, sometimes called marginal or differential analysis, is used to analyze the financial information needed for decision making. It identifies the relevant revenues and/or costs of each alternative and the expected impact of the alternative on future income.
Here are some examples of incremental analysis:
- Accepting additional business.
- Making or buying parts or products.
- Selling products or processing them further.
- Allocating scarce resources (sales mix).
Accepting additional business
The Party Connection prepares complete party kits for various types of celebrations. It is currently operating at 75% of its capacity. It costs The Party Connection $4.50 to make a packet that it sells for $25.00. It currently makes and sells 84,000 packets per year. Detailed information follows:
The Party Connection has received a special order request for 15,000 packets at a price of $20 per packet to be shipped overseas. This transaction would not affect the company's current business. If 84,000 packets is 75% of capacity, 112,000 packets would be 100% of capacity. The Party Connection has the capacity to prepare the 15,000 packets requested without changing its existing operations. Should the Party Connection accept this special order? Using its current cost information, the answer would be no because accepting the order would generate a $7,500 loss.
However, this is not the proper way to analyze the alternative. Incremental analysis, which identifies only those revenues and costs that change if the order were accepted, should be used to analyze the alternative. This requires a review of the costs. Suppose the following information is discovered with further analysis:
- Accepting this order would not impact current sales.
- To manufacture 15,000 packets would require $12.00 of direct materials and $6.00 of direct labor.
- The per unit overhead cost of $0.50 is 50% variable ($0.25) and 50% fixed ($0.25).
- Selling costs (includes commissions and delivery costs) for the 15,000 packets would be $7,000.
- Administrative expenses would not change.
Under this scenario, $300,000 of additional revenues would be created with additional costs of $280,750, so operating income would increase by $19,250 if the order were accepted. Given the available capacity, this opportunity would not result in additional costs to expand capacity. If the current capacity were unable to handle the special request, any new costs for expanding capacity would be included in the analysis. Also, if current sales were impacted by this order, then the lost contribution margin would be considered an opportunity cost for this alternative. With additional operating income of $19,250, this order could be accepted.
The decision to make or buy component parts also uses incremental analysis to determine the relevant costs. Opportunity costs must also be considered. Toyland Treasures uses part #56 in several of its products. Toyland Treasures currently produces 50,000 of part #56 using $0.30 of direct materials, $0.20 of direct labor, and $0.10 of overhead. The purchase of parts is under review by the company's management. Purchasing has determined it would cost $0.75 per unit to purchase 50,000 of part #56. Should Toyland Treasures continue to make part #56 or should it purchase the part?
The total costs to produce part #56 are $30,000, a savings of $7,500 over the purchase option, and the choice would be for Toyland Treasures to continue to make the part.
If Toyland Treasures can use the part #56 production space for a product that would generate $20,000 of additional operating income, the make or buy analysis would generate incremental costs of $12,500 to make the part. In this case, the company would likely choose to purchase part #56 and produce the other product. The $20,000 additional operating income is considered an opportunity cost and is added to the Make column of the analysis.
Some companies' product can be sold at different stages in their production cycle. For example, the DGK Company manufactures children's play gyms. It can sell the gyms assembled or unassembled. Incremental analysis is used in the decision to sell unassembled products. A general guideline DGK should consider when deciding how to sell its units is that if the incremental revenues generated from assembling the gyms are greater than the incremental assembly costs, DGK should assemble the gyms (process further). DGK sells an unassembled gym for $1,000. Its costs to manufacture a gym are $550, which consist of direct materials of $300, direct labor of $150, and overhead of $100. It is estimated that assembling a gym would take additional labor of $100 and overhead of $25, and once assembled, the gym could be sold for $1,500.
On a per unit basis, the incremental analysis shows that DGK should process further and assemble the gyms. Qualitative factors such as loss of business if unassembled gyms were not offered (an opportunity cost) and customers' willingness to pay the additional $500 for an assembled gym need to be considered.
An alternative way of analyzing this decision is: