Unformatted text preview: Chapter 26 Incremental Analysis
and Capital Budgeting Chapter
261 Accounting Principles, Ninth Edition Incremental Analysis and
Capital Budgeting Incremental Analysis Management’s decisionmaking process
Accept specialprice order
Make or buy
Sell or process further Chapter
262 Retain or replace
Retain
equipment
Eliminate unprofitable
segment
segment
Allocate limited resources Capital Budgeting Evaluation process
Annual rate of return
Cash payback
Discounted cash flow:
Discounted
NPV and IRR
NPV Management’s DecisionMaking Process
Im
portant m
anage e function
m nt
Doe not always follow a se patte
s
t
rn
De
cisions vary in scope urge and im
,
ncy,
portance
S ps usually involve in proce include
te
d
ss
:
Illustration 261 Chapter
263 SO 1: Identify the steps in management’s decisionmaking process. Management’s DecisionMaking Process
C
onside both financial and nonfinancial inform
rs
ation
Financial information include re nue and costs as we
s ve s
ll
as the e ct on ove profitability
ir ffe
rall
Nonfinancial information include e ct on e ploye
s ffe
m
e
t urnove thee
r,
nvironm nt, or ove com
e
rall
pany im
age Chapter
264 SO 1: Identify the steps in management’s decisionmaking process. Management’s DecisionMaking Process
Incremental Analysis Approach
De
cisions involvea choice am alte
ong rnativeactions
De
choice am
Financial data re vant to a de
le
cision arethedata that vary in the
Financial
future among alternatives
future
Both costs and re nue m vary or
ve s ay
Only re nue m vary or
ve s ay
Only costs m vary
ay Chapter
265 SO 2: Describe the concept of incremental analysis. Management’s DecisionMaking Process
Incremental Analysis
Proce use to ide
ss d
ntify thefinancial data that change
Proce
unde alte
r
rnativecourse of action
s
unde
I de
ntifie probablee cts of de
s
ffe
cisions on future
e
arnings
Also calle diffe ntial analysis be
d diffe
re
causeit focuse on
s
Also
diffe nce
re s
diffe Chapter
266 SO 2: Describe the concept of incremental analysis. How Incremental Analysis Works
Basic Example Illustration 262 C parison of Alte
om
rnativeB with Alte
rnativeA:
I ncre e re nueis $15,000 less under Alternative B
m ntal ve
Incremental cost savings of $20,000 is realized
Alternative B produces $5,000 more net income
Chapter
267 SO 2: Describe the concept of incremental analysis. How Incremental Analysis Works
S e e involve change that se mcontrary to intuition
om tim s
s
s
e
Variablecosts som tim s do not change unde
e e do
r
Variable
alte
rnative
s
alte
Fixe costs som tim s change be e alte
d
e e change twe n rnative
s
Fixe
I ncre e analysis not t hesam as C analysis
m ntal
e VP
not Chapter
268 SO 2: Describe the concept of incremental analysis. S enote pagefor solution
e
s How Incremental Analysis Works
BE262: Ming C pany is conside two alte
om
ring
rnative Alte
s.
rnativeA will
havesale of $150,000 and costs of $100,000. Alte
s
rnativeB will havesale of
s
$180,000 and costs of $120,000. C pareAlte
om
rnativeA to Alte
rnativeB
showing incre e re nue costs, and ne incom . Which alte
m ntal ve s,
t
e
rnativeshould
you choose
? Chapter
269 SO 2: Describe the concept of incremental analysis. Types of Incremental Analysis
Types
Acce an orde at a spe price
pt
r
cial
Acce
Makeor buy
S ll or proce furthe
e
ss
r
Re or re
tain
placee
quipm nt
e
Elim
inatean unprofitablebusine se e
ss gm nt
Allocatelim d re
ite source
s Chapter
2610 SO 2: Describe the concept of incremental analysis. Accept an Order at a Special Price
Obtain additional busine by m
ss
aking a m priceconce
ajor
ssion to a
Obtain
spe custom r
cific
e
spe
Assum s that sale of products in othe m ts arenot affe d by
e
s
r arke
cte
Assum
spe orde
cial
r
spe
Assum s that com
e
pany is not ope
rating at full capacity Chapter
2611 SO 3: Identify the relevant costs in accepting an order at a special price. Accept an Order at a Special Price
Example
C
ustom r offe to buy a spe orde of 2,000 units at $11 pe unit
e
rs
cial
r
r
No e ct on norm sale
ffe
al
s
No e ct on plant capacity; curre ope
ffe
ntly rating at 80%which is 100,000 units
Curre variablem
nt
anufacturing cost = $8 pe unit
r
Curre fixe m
nt
d anufacturing costs = $400,000 or $4 pe unit
r
Norm se
al lling price= $20 pe unit
r Base strictly on total cost of $12 pe unit ($8 + $4), reject offe as cost
d
r
r
Base
reject
e e se
xce ds lling priceof $11 Chapter
2612 SO 3: Identify the relevant costs in accepting an order at a special price. Accept an Order at a Special Price
Example  Continued
Fixed costs do not change since within existing capacity – thus fixed
Fixed
costs are not relevant
costs
Variable manufacturing costs and expected revenues change – thus
Variable
both are relevant to the decision
both
Illustration 263 Decision: Accept the offer; Income increases by $6,000
Chapter
2613 SO 3: Identify the relevant costs in accepting an order at a special price. S enote pagefor solution
e
