EXERCISES FOR INCREMENTAL ANALYSIS
1. Print Jiff manufactures books. The company is trying to decide whether to print the individual
pages in-house (the current practice) or have a printing company perform this task. For each of
the following items, indicate if the item is relevant or not relevant to this decision.
________ A. Cost of buying ink
________ B. Rent on the Print Jiff factory
________ C. Original price of the book binder owned by Print Jiff
________ D. Salvage value of the binding equipment owned by Print Jiff
________ E. Cost of paper for printing books
________ F. Morale of employees in the printing company
Answer
A. Relevant D. Relevant
B. Not relevant E. Relevant
C. Not relevant F. Relevant
2. Marcus Company requires three units of P11 for every unit of A5 that it produces. Currently, P11
is made by Marcus, with the following per unit costs in a month when 4,000 units were produced:
Direct materials $4.00
Direct labor 1.50
Manufacturing overhead 2.60
Total $8.10
Variable manufacturing overhead is applied at $1.00 per unit. The other $1.60 of overhead
consists of allocated fixed costs. Marcus will need 6,000 units of P11 for next year’s production.
Landers Corporation has offered to supply 6,000 units of P11 at a price of $7.00 per unit. If
Marcus accepts the offer, all of the variable costs and $1,200 of the fixed costs will be avoided.
Should Marcus Company accept the offer from Landers Corporation?
Answer
Cost to buy: 6,000 × $7 = $42,000
Cost to make:
Variable costs ($4.00 + $1.50 + $1.00) × 6,000 $39,000
Fixed costs 1,200
Total costs $40,200
Incremental decrease in profit if offer is accepted = $1,800
Marcus should not accept the offer.
3. An employee of SaniTan has found some partially completed units of Model 45 in a dusty corner
of the warehouse. A job ticket attached to the units indicates that a total of $600 in manufacturing
costs have been used to bring the materials to this point in the manufacturing process. The units
can be sold in their current condition for $200 to a scrap metal dealer. If SaniTan spends $180 to
complete the units, they can be sold for $500.
a. What should SaniTan? Justify your answer.
b. Identify a sunk cost in this problem.
Answer
a. SaniTan should finish the units. The incremental revenue of $300 ($500 – $200) is
greater than the incremental cost of $180. Profit increases by $120.
b. The $600 in costs incurred is sunk and not relevant.
4. Starwood Aviation produces an executive jet for which it currently manufactures an airflow lever.
The cost of each lever is indicated below:
Variable costs
Direct material $300
Direct labor 200
Variable overhead 150
Total variable costs $650
Fixed costs
Depreciation of equipment 120
Depreciation of building 80
Supervisory salaries 140
Total fixed costs 340
Total cost $990
The company has an offer from Lans Levers to produce the part for $700 per unit and is able to
supply the 600 levers needed in the coming year. If the company accepts this offer and shuts
down production of levers, supervisors will be reassigned to other areas needing their services.
The equipment cannot be used elsewhere in the company, and it has no market value. However,
the space occupied by the production of the lever can be used by another production group that is
currently leasing space for $21,000 per year. Prepare a single column incremental analysis in
good form to determine if the company should make or buy the lever.
Answer
Incremental cost to buy (600 × $700) ($420,000)
Incremental cost savings:
Direct material (600 × $300) $180,000
Variable overhead (600 × $150) 90,000
Direct labor (600 × $200) 120,000
Leasing cost reduction 21,000 411,000
Incremental additional cost to buy ($ 9,000)
5. Deason Distributors has decided to discontinue manufacturing its Venus model blender.
Currently, the company has 4,600 partially completed blenders on hand. The government has
taken the blades off the market that the company uses in the blender, so each base must be
reworked to accommodate a new style of blades. The company has spent $110 per unit to
manufacture these blenders to their current state. Reworking each blender will cost $20 for
material and $20 for direct labor. In addition, $7 of variable overhead and $32 of allocated fixed
overhead (relating primarily to depreciation of plant and equipment) will be allocated per unit. If
Deason completes the blenders, it can sell them for $160 per unit. On the other hand, another
manufacturer is interested in purchasing the partially completed blenders for $104 each and
converting them into choppers. In good form, prepare an incremental analysis per unit to
determine if Deason should complete the blenders or sell them in their current state.
