CH 11: Incremental Analysis (The Key to Decision Making)

Incremental Analysis

What is the key to decision making?

unavoidable

Depreciation expense on previously purchased machinery that is used in the Orange County division; the machinery will have no other use or resale value if the division is dropped. Depreciation is an ___ cost.

incremental costs (ignore sunk costs)

for special order decisions consider only:

irrelevant

Costs and revenues that do not differ between alternatives are _____ to decision making.

Differential benefits > Differential costs

When does a company get financial advantage in incremental analysis?

differential analysis

incremental analysis is also known as

incremental analysis

process in which managers identify data that change under alternative actions to allow managers to choose among alternatives (compare to total cost approach)

Relevant

for incremental analysis, it is important to identify which revenues and costs are ___ to the decision

change, may or may not change

during incremental analysis, the VC will ___ , and the FC ___.

idle capacity

the FC will or will not change based on the existence of ___.

idle capacity

not being used; if you have ___, FL will change very little if you decided to change (add customer or product line)

at least two

within incremental analysis, there will always be ___ alternatives

incremental revenue

the total difference in revenues among the two alternatives

incremental cost

the total difference in costs among the two alternatives

relevant costs

future costs that differ among the alternatives

relevant revenues

future revenues that differ among the alternatives

relevant costs

examples of ___: tuition and books when considering to go/not to go college

avoidable costs

a cost that can be eliminated (in whole or part) by choosing one alternative other another

relevant costs

avoidable costs are considered __-

avoidable costs

examples of ___: you can avoid tuition if you don’t attend college

sunk costs

cost that has already been incurred (and cannot be changed)

not relevant

sunk costs are considered:

sunk cost

examples of ___: decision to drop a class- tuition, books, and time spent on the class

opportunity costs

benefits forgone (ie income/profits) by choosing the best alternative (most profitable option)

opportunity costs

examples of ___: full-time income you give up to attend college

saves time, and places focus on what’s relevant

Why use incremental analysis approach? (advantages)

special orders, add/drop segments, further processing joint products, Sourcing decisions, utilizing constrained resources

What are the 5 decisions that can use incremental analysis to determine the best course of action?

special orders

occur when a customer orders a product that differs from the standard output or offers a price lower than usual sales price

incremental rev > incremental costs

Special orders are accepted if:

increase, increase, may or may not increase

special orders typically cause revenues to ___, VC to __, and FC’s to _ (depends on if idle capacity exists)

add/drop a segment

focus’s on relevant info such as the loss of the CM off the segment and the FC we can eleminate

decrease

when dropping a segment, total revenues will ___ by the amount of the division’s revenues

decrease

when dropping a segment, total VC will ___ by that division’s variable costs

avoidable

Only ___ FC can be eliminated when dropping a segment, the rest of the FC is sunk costs.

FC eliminated > CM lost

Retain the segment unless:

sell as-is or process further

what are the two options when joint products emerge

joint products

end products resulting from a company using a single raw material to make a product

cost of crude oil makes gasoline and kerosine which can be further processed into high octane gas

Example of joint products

split-off point

point in manufacturing process at which the joint products can be recognized as separate products (these products can now be sold as is or sent to further processing)

joint cost

costs incurred up to split-off point. These costs are not relevant in process further decisions because they are sunk costs.

Incremental Rev > incremental costs

Process further if:

sourcing decisions

company must decide whether to make a component part or buy it from an external supplier

“outsourcing”

buying component parts from an external supplier is also called:

opportunity costs

Note on Sourcing decisions: make sure to consider the ___ if facilities could be used to manufacture another product (ask: what is the best use of the capacity)

change, may or may not change

If the part is made in company, then VC will generally ___ and FC ___

product quality, relationship with supplier, dependability of supplier

factors that influence sourcing decisions:

utilization of a constrained resource

management must decide which products to produce and sell to maximize net income

product mix decisions

utilization of constrained resources are also known as

CM / unit and the CM ratio

If resources are not limited, for product mix decisions: simply rank product lines according to the___ .

floor space

Ex of constrained resource for a retailer

Raw material, DL hours, Machine Capacity

Ex of constrained resources for a manufacturer

greatest CM / unit of scarce resource

If resources are limited, for product mix decisions: emphasize products with the ___ .

work overtime, hire subcontractors, shift workers to bottleneck processes, invest in additional equipment, and make process improvements

how do managers manage constraints: (5)

incremental CM / hr - Incremental Cost / hr

Incremental Profit / hr = (formula)