Chapter 21—Incremental Analysis
Financial and Managerial Accounting, 18e 21-1
21 INCREMENTAL ANALYSIS
Chapter Summary
The short-run planning problems covered in Chapter 21 are a natural extension of
cost-volume-profit analysis from the previous chapter. The chapter begins with a simple
illustration to explain the nature of relevant cost information. We also define the concepts
of opportunity cost and sunk costs at this point, and emphasize the irrelevance of sunk costs
to decision-making.
The chapter goes on to explore a variety of decision-making situations. The first of
these illustrates the use of idle capacity to fill special orders priced below full cost. The
analysis recalls the importance of contribution margin to planning. Production with a
resource constraint highlights contribution margin somewhat differently stressing CM per
unit of the limiting input. Make or buy decisions are explored next. Such problems are
particularly interesting given the ongoing prevalence of outsourcing. This section closes
with an examination of the options regarding defective units of output.
The chapter concludes with an explanation of joint products and the allocation of
joint costs. Of the many approaches to joint cost allocation, only relative sales value is
explored. We also consider the decision to further process the products beyond the split-
off point.
Learning Objectives
1. Explain what makes information relevant to a particular business decision.
2. Discuss the relevance of opportunity costs, sunk costs, and out-of-pocket costs in
making business decisions.
3. Use incremental analysis in common business decisions.
4. Discuss how contribution margin can be maximized when one factor limits
productive capacity.
5. Identify nonfinancial considerations and creatively search for better courses of action.
Brief Topical Outline
A. The challenge of changing markets
B. The concept of relevant cost information
Chapter 21—Incremental Analysis
21-2 Instructor’s Resource Manual
1. Relevant information in business decisions
2. International financial reporting standards and relevant costs
3. A simple illustration of relevant costs
a. Opportunity costs
b. Sunk costs versus out-of-pocket costs—see Ethics, Fraud, &
Corporate Governance (page 931)
C. Incremental analysis in common business decisions
D. Special order decisions—see Your Turn (page 927)
E. Production constraint decisions—see Your Turn (page 928)
F. Make or buy decisions—see Case in Point (page 930)
G. Sell, scrap, or rebuild decisions—see Case in Point (page 931) and
Pathways Connection (page 933)
H. Joint product decisions
4. Joint costs
5. Decisions after the split-off point
I. Concluding remarks
Topical Coverage and Suggested Assignment
Class
Meetings
on Chapter
Topical
Outline
Coverage
Discussion
Questions*
Brief
Exercises*
Exercises*
Problems*
Critical
Thinking
Cases*
1
A – B
1, 2, 4
1, 2
1, 2, 4
1
2
C
6, 7, 8
7, 8, 9
9, 10, 11
4
2
3
C – D
10, 15
10
13, 14
8
*Homework assignment (to be completed prior to class)
Comments and Observations
Teaching Objectives for Chapter 21
In this chapter, we address the topic of selecting that information which is most useful in
making a specific decision. This topic depends far more upon judgment and reasoning than
upon mechanical computations. Our classroom objectives during the presentation of this
chapter are to:
1. Provide criteria for identifying the information that is relevant to a particular business
decision.
2. Discuss the nature and relevance of opportunity costs and sunk costs.
3. Illustrate and explain the concept of incremental analysis
4. Apply incremental analysis to a variety of business situations including:
a. special orders
b. make or buy decisions
Chapter 21—Incremental Analysis
Financial and Managerial Accounting, 18e 21-3
c. production in the presence of constrained resources
d. sell or process further decisions
5. Discuss the relevance of contribution margin to incremental analysis.
General Comments
In discussing incremental analysis, we emphasize the importance of identifying
those revenue, expense, and other considerations that are relevant to the decision at hand.
We accordingly spend considerable time discussing the short sections in the text on
opportunity costs and the irrelevance of sunk costs. Case 2 is especially helpful in this
regard. Most of our exercises and problems stress the importance of identifying relevant
information. We particularly like Problem 1.
We have linked this chapter with our coverage of cost-volume-profit analysis by
explaining the relevance of contribution margin to several of the decision problems
illustrated in the text. This linkage is especially obvious in our discussion of production
with constrained inputs. Problem 4 and Case 1 both emphasize the similarity of the analysis
in the two chapters.