Answer
Incremental revenue per unit ($160 – $104) $56
Incremental costs:
Materials ($20)
Direct labor (20)
Variable overhead (7) (47)
Incremental benefit per blender $ 9
6. Football Fanatics sells logo sports merchandise and does custom embroidery. The company is
contemplating whether or not to continue the embroidery service. All of the company’s direct
fixed costs can be avoided if a segment is dropped. The following information is available for the
segments.
Embroidery Apparel
Sales $60,000 $250,000
Variable costs 30,000 110,000
Contribution margin 30,000 140,000
Direct fixed costs 22,000 40,000
Allocated common fixed costs 12,000 50,000
Net income ($ 4,000) $ 50,000
a. What will be the impact on net income if the embroidery segment is dropped?
b. Assume that if the embroidery segment is dropped, apparel sales will increase 10%. What
is the impact on contribution margin and net income solely for the apparel ?
c. Identify one cost that is not relevant in this analysis.
Answer
a. If the embroidery segment is dropped, the contribution margin of $30,000 will be lost and
only the direct fixed costs of $22,000 will be saved, so there will be a decrease of $8,000
in net income.
b. For the apparel segment:
Contribution margin = 140,000 × 10% = $14,000 increase
Net income = $140,000 × 10% = $14,000 increase
c. The common fixed costs are not relevant since they will exist in either option.
7. Sausalita’s Cantina has been approached by Luck & Dewey that wants to hold an employee
recognition dinner next month. The restaurant manager agreed to a charge of $50 per person for
food, wine, and dessert for 90 people. The manager estimates that the cost of the food will be $17
per person and beverages will be $15 per person.
To be able to accommodate the group, the restaurant must be closed for dinner that night.
Typically, 100 people with an average bill of $44 per person would be served each evening, with
the cost of food estimated at $14 per person and beverages at $11 per person. No additional staff
will need to be hired to accommodate the group from Luck & Dewey.
a. In good form, prepare an incremental analysis to determine the effect on net income
associated with accepting the Luck & Dewey group.
b. What is the opportunity cost of accepting the Luck & Dewey group?
Answer
a.
Incremental revenue ($50 × 90) $4,500
Cost of food and beverage ($32 × 90) (2,880)
Lost revenue ($44 × 100) (4,400)
Cost savings for food and beverage ($25 × 100) 2,500
Incremental decrease in profit ($ 280)
b. $4,400 – $2,500 = $1,900
8. Acer Computing manufactures tablets. The manufacturing process uses a processor that Acer
currently manufacturers. The resource officer of Acer has been asked to determine if it is
advisable to purchase the processors rather than make them internally (the current practice).
Identify which of the following items are relevant to the resource officer’s decision by circling
the number preceding each relevant item.
1. The original cost of equipment currently used to manufacture the processors
2. The market value of equipment currently used to manufacture the tablets
3. The cost of buying processors from suppliers
4. Rent revenue for the space freed up if the processors are not manufactured internally
5. The salary of the president of Acer Computing
6. The quality of the processors made internally
7. The quality of the processors purchased from suppliers
8. Depreciation on equipment used to manufacture the processors
9. The labor contract with production workers
10. The selling prices of tablets
Answer
2, 3, 4, 6, 7, and 9
9. Rocking Express manufactures rocking chairs. Recently, the company began manufacturing and
marketing a chair with an automatic rocker. Demand for this rocker is very strong and the CEO of
Rocking Express is considering dropping production of the company’s original rocker. This will
give the company increased capacity to devote to the new model. Identify which of the following
items are relevant to the CEO’s decision by circling the number preceding each relevant item.
