COMM294 - Week #7 Notes - Incremental Analysis - Instructor Copy PDF

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Course: COMM294 Week #7 Instructor: Kyla Gunderson Topic: Incremental Analysis (Chapter 20) (Instructor Copy)

CHAPTER REVIEW

Decision-Making Process and Incremental Analysis 1.

Management’s decision-making process frequently involves the following steps: a.

Identify the problem and assign responsibility.

b.

Determine and evaluate possible courses of action.

c.

Make a decision.

d.

Review results of the decision.

Accounting’s contribution to the decision-making process occurs primarily in steps (b) and (d). 2.

3.

4.

Decisions involve a choice among alternative courses of action. In making business decisions, management ordinarily considers both financial and nonfinancial information. The process used to identify the financial data that change under alternative courses of action is called incremental analysis. a.

Incremental analysis involves not only determining relevant revenues and costs, but also identifying the probable effects of the decision on future earnings.

b.

Incremental analysis involves estimates and uncertainty.

c.

Gathering data may involve market analysts, engineers, and accountants.

Three important cost concepts used in incremental analysis include: a.

Relevant costs are those costs and revenues that differ across alternatives.

b.

Often in choosing one course of action, a company must give up the opportunity to benefit from some other course of action. This lost benefit is known as opportunity cost.

c.

Sunk costs are costs that have already been incurred and will not be changed or avoided by any present or future decisions.

Incremental analysis sometimes involves changes that might seen contrary to intuition. However, in some cases (1) variable costs may not change under the alternative courses of action, and (2) fixed costs may change.

Special Orders 5.

An order at a special price should be accepted when the incremental revenue from the order exceeds the incremental costs. a.

It is assumed that sales in other markets will not be affected by the special order.

b.

If the company has excess operating capacity, generally only variable costs will be affected.

Make or Buy 6.

In a make or buy decision, management must determine the costs which are different under the two alternatives. If there is an opportunity to use the productive capacity in some other manner, then opportunity cost must be considered. Opportunity cost is the potential benefit that may be obtained by following an alternative course of action. This cost is an additional cost of making the component.

Sell or Process Further 7.

The basic decision rule in a sell or process further decision is: Process further as long as the incremental revenue from such processing exceeds the incremental processing costs. Incremental revenue is the increase in sales which results from processing the product further.

8.

Sell-or-process-further decisions are particularly applicable to production processes that produce multiple products simultaneously. In these types of decisions, all costs incurred prior to the point at which the joint products are separately identifiable (the split-off point) are called joint costs. Joint product costs are sunk costs.

Repair, Retain or Replace Equipment 9.

In a decision to retain or replace equipment, management compares the costs which are affected by the two alternatives. Generally, these are variable manufacturing costs and the cost of the new equipment. a.

The book value of the old asset is a sunk cost which does not affect the decision.

b.

However, any trade-in allowance or cash disposal value of the existing asset must be considered.

Eliminate an Unprofitable Segment or Product 10. In deciding whether to eliminate an unprofitable segment, management should choose the alternative which results in the highest net income. Often fixed costs allocated to the unprofitable segment must be absorbed by the other segments. It is possible, therefore, for net income to decrease when what appears to be an unprofitable segment is eliminated.

11. In deciding on the future status of an unprofitable segment, management should consider the effect of elimination on related product lines. It may be possible for continuing product lines to obtain some of the sales lost by the discontinued product line.

PRACTICE PROBLEMS Question #1: ThreePoint Sports Inc. manufactures basketballs for the Women's National Basketball Association (WNBA). For the first 6 months of 2020, the company reported the following operating results while operating at 80% of plant capacity and producing 120,000 units. Sales

$4,800,000

Cost of goods sold

3,600,000

Selling and administrative expenses

405,000

Net income

$795,000

Fixed costs for the period were cost of goods sold $960,000, and selling and administrative expenses $225,000. In July, normally a slack manufacturing month, ThreePoint Sports receives a special order for 10,000 basketballs at $28 each from the Greek Basketball Association (GBA). Acceptance of the order would increase variable selling and administrative expenses $0.75 per unit because of shipping costs but would not increase fixed costs and expenses. PART A: Prepare an incremental analysis for the special order.

