7.7 Incremental Analysis PDF

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Chapter 7 Incremental Analysis....

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6/25/2020

Incremental Analysis

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7.7 Allocate Limited Resources LEARNING OBJECTIVE 7 Determine the sales mix when a company has limited resources. In our break-even analysis in Chapter 6, we assumed a certain sales mix. But management must constantly evaluate its sales mix to determine whether it is as good as it can be. One factor that affects the sales mix decision is how much of the available resources each product uses. Everyone's resources are limited. For a company, the limited resource may be floor space in a retail department store, or raw materials, direct labour hours, or machine capacity in a manufacturing company. When a company has limited resources, management must decide which products to make and sell in order to maximize net income. To illustrate, assume that Bilodeau Company manufactures deluxe and standard pen-and-pencil sets. The limiting resource is machine capacity, which is 3,600 hours per month. Relevant data appear in Illustration 7.21. ILLUSTRATION 7.21Contribution margin and machine hours Deluxe SetsStandard Sets Contribution margin per unit $8 $6 Machine hours required per unit 0.4 0.2 The deluxe sets may appear to be more profitable since they have a higher contribution margin ($8) than the standard sets ($6). However, note that the standard sets take fewer machine hours to produce than the deluxe sets. Therefore, it is necessary to find the contribution margin per unit of the limited resource; in this case, it is the contribution margin per machine hour (see Helpful Hint). This is obtained by dividing the contribution margin per unit of each product by the number of units of the limited resource required for each product, as shown in Illustration 7.22.

HELPFUL HINT Contribution margin (CM) alone is not enough to make this decision. The key factor is CM per limited resource. ILLUSTRATION 7.22Contribution margin per unit of limited resource Deluxe SetsStandard Sets Contribution margin per unit (a) $ 8 $ 6 Machine hours required (b) ÷ 0.4 ÷ 0.2 Contribution margin per unit of limited resource [(a) ÷ (b)] $20 $30 The calculation shows that the standard sets have a higher contribution margin per unit of the limited resource. This would suggest that, if there is enough demand for standard sets, the company should shift the sales mix to standard sets or increase its machine capacity. If Bilodeau Company is able to increase machine capacity from 3,600 hours to 4,200 hours, it could use the additional 600 hours to produce either the standard or deluxe pen-and-pencil sets. The total contribution margin under each alternative is found by multiplying the machine hours by the contribution margin per unit of the limited resource, as shown in Illustration 7.23. ILLUSTRATION 7.23Incremental analysis—calculation of total contribution margin Produce Produce Deluxe Sets Standard Sets https://edugen.wileyplus.com/edugen/courses/crs12376/ebook/c07/d2V5Z2FuZHQ5NzgxMTE5NDAzOTk5YzA3XzhfMC54Zm9ybQ.enc?course=crs12… 1/4

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Incremental Analysis

Produce Produce Deluxe Sets Standard Sets Machine hours (a) 600 600 Contribution margin per unit of limited resource (b) × $20 × $30 Contribution margin [(a) × (b)] $12,000 $18,000 From this analysis, we can see that to maximize net income, all of the increased capacity should be used to make and sell the standard sets. When there are multiple limited resources, solving the product mix requires the use of a specialized mathematical technique called linear programming, which is covered in production management or operations research courses. As indicated in Illustration 7.22, the constraint on the production of the deluxe sets is the larger number of machine hours needed to produce these items. In addressing this problem, we have not questioned the limited number of machine hours, and have simply tried to maximize the contribution margin under this constraint. One question that Bilodeau should ask, however, is whether it can minimize this constraint. For example, the constraint might be due to a bottleneck in production or poorly trained machine operators. In addition, the company should consider other possible solutions, such as outsourcing part of the production, acquiring additional equipment (discussed in Chapter 13), or striving to eliminate any non-value-added activities. As discussed in Chapter 1, this approach to evaluating constraints is called the theory of constraints. The theory of constraints is a specific approach to constraints in which the company manages them to improve its overall results. According to this theory, a company must continually identify its constraints and find ways to reduce or eliminate them, where appropriate.

DO IT! 7 Sales Mix with Limited Resources Canada Bearings Corporation manufactures and sells three different types of high-quality sealed ball bearings, which vary in their quality specifications—mainly in terms of their smoothness and roundness. They are referred to as Fine, Extra-Fine, and Super-Fine bearings. Machine time is limited. The company requires more machine time to manufacture the Extra-Fine and Super-Fine bearings. Additional information follows: Product Fine Extra-FineSuper-Fine Selling price $6.00 $10.00 $16.00 Variable costs and expenses 4.00 6.50 11.00 Contribution margin $2.00 $ 3.50 $ 5.00 Machine hours required 0.02 0.04 0.08 Total fixed costs: $234,000 a. Ignoring the machine-time constraint, determine what strategy would be the best. b. Calculate the contribution margin per unit of the limited resource for each type of bearing. c. Assuming the company could obtain additional machine time, determine how it should use the additional capacity. ACTION PLAN •To determine how best to use a limited resource, calculate the contribution margin per unit of the limited resource for each product type. https://edugen.wileyplus.com/edugen/courses/crs12376/ebook/c07/d2V5Z2FuZHQ5NzgxMTE5NDAzOTk5YzA3XzhfMC54Zm9ybQ.enc?course=crs12… 2/4