Supplemental Exercises
Group Exercise
As a group, select a manufacturing company to examine. Imagine that the CEO of
the company has established your group as a committee for the purchase of determining
whether to make or buy key component parts of the company’s final products. Your group
has three options:
a. The component parts can be made in-house.
b. The component parts can be purchased from another domestic manufacturer.
c. The component parts can be purchased from an offshore supplier.
Prepare a presentation for the CEO in which you explain the primary assumptions
and considerations used in making your decision. Explain the advantages and
disadvantages associated with approaches A, B, and C. Finally, as a group, provide the
CEO with a recommendation.
Internet Exercise
What resource is common to all of Ben and Jerry’s products? How many joint
products does Ben and Jerry’s produce from this common resource? What approach could
the company use to allocate the joint costs of processing the common input prior to the
split-off point? Should these allocated joint costs be considered when deciding whether to
delete a flavor of ice cream from the product line? Why or why not?
Chapter 21—Incremental Analysis
21-4 Instructor’s Resource Manual
CHAPTER 21 NAME #
10-MINUTE QUIZ A SECTION
Indicate the best answer for each question in the space provided.
1. Which of the following would be least relevant in deciding whether to further process a
joint product past the split-off point?
a Incremental revenue earned from additional processing.
b Incremental costs incurred as a result of additional processing.
c Joint costs allocated to the joint product at the split-off point.
d Customer demand for the product that emerges from additional processing.
2. Johnson produces 7,000 skateboards each month, which it sells for $60 each. Variable costs
are $25 per unit, and fixed costs are $95,000 per month. A Canadian company has offered
to buy an additional 1,000 skateboards for $30 per unit. Assuming that normal sales volume
and fixed costs remain unchanged, filling this special order will cause Johnson’s operating
income to:
e Decrease by $30,000.
f Decrease by $6,250.
g Decrease by $5,000.
3. ILF makes 2,000 waterproof mattresses annually to be used in one of its products. The unit
cost of the mattresses includes variable costs of $45 and fixed costs of $30. If the mattresses
were purchased from an outside supplier, 60% of the fixed costs could be eliminated.
Buying mattresses from an outside supplier at a price of $50 each would cause ILF’s
operating income to:
a Increase by $26,000.
b Increase by $30,000.
c Increase by $6,000.
d Decrease by $10,000.
4. The decision to rework a defective branch of products will improve net income whenever
the incremental revenue earned as a result of the decision exceeds:
a The variable costs of reworking the batch.
b The incremental cost of reworking the batch.
c The average cost per unit associated with reworking the batch.
d The cash expenditure to rework the batch.
5. Which of the following costs is generally considered irrelevant in incremental analysis?
a Sunk costs.
b Out-of-pocket costs.
c Incremental costs.
d Opportunity costs.
Chapter 21—Incremental Analysis
Financial and Managerial Accounting, 18e 21-5
CHAPTER 21 NAME #
10-MINUTE QUIZ B SECTION
1. When constrained by a limiting resource, managers often seek to produce those products
which have:
a The highest selling prices.
b The lowest average cost per unit.
c The highest contribution margin per unit of limiting resource.
d The highest contribution margin ratios.
2. The average total cost of producing Z-12 is $35 per unit. The average variable cost
associated with the production of Z-12 is $12 per unit, of which $2 is manufacturing
overhead. The normal selling price of Z-12 is $50 per unit. If excess capacity exists, a
special order for Z-12 will increase net operating income if it is priced at least:
a $50 per unit.
b $35 per unit.
c $12 per unit.
d $10 per unit.
3. When deciding whether to make or buy a component part, the most relevant consideration
is often:
a The average total cost of making the part.
b The unavoidable fixed manufacturing costs.
c The variable manufacturing costs per unit.
d The sunk cost of equipment used to manufacture the part.
4. Products for which sales of one contribute to the sales of another are called:
a Complementary products.
b Joint products.
c Common products.
d Dependent products.
5. Opportunity costs represent:
a Cash expenditures for business opportunities.
b Benefits foregone.
c Costs avoided by making a particular decision.
d Indirect costs typically classified as manufacturing overhead.