Revenues (10,000 X $28) Var. Cost of goods sold Var. Selling and administrative expenses Net income

Reject Order

Accept Order

Net Income Increase (Decrease)

$0 0

$280,000 220,000

$ 280,000 ( (220,000)

0 $0

22,500 $ 37,500

(1)

(1) (2)

( (22,500) $ 37,500

Variable CGS = $3,600,000 – $960,000 = $2,640,000; $2,640,000 ÷ 120,000 units = $22.00 per unit; 10,000 X $22.00 = $220,000. [($3,600,000 - $960,000 = $2,640,000); ($2,640,000 ÷ 120,000 = $22); ($22 x 10,000 = $220,000)] [(Tot. CGS – Fixed CGS = Var. CGS); (Var. CGS ÷ No. units produced = Var. CGS/unit); (Var. CGS/unit x No. units in spec. order = Spec. order Var. CGS)] (2)

Variable S&A expenses = $405,000 – $225,000 = $180,000; $180,000 ÷ 120,000 units = $1.50 per unit;

10,000 X ($1.50 + $0.75) = $22,500. [($405,000 - $225,000 = $180,000); ($180,000 ÷ 120,000 = $1.50); (10,000 x ($1.50 + $.75) = $22,500)] [(Tot. S&A exp. – Fixed S&A = Var. S&A exp.); (Var. S&A exp. ÷ No. units produced = Var. S&A exp./unit); (No. units in spec. order x (Var. S&A exp./unit + Ship. exp./unit) = Spec. order var. S&A exp.)] PART B: Should ThreePoint Sports Inc. accept the special order? Explain your answer. Yes, the special order should be accepted because net income is expected to increase by $37,500.

PART C: What is the minimum selling price on the special order to produce net income of $5.00 per ball? Unit selling price = $22.00 (variable manufacturing costs) + $2.25 ($1.50 + $0.75) variable selling and administrative expenses + $5.00 net income = $29.25.

PART D: What nonfinancial factors should management consider in making its decision? Nonfinancial factors to be considered are: (1) possible effect on domestic sales, (2) possible alternative uses of the unused plant capacity, and (3) ability to meet customer’s schedule for delivery without increasing costs. Question #2: The management of Shatner Manufacturing Company is trying to decide whether to continue manufacturing a part or to buy it from an outside supplier. The part, called CISCO, is a component of the company's finished product. The following information was collected from the accounting records and production data for the year ending December 31, 2020. 1. 8,000 units of CISCO were produced in the Machining Department. 2. Variable manufacturing costs applicable to the production of each CISCO unit were: direct materials $4.80, direct labor $4.30, indirect labor $0.43, utilities $0.40. 3. Fixed manufacturing costs applicable to the production of CISCO were: Cost Item Depreciation Property taxes Insurance

Direct $2,100 500 900 $3,500

Allocated $ 900 200 600 $1,700

All variable manufacturing and direct fixed costs will be eliminated if CISCO is purchased. Allocated costs will not be eliminated if CISCO is purchased. So if CISCO is purchased, the fixed manufacturing costs allocated to CISCO will have to be absorbed by other production departments. 4. The lowest quotation for 8,000 CISCO units from a supplier is $80,000.

5. If CISCO units are purchased, freight and inspection costs would be $0.35 per unit, and receiving costs totaling $1,300 per year would be incurred by the Machining Department. PART A: Prepare an incremental analysis for CISCO. Your analysis should have columns for (1) Make CISCO, (2) Buy CISCO, and (3) Net Income Increase/(Decrease). (a) Net Income Increase Make CISCO Buy CISCO (Decrease) Direct materials (8,000 X $4.80) Direct labor (8,000 X $4.30) Indirect labor (8,000 X $0.43) Utilities (8,000 X $0.40) Depreciation Property taxes Insurance Purchase price Freight and inspection (8,000 X $0.35) Receiving costs Total annual cost

$38,400

$

0

($38,400)

34,400

0

( 34,400)

3,440 3,200

0 0

3,000 700 1,500 0

900 200 600 80,000

( 3,440) ( 3,200 ) ( 2,100) ( 500) ( 900) ( (80,000)

0 2,800 ( (2,800) 0 1,300 ( (1,300) $84,640 $85,800 ($ (1,160) [Net inc. effect: (8,000 x $4.80) + (8,000 x $4.30) + (8,000 x $.43) + (8,000 c $.40) + $2,100 + $500 + $900 - $80,000 – (8,000 x $.35) - $1,300 = ($1,160)] [Net inc. effect: (Units made x DM/unit saved) + (Units made x DL/unit saved) + (Units made x Ind. labor/unit saved) + (Units made x Util./unit saved) + Depr. savings + Prop. tax savings + Ins. savings – Purch. price – (Units made x Frt. & inspect./unit) – Rec. costs = Net inc. decr.]