1. The original cost of equipment used to manufacture the old rocker
2. Depreciation of the equipment used to manufacture the old rocker (ignore taxes)
3. The rent on the warehouse used to store the completed inventory and materials
4. The time it takes to manufacture each rocker
5. The factory janitor’s salary
6. The selling price of the new rocker
7. The variable cost of producing the new rocker
8. The cost of retraining personnel to make the newer rocker
9. Depreciation of the factory building allocated to the old rocker
Answer
4, 6, 7, and 8
10. Sandford Electronics sells desktops and notebook computers. Currently, the desktop product line
takes up approximately 50 percent of the company’s retail floor space. The president of the
company is trying to decide whether the company should continue offering desktops or just
concentrate on notebooks. If the desktop product line is dropped, salaries and other direct fixed
costs can be avoided. In addition, sales of notebooks will increase by 10 percent. Allocated fixed
costs are assigned based on labor hours.
Notebooks Desktops Total
Sales $1,200,000 $800,000 $2,000,000
Less cost of goods sold 700,000 500,000 1,200,000
Contribution margin 500,000 300,000 800,000
Less direct fixed costs:
Salaries 175,000 175,000 350,000
Other 60,000 60,000 120,000
Less allocated fixed costs:
Rent 14,118 9,882 24,000
Insurance 3,529 2,471 6,000
Cleaning 4,117 2,883 7,000
President’s salary 76,470 53,530 130,000
Other 7,058 4,942 12,000
Total costs 340,292 308,708 649,000
Net income $ 159,708 ($ 8,708) $ 151,000
Prepare an incremental analysis in good form to determine the incremental effect on net income
of discontinuing the desktop computer line.
Answer
Incremental drop in desktop revenue ($800,000)
Incremental cost savings on desktops:
Cost of goods sold 500,000
Salaries 175,000
Other 60,000
Incremental increase in revenue of notebooks
(10% × $1,200,000) 120,000
Incremental increase in variable costs of notebooks
(10% × $700,000) (70,000)
Incremental decrease in profit ($ 15,000)
11. Budget Enterprises is considering a special order from an overseas customer for 10,000 units at a
price of $40.00 per unit. The company’s product normally sells for $52.00 per unit and has
variable manufacturing costs of $21.00 per unit and variable selling costs of $4.00 per unit. Fixed
manufacturing costs are $500,000 and fixed selling and administrative costs are $200,000. Budget
Enterprises has the capacity to produce 100,000 units and is currently producing 80,000. If
Budget accepts the order, it will incur legal and accounting fees of $7,000 in connection with the
order, though variable selling costs will not be incurred on the special order and it will not affect
any of its other operations.
a. How much are the incremental revenues associated with the special order?
b. How much are the incremental costs associated with the special order?
c. How much additional profit or loss will be incurred if the order is accepted?
Answer
a. $40.00 × 10,000 = $400,000
b. $21.00 × 10,000 = $210,000
7,000
$217,000
c. $400,000 – $217,000 = $183,000 profit
12. Canon Equipment produces a machete that it sells for $45 each. The cost of producing 20,000
machetes in the prior year was:
Direct material $220,000
Direct labor 100,000
Variable overhead 140,000
Fixed overhead 120,000
Total cost $580,000
At the start of the current year, the company received an order for 2,000 machetes from a
company in South America. Management of Canon has mixed feelings about the order. On the
one hand, they welcome the order because they currently have excess capacity. This is also the
company’s first international order. On the other hand, the company in South America is only
willing to pay $37 for each machete. What will be the effect on profit of accepting the order?
Answer
Accepting the order will result in $28,000 of incremental profit.
