jeep and Ford.
h. The difference in resale value 5 years from now for the Jeep and Ford.
i. The fact that the Ford (being a new car) comes with a warranty while
the Jeep does not. Qualitative factors: safety, down time
Analyze a special-order decision.
Special-Order Decisions (1 of 5)
A special order is a one-time order that is

outside the scope of normal sales.
When analyzing a special order, only the
incremental costs and benefits are relevant.
A major university has asked IKEA to make some
“sit-or-stand” desks for dorm rooms.
The university has offered to buy 5,000 of these
desks at a price of $200 each.
IKEA has the capacity to fill the order without
affecting production of other desk products, which
are normally sold for $300 each in stores, catalogs,
and the company website.
Should IKEA accept the special order?
Incremental Analysis (with Excess Capacity)
The special order will result in a profit of $30.00 per desk and
a total profit of $150,000. Note that fixed costs are excluded
because they are irrelevant to the decision.
Qualitative Analysis
• Three important cautions:

1. This analysis should only be used for
one-time or special orders. In the long-
term, all costs, including fixed costs,
must be covered.
2. The impact that the special order price
might have on customers who pay
through regular channels be considered.
3. The results of this analysis are valid only
if the company has excess, or idle,
production capacity.
Incremental Analysis (without
Excess Capacity) (1 of 3)
Now assume that IKEA is operating at full
production capacity and cannot fill the special order
for 5,000 University sit-or-stand desks without
giving up production and sale of desks sold through
normal channels.
The desks are normally sold in IKEA stores,
catalogs, and the company website for $300 each.
Should IKEA’s managers accept a special-order
price of $200?
Limited Capacity
Unit Cost
Direct materials (wood top, metal legs, lifting mechanism) $ 125.00
Direct labor 30.00
Variable manufacturing overhead (50% of direct labor cost) 15.00
Fixed manufacturing overhead (factory rent, supervision, etc.) 50.00
Total manufacturing cost $220.00
Variable Cost = $170.00

Regular Sit or Stand Desk Sale Per Unit
Regular sales price $300
Variable cost 170
Contribution margin $130
The opportunity cost is the contribution

margin lost on regular sales.
Qualitative Factors for Accepting a Special Order at Full Capacity
There may be other strategic reasons for

accepting the special order:
1. Opportunity to enter a new market or
region
2. Opportunity to increase brand awareness
by partnering with a major university
Please keep in mind, the numerical analysis
must be balanced against these qualitative
factors.
Analyze a make-or-buy decision.
Make-or-Buy Decisions (1 of 3)
A decision to perform a particular activity or

function in-house or purchase from an outside
supplier has traditionally been called a make-or-
buy decision, but it could also be called an
insourcing versus outsourcing decision.
Key Questions Managers Should Ask
1. How much will costs and revenue change?
2. Are there opportunity costs associated with
either alternative?
3. Are there other qualitative factors to consider?
IKEA is trying to decide whether to provide food service or
outsource to another company that specializes in food
service.
An outside supplier bids (pays to IKEA) $5.00 per

customer for the food service work. Should IKEA
outsource the food service?
Incremental Analysis Relating to Food Service
Note that other fixed costs are excluded because they are irrelevant to the decision.
IKEA should outsource the food service.
Qualitative Analysis:
Other Qualitative Factors
• Will the quality of the food service be as good, or
even better, than IKEA can provide internally?
• Is the function a critical part of the company’s
business strategy?
• Are there any safety or liability issues to consider?
• How will outsourcing impact employees and other
critical stakeholders? What will happen to employees
who are let go? Will the supplier hire them?
• 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
any environmental or social impacts to consider?
Analyze a keep-or-drop decision.
Decisions to Keep-or-Drop
Segments (1 of 3)
Managers must sometimes decide whether to
eliminate a particular division or segment of the
business. These decisions are called keep-or-drop
decisions or continue-or-discontinue decisions.
Key Questions
1. How much will total revenue and total costs
change if the segment is eliminated?
2. Will other segments or product lines be affected?
3. Are there opportunity costs associated with
keeping the segment?
4. Are there other qualitative factors to consider?
Decisions to Keep-or-Drop Segments
(1 of 4)
Should IKEA drop the Finnby Bookcase because of the

$200,000 loss last year?
IKEA should consider the segment margin of $100,000.

(2 of 4)
Impact on Other Segments
• Elimination of the Finnby bookcase will eliminate the revenues,
variable costs, and direct fixed costs for the Finnby bookcase
profit.
• Elimination of the Finnby bookcase will increase sales of the
Hemnes bookcase by 10 percent, with no effect on the Billy
bookcase.
• Total variable costs of the Hemnes bookcase will also increase by
10 percent as a result of the increased sales.
• The net effect will be a 10 percent increase in the contribution
margin of the Hemnes bookcase.
• Total common fixed costs will not be affected by the elimination
of the Hemnes bookcase. They will be reallocated to the
remaining products based on total sales dollars.
Opportunity Costs
• There are no alternative uses for the resources.
(3 of 4)
Incremental Analysis
(4 of 4)
Using the Segmented Income Statement in the Analysis
Qualitative Analysis: Other Factors
to Consider
What is the impact on customer loyalty and
employee moral?
Will there be any impact on other products and
customers?
• Regarding substitute goods, customers
might choose an alternate good, for
example, purchasing the Hemnes bookcase if
the Finnby bookcase was unavailable.
• However, with complementary goods,
eliminating one product could have a
negative effect on the related product.
Analyze a sell-or-process-further decision.
Sell-or-Process-Further Decisions
(1 of 4)
Businesses are often faced with the decision
to sell a product “as is” or add additional
features (refine) it so that it can be sold for a
higher price.
• As a general rule, we process further only
if incremental revenues exceed incremental
costs.
• Costs of manufacturing the product up to the
sell-or-process decision point are sunk and
therefore irrelevant.
(2 of 4)
• IKEA is deciding on whether to add new features
to one of its entertainment wall units to include
lighted shelves and outlets for charging electronic
devices. Based on existing design (without these
features), managers expect to sell 10,000 units
at a price of $150 each.
• If the company spends an additional $10,000 on
updating the design specifications and assembly
instructions, they believe they can increase the
price to $200, but will only be able to sell 8,000
units. However, the enhanced wall unit would
have a higher manufacturing cost.
(3 of 4)
(4 of 4)
Incremental Analysis
Prioritize products to maximize short-term

