Chapter 7: Incremental analysis

Question 1

What are the four general steps in management’s decision-making process?

Answer 1

1) Identify the problem and assign responsibility.
2) Determine and evaluate possible courses of action.
3) Make a decision.
4) Review the results of the decision

Question 2

What is incremental analysis and how is it relevant to managerial decision-making?

Answer 2

Incremental analysis is the process of identifying the financial outcomes of different alternatives.

It involves considering only the costs and revenues that will change as a result of the decision, known as relevant costs.

Question 3

What are relevant costs and why are they important in incremental analysis?

Answer 3

Relevant costs are those that will occur in the future and differ between alternatives.

They are important because they help management focus on the financial impacts that can be influenced by decisions.

Question 4

Define opportunity cost in the context of incremental analysis.

Answer 4

Opportunity cost is the benefit foregone by choosing one option over another. It is the potential income from the next-best alternative that is not selected.

Question 5

What are sunk costs and are they considered in incremental analysis?

Answer 5

Sunk costs are expenses that have already been incurred and cannot be recovered or changed by any future decision.

They are not considered in incremental analysis because they do not affect the incremental costs and benefits of current and future choices.

Question 6

Besides quantitative factors, what other types of considerations might influence managerial decision-making?

Answer 6

Qualitative factors such as:

• The potential effects of a decision on employee morale,
• company reputation,
• and community impact

may also influence managerial decision-making.

Question 7

How does activity-based costing relate to incremental analysis?

Answer 7

Activity-based costing helps in the better identification of relevant costs, thereby leading to a more accurate incremental analysis by allocating overhead costs more precisely to products.

Question 8

What are the common types of decisions that involve incremental analysis?

Answer 8

1) Accepting an order at a special price.
2) Making a make or buy decision.
3) Deciding whether to sell or process products further.
4) Retaining or replacing equipment.
5) Eliminating or retaining an unprofitable segment.
6) Allocating limited resources.

Question 9

When should a company accept a special order?

Answer 9

A company should accept a special order if the incremental revenue from the special order exceeds the incremental costs to complete the order.

Question 10

In incremental analysis for special orders, what costs are relevant?

Answer 10

Relevant costs include variable costs that will change as a result of accepting the order.

Fixed costs are not relevant if they do not change with the decision to accept the order.

Question 11

What two conditions are important when considering a special order?

Answer 11

1) Sales of the product in other markets should not be affected by the special order.

2) If operating at full capacity, the company would need to consider whether the special order requires additional fixed costs for expanding plant capacity.

Question 12

What is a make-or-buy decision?

Answer 12

A make-or-buy decision is the choice between producing a component part in-house (make) or purchasing it from an external supplier (buy).

Question 13

What are the key costs to consider in a make-or-buy decision?

Answer 13

The key costs to consider are:

• The variable costs that would be saved by not making the component.
• Any avoidable fixed costs,
• The cost of purchasing the component from a supplier.

Question 14

How does opportunity cost affect make-or-buy decisions?

Answer 14

If not producing the part frees up capacity that could be used to generate additional income, this potential income is an opportunity cost that should be considered in the make-or-buy decision.

Question 15

When including an opportunity cost of $38,000 for the capacity to produce an alternative product, should Baron Company make or buy the switches?

Answer 15

Including the opportunity cost, Baron Company should buy the switches, as this would increase the company’s net income by $13,000 compared to making them in-house.

Question 16

What is the basic decision rule when deciding whether to sell or process materials further?

Answer 16

Process further as long as the incremental revenue from processing is more than the incremental processing costs.

Question 17

In a single-product case, how do you determine if processing further is beneficial?

Answer 17

Calculate the incremental revenue from selling the processed product and subtract the incremental costs of processing.

If the net income per unit increases, processing further is beneficial.

Question 18

What does the incremental analysis for processing a single-product further involve?

Answer 18

The analysis involves comparing the net income per unit if sold as is versus if processed further, taking into account only the additional costs and revenues from further processing.

Question 19

What additional complexity is involved in the sell-or-process-further decision for multiple products?

Answer 19

Multiple products arise from a common production process, and the decision must consider the allocation of joint costs and the revenues and costs associated with each potential end product.