Incremental revenue ($37 × 2,000) $74,000
Incremental costs:
Direct material ($11 × 2,000) $22,000
Direct labor ($5 × 2,000) 10,000
Variable overhead ($7 × 2,000) 14,000 46,000
Incremental profit $28,000
CHALLENGE EXERCISES
1. Lance, Inc. produces a line of products, which includes umbrellas. During 2014, there are 4,400
umbrellas budgeted for production. Total material costs for the umbrellas are budgeted at $7,700
and direct labor is $5,500. Overhead costs are $2.15 per unit of which $0.95 is variable. Forty-
five percent of the fixed overhead is allocated and unavoidable. Supplier, Inc. has contacted
Lance, Inc. with an offer to sell the umbrellas to Lance, Inc. for $4.50 each.
a. Prepare an incremental analysis to assess the decision.
b. Explain the nature of the ‘allocated’ fixed overhead. Why is this amount considered to be
‘unavoidable’?
Answer
a.
Incremental cost to buy ($4.50 × 4,400) ($19,800)
Incremental cost savings:
Direct materials 7,700
Direct labor 5,500
Variable overhead ($0.95 × 4,400) 4,180
Fixed overhead [($2.15 – $0.95) × 55% × 4,400] 2,904
Incremental increase in net income if umbrellas are bought $ 484
a. Allocated fixed overhead consists of fixed costs that cannot be traced to a particular
product or service provided. The costs are grouped together in a cost pool and then
allocated to all products using a basis on which the company thinks will distribute the
costs to the products that use the resources. If a product is eliminated, the total allocated
costs do not change, and any cost that was allocated to the eliminated product must be
reallocated to the remaining products. In total, there is no cost reduction of allocated
fixed overhead.
2. For each situation listed as items 1 through 3, identify the type of decision situation that is
presented, and recommend the appropriate action assuming only the financial impact is considered.
Justify your choice.
Scenario Type of Appropriate
Decision Action
1. Blockbuster has 3 product lines. Compact Discs (CDs) have a loss of $4,000 for
last year, while the other lines are profitable. If the CD product line is dropped,
allocated costs are unavoidable. The allocated costs exceed the operating loss of
the CD product line.
2. The incremental cost to make widgets for June is $3,380. The incremental cost to
buy from a supplier is $3,200.
Answer
Comments Type of Decision Appropriate Action
1. Dropping products/product lines causes profits to Drop a product or product Do not drop; Keep the
decline due to fixed costs that must be allocated. line (i.e., Keep or drop) CD product line
2. Cost to buy ($3,200) + cost savings $3,380 = $180
incremental profit if widgets are bought. Make or buy Buy from supplier
SHORT-ANSWER ESSAYS
1. What are the components of incremental analysis that are used to calculate incremental profit or
incremental loss?
Answer
Incremental analysis uses incremental revenues and incremental costs to calculate the incremental
profit or the incremental loss.
2. What are avoidable costs? Which costs are usually avoidable in a make-or-buy decision?
Answer
Avoidable costs are those costs that can be avoided, or eliminated, if a particular action is
undertaken. If a company chooses to buy an item, rather than make it, direct materials, direct
labor, variable overhead, and perhaps a portion of fixed manufacturing overhead are usually
avoidable costs.
3. What is the cause of the cost allocation death spiral?
Answer
The cost allocation death spiral is caused by not realizing that when a department that appears to
be unprofitable is dropped, the common fixed costs that had been allocated to that department
will need to be allocated to other departments. This may make these departments appear to be
unprofitable. If these departments are dropped, the same costs will continue to be allocated to
fewer and fewer departments.
4. What is the role of opportunity costs in a make-or-buy decision?
Answer
Opportunity costs are always incremental costs and should be considered in a make-or-buy
decision. If some components are purchased instead of made, the space and other resources that
are used for the production of these components can be used to generate additional profit.
5. List three disadvantages of using an outside supplier.
Answer
1. There is a loss of control over the production process, so quality control specifications
and delivery schedules may not be met.
2. The outside supplier may raise prices significantly in the future.
3. Employee morale may suffer if employees are transferred or terminated when an outside
supplier is used.
