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Incremental Analysis

 

Incremental analysis is used to find the impact of changes in costs or revenues, given a specific potential scenario. Decisions involving incremental analysis include the following:

Make or buy: Should we make a component ourselves or farm out the work to someone else? Qualitative considerations may or may not override quantitative issues. For example, we may be able to subcontract work more economically than we can do it ourselves, but if the contractor is unable to maintain the necessary level of quality or meet delivery schedules, subcontracting may not be worthwhile. The impact of quality and/or delivery problems may not be quantifiable, thus making the whole business a judgment call.

Sell or process further: Sell or process further issues often arise in industries which refine raw materials. The key question is whether the incremental revenues from a more highly refined product will at least offset the increased costs associated with additional processing.

Special order: Special orders typically involve special requests from customers who want a reduced price or some sort of special work. The extra effort might take the form of extra machining, special finishes, rush delivery [which could entail both an accelerated production schedule as well as air freight or other transportation costs], or an unusually small production run. As with the other decisions discussed here, quantitative and qualitative issues may be in conflict. Suppose an especially valuable customer want some sort of special deal, whether a reduced price or extra work. The lower revenue or added costs may mean taking a loss on the job, but we have to decide whether alienating the customer is more serious than the short term hit on profits. Some costs associated with special orders are not easily accounted for. Special production runs may require extra set ups of machinery which increase total indirect costs; however, such costs are often not easily accounted for, and therefore may not be readily added to the charges to the customer, even if the customer is willing to absorb such charges.

Changes in production and/or technology: Modifications in production processes or acquisition of new machinery typically entail adjustments in costs. New machinery or a revised process may enhance efficiency in the use of labor and/or material. It is clearly important to know whether the improvements offset whatever incremental costs may be associated with the changes.

It is obviously important to be able to understand how decisions like these affect both fixed and variable costs. If a given costs element does not change with a particular decision, it is irrelevant for purposes of that decision and we can ignore it. This may simplify calculations. For example, if the only change due to a decision is an increase or decrease in variable costs, all we need to do is recalculate the contribution margin.

A question of relevance

The basic concept underlying almost all incremental analyses is the idea of relevance: What revenues and/or costs are relevant to the decision in question? In many situations requiring incremental analysis, fixed costs remain unchanged, irrespective of the course of action finally taken. Therefore, those fixed costs are irrelevant for the purposes of the decision in question and can be ignored. [This is not to say that fixed costs are unimportant, or that they don't eventually have to be taken into account. In the long run, fixed costs have to be covered if we are going to make money.] However, incremental analysis is typically used for short run, one-time decisions.

When "one-time decisions" get to be routine, it may be time to reevaluate the situation. For example, suppose a customer wants some sort of special attachment on a product--what on the surface appears to be a "this month only" occurrence. Then perhaps two or three months later, the same customer calls and says "Remember back in May you did a special job for us? Well, we need another thousand of those. How soon could you have them?" At some point, management needs to determine whether the "one-time occurrence" has suddenly become the "normal circumstances."

Another key element in incremental analysis is the notion of sunk costs. Sunk costs are costs which were incurred in the past. No future action or inaction can change the situation. Suppose we spend a million dollars on June 1st for a large machine which will enhance productivity. On June 2nd, a sales representative offers to sell us a competitive machine for $500,000; this machine has twice the productivity of the one purchased on June 1st. In this classic case of "buyer's remorse," it is tempting to we now have a $1.5 million decision. However, the million spent on machine #1 is a sunk cost. We may have really messed up by not doing our homework and surveying all the options available before we bought the machine. However, if the second machine really will have the stated impact on productivity, it would be foolish not to spend the money [if we have, of course; we may have "shot our wad" on machine #1]. However, no matter what we do, the million is gone and is irrelevant to the decision about machine #2.

Copyright 2004 Gerald M. Myers. All rights reserved. This site has been developed as aid to instructors and students in managerial accounting. The scenarios contained herein are not intended to reflect effective or ineffective handling of managerial situations. Any resemblance to existing organizations is purely coincidental.
Last modified: August 03, 2005