Chapter 21—Incremental Analysis
21-6 Instructor’s Resource Manual
CHAPTER 21 NAME #
10-MINUTE QUIZ C SECTION
Technical Chemical manufactures two products as part of a joint process: MB and EB. Joint costs
up to the split-off point total $70,000, and are allocated to each line of product in proportion to its
relative sales value. At the split-off point, product MB can be sold for $85,000, and EB can be sold
for $25,000. At an incremental cost of $30,000, MB can be processed into MB-2 and sold for
$105,000. At an incremental cost of $25,000, EB can be processed into EB-2 and sold for $62,500.
a Joint costs allocated to product MB total: $____________
b Joint costs allocated to product EB total: $____________
c The net change in operating income resulting from a decision to manufacture MB-2 is
(specify whether the change is an increase or a decrease): $____________
d The net change in operating income resulting from a decision to manufacture EB-2 is
(specify whether the change is an increase or a decrease): $____________
e The net change in operating income resulting from a decision to manufacture both MB–2
and EB-2 is (specify whether the change is an increase or a decrease): $____________
Chapter 21—Incremental Analysis
Financial and Managerial Accounting, 18e 21-7
CHAPTER 21 NAME #
10-MINUTE QUIZ D SECTION
A job of 1,000 VCRs manufactured by K Corp. contains defective parts. The cost incurred in
manufacturing these defective units is $140,000. K Corp. can sell these units as scrap materials for
$45 per unit or repair all 1,000 units at a total cost of $70,000. If the units are repaired, they can be
sold at the normal price of $200 per unit.
1. What will be the total amount of the loss incurred by K Corp. on the sale of these units if
they are sold for scrap at $45 per unit?
$____________ loss
2. What will be the average per-unit manufacturing cost of the VCR, including repair costs,
assuming that K Corp. does the repairs? $____________ per unit
3. What will be the total amount of the loss incurred by K Corp. on the sale of these units if
they are repaired and sold for $200 per unit? $____________ loss
4. What is the relevant cost to K Corp. in deciding whether or not to repair the units? (State
this cost as a total amount for all 1,000 units.) $____________
5. Should K Corp.(1) sell the units for scrap or (2) repair the units? Underline the most
profitable action, and indicate the amount of the net financial benefit of this action to the
company. $____________
Chapter 21—Incremental Analysis
21-8 Instructor’s Resource Manual
SOLUTIONS TO CHAPTER 21 10-MINUTE QUIZZES
QUIZ A
1 C
QUIZ B
QUIZ C
Learning Objective: 4
% of total sales
Joint costs
=
Allocation
Chapter 21—Incremental Analysis
Financial and Managerial Accounting, 18e 21-9
QUIZ D
Learning Objective: 4
Proceeds from sale of repaired units @ $200 …………………………………………………………… $200,000
Proceeds from sale of defective sets as scrap @ $45 ………………………………………………… ( 45,000)
Chapter 21—Incremental Analysis
Financial and Managerial Accounting, 18e 21-10
Assignment Guide to Chapter 21
Brief
Exercises
Exercises
Problems
Cases
Net
Item Number
1 – 10
1 – 15
1
2
3
4
5
6
7
8a/b
1
2
4
3
Time estimate (in minutes)
< 15
< 15
25
30
30
30
25
25
25
35/2
0
35
15
20
20
Difficulty rating
E
E
E
M
M
M
M
M
M
S/M
M
M
M
E
Learning Objectives:
1, 3, 8
1, 2, 3, 4,
5, 6, 7, 8,
9, 10, 11,
12, 13, 14,
15
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1. Explain what makes
information relevant to a
particular business decision.
2. Discuss the relevance of
opportunity costs, sunk costs,
and out-of-pocket costs in
making business decisions.
2, 3, 4, 5, 6,
9, 10
1, 2, 3, 4,
5, 6, 7, 8,
9, 10, 11,
12, 13, 14,
15
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√
√
√
√
√
√
√
√
√
common business decisions.
1, 2, 8, 9, 10
1, 3, 4, 5,
6, 7, 8, 9,
10, 11, 12,
13, 14, 15
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√
√
√
√
√
√
√
√
√
margin can b maximized
9, 10
1, 4, 5, 6,
7, 8, 9, 10,
11, 14
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√
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