Question 20

Are joint costs relevant in making sell-or-process-further decisions for multiple products?

Answer 20

No, joint costs are sunk costs and are not relevant.

They are incurred before the split-off point and do not affect the incremental analysis for further processing.

Question 21

How do you decide whether to sell or process further in joint product situations?

Answer 21

For each product that could be processed further, compare the incremental costs of further processing with the incremental revenue.

Process further if the incremental revenue exceeds the incremental costs.

Question 22

Why might a company need to re-evaluate its sell-or-process-further decisions?

Answer 22

Market conditions can change, affecting the relative profitability of selling now versus processing further.

Companies must remain adaptable and reassess these decisions periodically.

Question 23

What factors should be considered when deciding whether to retain or replace equipment?

Answer 23

Consider the total variable manufacturing costs over the relevant time period, the cost of the new machine, and any proceeds from selling the old machine.

Do not consider the book value of the old machine, as it is a sunk cost.

Question 24

How do you conduct an incremental analysis when considering equipment replacement?

Answer 24

Compare the total variable costs of retaining the equipment with the costs of replacing it, including the cost of the new machine and any salvage value from the sale of the old machine.

Question 25

Why are sunk costs like the original purchase cost and past repairs not considered in the decision to retain or replace equipment?

Answer 25

Sunk costs have already been incurred and cannot be recovered, so they should not influence the decision. Only future costs and savings are relevant.

Question 26

When deciding whether to eliminate an unprofitable segment, what costs and revenues are relevant?

Answer 26

Relevant costs are those that will change if the segment is eliminated, such as variable costs and avoidable fixed costs. Contribution margins of the segment are also relevant.

Question 27

Why is contribution margin important in the decision to eliminate an unprofitable segment?

Answer 27

If discontinuing a segment, the lost contribution margin must be considered against any fixed costs that can be eliminated.

If the lost contribution margin exceeds the fixed costs saved, total net income may decrease.

Question 28

How does the reevaluation of fixed costs affect the decision to eliminate an unprofitable segment?

Answer 28

If some fixed costs associated with an unprofitable segment can be eliminated, this could potentially turn a net loss into a net gain by reducing the company’s overall fixed costs.

Question 29

What behavioural errors might affect decisions on equipment replacement?

Answer 29

Decisions may be affected by errors such as considering sunk costs, like past repairs, or hesitating to replace recently purchased equipment with more efficient alternatives due to the recentness of the purchase.

Question 30

What additional factors should be considered when deciding to eliminate a product line?

Answer 30

Consider the effects on linked products or services,

the potential loss of sales from discontinuing a line,

and the impact on employees who may need to be discharged or retrained.

Question 31

What should a company consider when deciding the sales mix if resources are limited?

Answer 31

When resources are limited, a company should allocate them towards the product that yields the highest contribution margin per unit of the limited resource.

Question 32

How do you calculate the contribution margin per unit of the limited resource?

Answer 32

Divide the contribution margin per unit by the number of units of the limited resource required for each product.

Question 33

Why is contribution margin per unit of limited resource important in decision-making?

Answer 33

It helps determine which product to prioritize in production to maximize the net income when there are constraints on resources like machine hours.

Question 34

What factors should be considered in an incremental analysis when deciding whether to retain or replace equipment?

Answer 34

Consider the savings in variable costs,

the cost of new equipment,

any proceeds from the sale of the old equipment,

and ignore sunk costs like the book value of the old machine.

Question 35

When is it appropriate to eliminate an unprofitable business segment?

Answer 35

An unprofitable segment should only be eliminated if doing so increases overall net income, which requires considering if fixed costs can be avoided and the contribution margin that will be lost.

Question 36

What is the theory of constraints and how is it applied to managerial decision-making?

Answer 36

The theory of constraints involves identifying limiting factors (constraints) in a process and finding ways to improve outcomes by managing these constraints effectively.

Question 37

How should a company approach a comprehensive decision-making scenario involving special orders and limited resources?

Answer 37

Perform incremental analysis to compare all relevant costs and revenues for the special order, considering the available capacity and any associated costs or savings.