Incremental analysis, 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.
Making or buying component parts or products
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.
Selling products or processing further
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:
Eliminating an unprofitable segment
If a company has several business segments, one of which is unprofitable, management must decide what to do with the unprofitable segment. In reviewing the quantitative information, a distinction must be made between those costs that will no longer exist if the segment ceases to do business and those costs that will continue and need to be covered by the remaining segments. Costs that go away if the segment no longer operates are called avoidable costs, and those that remain even if the segment is discontinued are called unavoidable costs.
Segment data for See Me Binoculars, Inc., shows the economy segment has operating income of $120,000, the standard segment has operating income of $250,000, and the deluxe segment is unprofitable by $200,000. The total company has operating income of $170,000.
To prepare the quantitative analysis for its decision whether to eliminate the deluxe segment, the fixed expenses must be separated into avoidable and unavoidable costs. It has been determined that unavoidable costs will be allocated 45% to economy and 55% to standard. If all the fixed expenses are unavoidable, the company would experience an operating loss of $130,000 if the deluxe segment was discontinued, split as follows:
If $300,000 of the fixed expenses are avoidable costs and $200,000 are unavoidable costs, the company's operating income would remain unchanged at $170,000.
The deluxe model has a contribution margin of $300,000, which helps cover some but not all of the fixed expenses generated by its production and the fixed corporate expenses that are allocated to it. If the unavoidable expenses (variable and fixed) are more than the segment's revenues, a decision should be made as to whether to discontinue the segment. If the avoidable expenses are less than the segment's revenues, discontinuing the segment could result in a loss to the company. Although a segment may be unprofitable, it may be contributing to the overall income of the company. This and other factors should be considered before discontinuing the segment.
Allocating scarce resources (sales mix)
When a company sells more than one product and has limited capacity for production of its products, it should optimize its production to produce the highest net income possible. To maximize profit, a calculation of the contribution margin for each product is required. In addition, the amount of the limited capacity each product uses must be determined. For example, if Golfers Paradise produces two different sets of golf clubs, it is limited by its machine capacity of 4,200 hours per month. The relevant data needed to determine production requirements are contribution margin and machine hours required to produce the standard and the deluxe set of golf clubs.
From the relevant data, the deluxe set appears to have the largest contribution margin. However, the standard set can be produced in half the time it takes to produce the deluxe set. To determine which unit should be produced, the contribution margin per hour (the limited resource) must be determined. It is calculated by dividing the contribution margin by the machine hours per set. This calculation shows the standard set has the highest contribution margin when the capacity limitation is considered. The company should produce the standard set.
If both sets required the same machine hours, the deluxe set would be produced. If the market for the standard set is less than 67,200 (the number of standard sets that could be produced in a year), the deluxe sets should be produced for any excess capacity remaining after the standard sets are produced.