Fall 2019

COMM 305 Managerial Accounting

Tutorial 7 – Chapter 7
 Incremental Analysis
Incremental analysis is the process used to identify the financial
expenses that change under alternative courses of action.

3 cost concepts in incremental analysis:

• Relevant cost: costs and revenues that are different for each
alternative or will occur in the future.
*Costs and revenues that do not differ across alternatives and will not
occur in the future can be ignored*

• Opportunity cost: The benefit lost in choosing one option over

another.

• Sunk cost Costs that have already been incurred and will not be
changed or avoided by any future decision.
*Sunk costs are not relevant costs*
 Most Common Scenarios
1. Accept or Reject a Special Order: opportunity to obtain additional
business if it is willing to make a major price concession to a
specific customers
2. Make or Buy: Deciding to make or buy component parts required
in producing a finished product
3. Sell or Process Further: selling products at a particular point in the
production cycle or continuing to process the products in order to
sell them later at a higher price.
4. Retain or Replace Equipment: Deciding whether to continue using
an asset or replace it
5. Keep or Eliminate: Deciding whether to eliminate an unprofitable
business segment or product.
6. Allocation of Limited Resources: Deciding to allocate limited
resources (Ex: floor space, raw materials, direct labour hours, or
machine capacity) products that will maximize net income.
 Question 1: Accept or Reject a
Special Order
Dupuis Inc. sells product E-Y1 at a price of $48 a unit. The per-unit cost
data are direct materials $15, direct labour $10, and overheads $12
(75% variable).

Dupuis Inc. has sufficient capacity to accept a special order for 40,000
units, but at a discount of 25% from the regular price. Selling costs
associated with this order would be $3 per unit.

Required:
1. Determine whether Dupuis Inc. should accept the special order.
2. Determine whether Dupuis Inc. should accept if they have no
excess capacity.
 Question 1 - Answer
1. Item Reject Accept Net Income Effect
DM - 600,000 (600,000)
DL - 400,000 (400,000)
VOH - 360,000 (360,000)
Selling - 120,000 (120,000)
Sale - 1,440,000 1,440,000
Net (40,000)

Reject because they'd lose $40,000 to accept the order

2. Item Reject Accept Net Income Effect

DM - 600,000 (600,000)
DL - 400,000 (400,000)
VOH - 360,000 (360,000)
Selling - 120,000 (120,000)
Sale - 1,440,000 1,440,000
Opp Cost - 560,000 (560,000)
(600,000)

Reject because they'd lose $600,000

Question 2: Make or Buy a Product
Camia Corp. has been manufacturing its own shades for its table lamps. The company is
currently operating at 100% of capacity, and variable manufacturing overhead is charged
to production at the rate of 50% of direct labour costs. The direct materials and direct
labour costs per unit to make the lampshades are $4 and $6, respectively. Normal
production is 50,000 table lamps per year.

A supplier offers to make the lampshades at a price of $13.50 per unit. If Camia Corp.
accepts the supplier’s offer, all variable manufacturing costs will be eliminated, but the
$50,000 of fixed manufacturing overhead currently being charged to the lampshades will
have to be absorbed by other products.

Required:
1. Prepare the incremental analysis for the decision to make or buy the lampshades
and explain your decision.
2. Would your answer be different in (1) if the productive capacity released by not
making the lampshades could be used to produce income of $40,000?
 Question 2 - Answer
1. Make Buy Income Effect
Direct material ($4.00) $200,000 $200,000
Direct labour ($6.00) 300,000 300,000
Variable MOH (50% × 150,000 150,000
$6.00)
Purchase price ($13.50) — 675,000 (675,000)
Total annual cost $700,000 $725,000 $(25,000)

They should not buy the shades, as it would cost them $25,000 more than if they made them.

2. Make Buy Income Effect

Direct material ($4.00) $200,000 $200,000
Direct labour ($6.00) 300,000 300,000
Variable MOH ($3.00) 150,000 150,000
Purchase price — 675,000 (675,000)
($13.50)
Opportunity cost 40,000 40,000
Total annual cost $740,000 $725,000 $15,000

Yes, by purchasing the shades, a total cost saving of $15,000 will result with the additional 40,000 income
Question 3: Sell or Process Further
Nadeau Inc. produces three separate products from a common process costing
$100,000. Each of the products can be sold at the split-off point or can be processed
further and then sold for a higher price. The cost and selling price data for a recent
period are as follows:

Sales Value at Cost to Sales Value after

Split-Off Point Process Further Further Processing
Product A $50,000 $100,000 $190,000
Product B 10,000 30,000 35,000
Product C 60,000 150,000 220,000

Required:
1. Determine the total net income if all products are sold at the split-off point.
2. Determine the total net income if all products are sold after further
processing.
3. Using incremental analysis, determine which products should be sold at the
split-off point and which should be processed further.
4. Determine the total net income using the results from part 3.
 Question 3 - Answer
1. Sales ($50,000 + $10,000 + $60,000)
Less: Joint costs
$120,000
100,000
Net income $20,000

2. Sales ($190,000 + $35,000 + $220,000) $445,000

Joint costs (100,000)
Add. costs ($100,000 + $30,000 + 150,000) (280,000)
Net income $65,000

3. Product A Product B Product C

Revenue of final product $190,000 $35,000 $220,000
Revenue at split-off 50,000 10,000 60,000
Incremental revenue 140,000 25,000 160,000
Less: Incremental costs 100,000 30,000 150,000
Incremental profit (loss) $40,000 $(5,000) $10,000

Products A and C should be processed further and product B should be sold at the split-off point.

4. Sales ($190,000 + $10,000 + $220,000) $420,000

Joint costs (100,000)
Additional costs ($100,000 + $150,000) (250,000)
Net income $70,000
 Question 4: Retain or Replace
Last year (2015), The Diamond Hotel installed a mechanized elevator for its guests. The owner of the
hotel, Charles, recently returned from an industry equipment exhibition where he watched a
computerized elevator demonstrated.
He was impressed with the elevator’s speed, comfortable ride, and cost efficiency. Upon returning
from the exhibition, he asked his purchasing agent to collect price and operating cost data on the
new elevator. In addition, he asked the company’s accountant to provide him with cost data on the
company’s current elevator. The information is presented below:
Old Elevator New Elevator
Purchase price $120,000 $180,000
Estimated salvage value 0 0
Estimated useful life 6 years 5 years
Depreciation method Straight-line Straight-line
Annual operating expenses other than depreciation:
Variable $ 35,000 $ 12,000
Fixed 23,000 8,400

Annual revenues are $240,000 and selling and administrative expenses are $29,000, regardless of
which elevator is used. If it replaces the old elevator now, at the beginning of 2016, The Hotel will be
able to sell it for $25,000.

Instructions
1. Determine any gain or loss if the old elevator is replaced.
2. Prepare a five-year summarized income statement for each of the following assumptions: The
old elevator is kept. The old elevator is replaced.
3. Using incremental analysis, determine whether the old elevator should be replaced.
 Question 4 - Answer
1. (a) Cost $120,000
Accumulated depreciation ($120,000 ÷ 6 yrs) × 1 yr 20,000
Book value 100,000
Sales proceeds (25,000)
Book loss on sale $75,000

2. Retain Replace
Sales ($240,000 × 5 yrs.) $1,200,000 Sales $1,200,000
Less costs: Less costs:
Variable operating costs $175,000 Variable operating costs $60,000
Fixed operating costs 115,000 Fixed operating costs 42,000
Selling & admin. 145,000 Selling and admin. 145,000
Depreciation 100,000 535,000 Depreciation 180,000 427,000
Net income $ 665,000 Operating income 773,000
Less: Loss on old elevator 75,000
Net income $698,000

3. Retain Replace Net Effect

Variable operating costs $175,000 $60,000 $115,000
Fixed operating costs 115,000 42,000 73,000
New elevator cost — 180,000 (180,000)
Salvage on old elevator — (25,000) 25,000
Totals $290,000 $257,000 $33,000
 Question 5: Keep or Eliminate
Tiffany, a recent accounting graduate, evaluated the operating performance of Power
Company’s six divisions. Tiffany made the following presentation to Power’s board of
directors and suggested the Coal division be eliminated. “If the Coal division is
eliminated,” she said, “our total profits would increase by $23,870.”

The Other Five Divisions Coal Division Total

Sales $1,664,200 $96,200 $1,760,400
Cost of goods sold 978,520 76,470 1,054,990
Gross profit 685,680 19,730 705,410
Operating expenses 527,940 43,600 571,540
Net income $157,740 $(23,870) $133,870

In the Coal division, the cost of goods sold is $70,000 variable and $6,470 fixed, and
operating expenses are $15,000 variable and $28,600 fixed. None of the Coal division’s
fixed costs will be eliminated if the division is discontinued.

Required:
Is Tiffany right about eliminating the Coal Division? Prepare a schedule to support your
answer.
 Question 5 - Answer

Keep Eliminate Net Effect

Sales $96,200 $ -0- $(96,200)
Variable costs ($70,000 + $15,000) 85,000 -0- 85,000
Contribution margin 11,200 -0- (11,200)
Fixed costs ($6,470 + $28,600) 35,070 35,070 -0-
Net income (loss) $(23,870) $(35,070) $(11,200)

Tiffany is incorrect. The incremental analysis above shows that net income will
be $11,200 less if the Coal Division is eliminated. This amount equals the
contribution margin that would be lost through discontinuing the division.
(Note: None of the fixed costs can be avoided, therefore the amount does not
differ between alternatives, making it irrelevant.)
 Question 6: Allocation of Limited
Resources
Meagher Inc. can produce three different products interchangeably on two
machines. The accounting department provides the following information on these
products:

A B C
Selling price per unit $25 $35 $45
Variable costs per unit $15 $27 $37
Units produced per machine hour 10 12 14
Minimum units produced 100 none 140
Maximum units produced 200 none 200

The total machine hours available are 100.

Required:
1. Determine the number of machine hours per unit.
2. Determine the contribution margin per machine hour.
3. Determine how many units of each product should be produced and the
total contribution margin.
 Question 6 - Answer
A B C
Selling price 25 35 45
Variable costs 15 27 37
Contribution Margin 10 8 8
Units/hour 10 12 14
1 1 1
Hours/unit
10 12 14

CM/Hour 100 96 112

Minimum units produced 100 none 140
Maximum units produced 200 none 200
Priority 2 3 1

First make minimum of A & C in order of priority:

1
140 ∗ = 10 hours 90 hours left
14
1
100 ∗ = 10 hours 80 hours left
10
Then maximize C:
1
60 ∗ = 4.29 hours 75.71 hours left
4
Then maximize A:
1
100 ∗ = 10 hours 65.71 hours left
10
Use remaining hours on B:
65.71hrs ∗ 12 units/hr = 788 units

Total CM: (200*10) + (788*8) + (200 ∗ 8) = $9,904

Thank you for coming!