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Incremental Analysis

Solution a.The Super-Fine bearings have the highest contribution margin per unit. Thus, ignoring any manufacturing constraints, it would appear that the company should shift toward production of more Super-Fine units. b.The contribution margin per unit of the limited resource is calculated as follows: Fine Extra-FineSuper-Fine Contribution margin per unit $ 2.00 $ 3.50 $ 5.00 ÷ Limited resource consumed per unit ÷ 0.02 ÷ 0.04 ÷ 0.08 Contribution margin $100.00 $87.50 $62.50 c.The Fine bearings have the highest contribution margin per limited resource, even though they have the lowest contribution margin per unit. Because of this resource constraint, any additional capacity should be used to make Fine bearings. Related exercise material: BE7.10, E7.28, E7.29, E7.30, and DO IT! D7.16.

All About You Big Decisions for Your Energy Future

The National Energy Board (NEB) forecasts that, between 2014 and 2040, energy use in Canada could increase at an average annual rate of 0.7%. This would be half the rate of energy consumption growth as in recent decades, largely due to increased energy efficiency. The NEB expects that fossil fuels will continue to be the main source of energy for heating and transportation. Many Canadians are wondering whether we should invest in renewable energy such as wind power that could be costly but might help the environment. Meanwhile, the NEB expects that oil and gas production in Canada will grow by 56% from 2014 to 2040, with much of this production happening in the oil sands. In 2015, oil and gas extraction accounted for about 5% of Canada's GDP and directly employed about 190,000 Canadians.

What Do You Think? Imagine that you work for a government department that is preparing a request for proposal for private companies to bid on building either a conventional or renewable energy-producing facility. Should you require bidders to show the environmental costs of conventional energy, such as increased greenhouse gases? YES—As long as environmental costs are ignored, renewable energy will seem more expensive than conventional energy. NO—Environmental costs are too difficult to estimate, so government decision-makers can't accurately compare financial bids for conventional and alternative facilities. Sources: National Energy Board, “Canada's Energy Future 2016: Energy Supply and Demand Projections to 2040,” January 2016; Natural Resources Canada, “10 Key Facts on Canada's Energy Sector,” August 2016, https://edugen.wileyplus.com/edugen/courses/crs12376/ebook/c07/d2V5Z2FuZHQ5NzgxMTE5NDAzOTk5YzA3XzhfMC54Zm9ybQ.enc?course=crs12… 3/4

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Incremental Analysis

www.nrcan.gc.ca/sites/www.nrcan.gc.ca/files/energy/pdf/10-Key-Facts_Energy_Sector_en.pdf.

USING DECISION TOOLS Suppose Canadian Communications Company must decide whether to make some of its components or buy them from Xenia Corp. The cost of producing 50,000 electrical connectors for its network is $110,000, broken down as follows: Direct materials$60,000Variable overhead$12,000 Direct labour 30,000Fixed overhead 8,000 Instead of making the electrical connectors at an average cost per unit of $2.20 ($110,000 ÷ 50,000), the company has an opportunity to buy the connectors at $2.15 per unit. If it purchases the connectors, it will eliminate all variable costs and one-half of the fixed costs. Instructions a. Prepare an incremental analysis showing whether the company should make or buy the electrical connectors. b. Will your answer be different if the productive capacity that becomes available because of the purchase of the connectors will generate additional income of $25,000? Solution a. Net Income Make Buy Increase (Decrease) Direct materials $ 60,000$ 0 $ 60,000 Direct labour 30,000 0 30,000 Variable manufacturing costs 12,000 0 12,000 a Fixed manufacturing costs 8,000 4,000 4,000 b Purchase price 0 107,500 (107,500) Total cost $110,000 $111,500 $ (1,500) a b $8,000 × 0.50; $2.15 × 50,000 This analysis indicates that Canadian Communications Company will incur $1,500 of additional costs if it buys the electrical connectors. Canadian Communications would, therefore, choose to make the connectors. b. Net Income Make Buy Increase (Decrease) Total cost $110,000$111,500 $ (1,500) Opportunity cost 25,000 0 25,000 Total cost $135,000$111,500 $23,500 Yes, the answer is different. The analysis shows that, if additional capacity is released by purchasing the electrical connectors, net income will increase by $23,500. In this case, Canadian Communications would choose to purchase the connectors. Copyright © 2018 John Wiley & Sons Canada, Ltd. All rights reserved.

https://edugen.wileyplus.com/edugen/courses/crs12376/ebook/c07/d2V5Z2FuZHQ5NzgxMTE5NDAzOTk5YzA3XzhfMC54Zm9ybQ.enc?course=crs12… 4/4...