profit with constrained resources.
Prioritizing Products with
Constrained Resources (1 of 4)
When a limited resource restricts a company’s
ability to satisfy demand, the company is said to
have a constrained resource that is referred to as
a bottleneck.
To maximize profits in the short run, a company
with a bottleneck must prioritize its products or
services so as to maximize contribution
margin per unit of the constrained resource.
The focus is on contribution margin because
fixed costs will not change in the short run and
are not relevant.
Prioritizing Products with Constrained
Resources (2 of 4)
One of IKEA’s factories produces three sizes of patio tables:
2-person (small), 4-person (medium), and 6-person (large)
with the following financial and production information.
Assume the company has only 300,000 feet of hardwood available.

Available hardwood is the bottleneck (limited resource).
Which tables should managers produce in order to maximize
profits?
Summary of Incremental Analysis
(1 of 2)
Common Rules for Analyzing Relevant Costs and
Benefits:
• 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.
• Fixed costs may not be relevant because they do not
change with the number of units produced or sold.
Summary of Incremental Analysis
(2 of 2)
• 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.
• The quantitative analysis provides a starting point for
making decisions but must be balanced against other
qualitative factors.
Exercise 2 (part a)
Fannie Company produces ceiling fans that include remotes to
operate them. The current cost to make 10,000 remotes follows:
Direct materials $65,000
Direct labor $55,000
Variable overhead $30,000
Fixed overhead $50,000
Total $200,000 unit cost: $20
Fannie can buy 10,000 remotes from a supplier for $18 per unit.
Consider the following scenario individually, should Fannie decided
to make or buy the remotes?
a. if none of the fixed overhead can be avoided?
Relevant cost to make:
Relevant cost to buy:
Total cost to make:

Total cost to buy:
Exercise 2 (part a)
operate them. The current cost to make 10,000 remotes follows:
Total $200,000 unit cost: $20
to make or buy the remotes
a. if none of the fixed overhead can be avoided?
Relevant cost to make: ($65,000+$55,000+$30,000)/10,000= $15
Relevant cost to buy: $18
Total cost to make: $200,000

Total cost to buy: $18*10,000 + $50,000 = $230,000
Exercise 2 (part b)
operate them. The current cost to make 10,000 remotes is as
follows:
Total $200,000
b. if $20,000 of the fixed overhead can be avoided?

Cost per unit to make: $20 per unit
Cost per unit to buy:
Exercise 2 (part b)
operate them. The current cost to make 10,000 remotes is as
follows:
Total $200,000
b. if $20,000 of the fixed overhead can be avoided?

Cost per unit to buy: $18 + $30,000/10,000 = $21 per unit
Exercise 2 (part c)
Fannie Company produces ceiling fans that include remotes to operate
them. The current cost to make 10,000 remotes is as follows:
Total $200,000
Fannie is approached by a supplier which offers to make the remotes for
$18 per unit.
Consider the following scenario individually, should Fannie decided to
make or buy the remotes?
c. if $20,000 of the fixed overhead can be avoided and Fannie can

rent out the factory space for $20,000?

Cost per unit to buy:
Exercise 2 (part c)
Fannie Company produces ceiling fans that include remotes to operate
them. The current cost to make 10,000 remotes is as follows:
Total $200,000
Fannie is approached by a supplier which offers to make the remotes for
$18 per unit.
Consider the following scenario individually, should Fannie decided to
make or buy the remotes?
c. if $20,000 of the fixed overhead can be avoided and Fannie can

rent out the factory space for $20,000?

Cost per unit to buy: $18 + ($30,000 - $20,000)/10,000 = $19 per unit
Buy is better

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Chapter 7

Incremental Analysis for

Describe the five steps in the decision-making

Define and identify relevant costs and benefits.

Relevant costs are also called:

Analyze a special-order decision.

A special order is a one-time order that is

Should IKEA accept the special order?

• Three important cautions:

Variable Cost = $170.00

The opportunity cost is the contribution

There may be other strategic reasons for

Analyze a make-or-buy decision.

A decision to perform a particular activity or

An outside supplier bids (pays to IKEA) $5.00 per

Analyze a keep-or-drop decision.

Should IKEA drop the Finnby Bookcase because of the

IKEA should consider the segment margin of $100,000.

Analyze a sell-or-process-further decision.

Prioritize products to maximize short-term

Assume the company has only 300,000 feet of hardwood available.

Total cost to make:

Total cost to make: $200,000

b. if $20,000 of the fixed overhead can be avoided?

b. if $20,000 of the fixed overhead can be avoided?

c. if $20,000 of the fixed overhead can be avoided and Fannie can

Cost per unit to make: $20 per unit

c. if $20,000 of the fixed overhead can be avoided and Fannie can

Cost per unit to make: $20 per unit

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