PART B: Based on your analysis, what decision should management make? The company should continue to make CISCO because net income is expected to be $1,160 less if CISCO were purchased from the supplier. PART C: Would the decision be different if Shatner Company has the opportunity to produce $3,000 of net income with the facilities currently being used to manufacture CISCO? Show computations. The decision would be different. Because of the opportunity cost of $3,000, net income is expected to be $1,840 higher if CISCO is purchased as shown below: Net Income Increase Make CISCO Buy CISCO (Decrease) Total annual cost Opportunity cost Total cost

$84,640 3,000 $87,640

$85,800 0 $85,800

$(1,160) (3,000) $(1,840)

PART D: What nonfinancial factors should management consider in making its decision? Nonfinancial factors include: (1) the adverse effect on employees if CISCO is purchased, (2) how long the supplier will be able to satisfy the Shatner Manufacturing Company’s quality control standards at the quoted price per unit, and (3) whether the supplier will deliver the units when they are needed by Shatner. Question #3: Thompson Industrial Products Inc. (TIPI) is a diversified industrial-cleaner processing company. The company's Dargan plant produces two products: a table cleaner and a floor cleaner from a common set of chemical inputs (CDG). Each week, 900,000 ounces of chemical input are processed at a cost of $210,000 into 600,000 ounces of floor cleaner and 300,000 ounces of table cleaner. The floor cleaner has no market value until it is converted into a polish with the trade name FloorShine. The additional processing costs for this conversion amount to $240,000. FloorShine sells at $20 per 30-ounce bottle. The table cleaner can be sold for $17 per 25-ounce bottle. However, the table cleaner can be converted into two other products by adding 300,000 ounces of another compound (TCP) to the 300,000 ounces of table cleaner. This joint process will yield 300,000 ounces each of table stain remover (TSR) and table polish (TP). The additional processing costs for this process amount to $100,000. Both table products can be sold for $14 per 25-ounce bottle.

The company decided not to process the table cleaner into TSR and TP based on the following analysis. Table Cleaner Production in ounces Revenues Costs: CDG costs TCP costs Total costs Weekly gross profit

Table Polish (TP)

300,000 $204,000

Table Stain Remover (TSR) 300,000 $168,000

Total

300,000 $168,000

$336,000

70,000* 0 70,000 $134,000

52,500 50,000 102,500 $ 65,500

52,500 50,000 102,500 $ 65,500

105,000** 100,000 205,000 $131,000

* If table cleaner is not processed further, it is allocated 1/3 of the $210,000 of CDG cost, which is equal to 1/3 of the total physical output. ** If table cleaner is processed further, total physical output is 1,200,000 ounces. TSR and TP combined account for 50% of the total physical output and are each allocated 25% of the CDG cost. PART A: Determine if management made the correct decision to not process the table cleaner further by doing the following. 1. Calculate the company's total weekly gross profit assuming the table cleaner is not processed further. (a) (1) Table Cleaner Not Processed Further Sales: FloorShine (600,000 ÷ 30) X $20 Table Cleaner (300,000 ÷ 25) X $17

$400,000 204,000

Total revenue

$604,000

Costs: CDG Additional costs of FloorShine Total costs Gross profit

210,000 240,000 450,000 $154,000

2. Calculate the company's total weekly gross profit assuming the table cleaner is processed further. Table Cleaner Processed Further Sales:

FloorShine Table Stain Remover (300,000 ÷ 25) X $14 Table Polish (300,000 ÷ 25) X $14 Total revenue

$400,000 168,000 168,000 $736,000

Costs: CDG

210,000

Additional costs of FloorShine TCP

240,000 100,000

Total costs Gross profit

550,000 $186,000

3. Compare the resulting net incomes and comment on management's decision. If the table cleaner is processed further overall company profit is expected to be $32,000 higher. Therefore, management made the wrong decision by choosing to not process table cleaner further.

PART B: Using incremental analysis, determine if the table cleaner should be processed further.

Incremental revenue Incremental costs Totals

Don’t Process Table Cleaner Further $204,000 0 $204,000

Process Table Cleaner Further $336,000 100,000 $236,000

Net Income Increase (Decrease) $132,000 (100,000) $ 32,000

When trying to decide if the table cleaner should be processed further into TSR and TP, only the relevant data need be considered. All of the costs that occurred prior to the creation of the table cleaner are sunk costs and can be ignored. The decision should be made by comparing the incremental revenue from further processing to the incremental costs....