s Accept an Order at a Special Price
BE263: In Karnes Company it costs $30 per unit ($20 variable and
$10 fixed) to make a product that normally sells for $45. A foreign
wholesaler offers to buy 4,000 units at $23 each. Karnes will incur
special shipping costs of $1 per unit. Assuming that Karnes has
excess operating capacity, prepare an incremental analysis that
indicates the net income (loss) Karnes would realize by accepting the
special order. Should the order be accepted? Chapter
2614 SO 3: Identify the relevant costs in accepting an order at a special price. Make or Buy
Must de whe r to m thecom nt parts or to buy the from
ake
pone
m
Must cide the
othe
rs
othe
Example:
The following costs are
The
incurre to m 25,000 switche
d
ake
s: Alternatively, the
the
switches can be
purchased for $8 per
switch ($200,000)
switch
Eliminates all variable
Eliminates
costs of making switches
costs
Eliminates $10,000 of
Eliminates
fixed costs; however,
$50,000 remain
$50,000 Chapter
2615 SO 4: Identify the relevant costs in a makeorbuy decision. Make or Buy
Example  Continued
Total manufacturing cost is $1 higher than purchase price
Must absorb at least $50,000 of fixed costs under either option
Illustration 265 Decision: Continue to make switches
Decision:
as purchasing adds $25,000 to cost
as
Chapter
2616 SO 4: Identify the relevant costs in a makeorbuy decision. Make or Buy
Opportunity Cost
t hepotential benefit t hat
thepotential
m beobtaine fromfollowing
ay
d
an alte
an rnativecourseof action
m beconside d in
ust
re
incre e analysis
m
incre ntal Chapter
2617 SO 4: Identify the relevant costs in a makeorbuy decision. Make or Buy
Example – Continued
Assume that buying the switches allows the company to use the
released capacity to earned $28,000 in additional income
The $28,000 lost income is an additional cost of making the
switches – an opportunity cost
Illustration 266 Decision: Buy the switches as company is $3,000 better off
Chapter
2618 SO 4: Identify the relevant costs in a makeorbuy decision.
SO Sell or Process Further
May haveoption to se product at a give point in production or
ll
n
May
to proce furthe and se at a highe price
ss
r
ll
r
to Decision Rule:
Proce furthe as long as theincre e re nuefromsuch
ss
r
m ntal ve
Proce
proce
ssing e e theincre e proce
xce ds
m ntal
ssing costs Chapter
2619 SO 5: Give the decision rule for whether to sell or process materials further.
SO Sell or Process Further
Example:
Costs to manufacture one unfinished table:
Direct materials
$ 15
Direct labor
$ 10
Variable manufacturing overhead
$6
Fixed manufacturing overhead
$4
Manufacturing cost per unit
$35
Selling price of unfinished unit is $50
Use capacity to finish tables to sell for $60 per table
Relevant unit costs of finishing table:
Direct materials increase $2
Direct labor increase $4
Variable overhead increase $2.40 (60% of direct labor)
No change in fixed overhead
Chapter
2620 SO 5: Give the decision rule for whether to sell or process materials further. Sell or Process Further
Example – Continued Illustration 268 Decision: Process further
Incremental revenue ($10) exceeds incremental processing costs
Incremental
($8.40); income increases $1.60 per unit
($8.40);
Chapter
2621 SO 5: Give the decision rule for whether to sell or process materials further. S enote pagefor solution
e
s Sell or Process Further
BE265: Stanton Inc. makes unfinished bookcases that it sells for
$60. Production costs are $30 variable and $10 fixed. Because it has
unused capacity, Stanton is considering finishing the bookcases and
selling them for $72.Variable finishing costs are expected to be $8
per unit with no increase in fixed costs. Prepare an analysis on a per
unit basis showing whether Stanton should sell unfinished or finished
bookcases. Chapter
2622 SO 5: Give the decision rule for whether to sell or process materials further. Retain or Replace Equipment
Example:
Assessment of replacement of factory machine:
Old Machine
New Machine
Book Value
$ 40,000
Cost
$ 120,000
Remaining useful life
four years
four years
Salvage value
00Variable manufacturing costs decrease from $160,000 to
Variable
$125,000 if new machine purchased
$125,000 Chapter
2623 SO 6: Identify the factors to consider in retaining or replacing equipment. Retain or Replace Equipment
Example – Continued
Illustration 269 Decision: Replace the Equipment
The lower variable costs due to replacement more than offset the
The
cost of the new equipment
cost
Chapter
2624 SO 6: Identify the factors to consider in retaining or replacing equipment. Retain or Replace Equipment
Additional Considerations
Thebook valueof old m
achinedoe not affe the
s
ct
The
de
cision.
de
Book valueis a sunk cost.
C which cannot bechange by future
osts
d
de
cisions (sunk cost) arenot re vant in
le
incre e analysis.
m
incre ntal
Howe r, any trade allowanceor cash disposal
ve
in
valueof thee
xisting asse is re vant.
t
le Chapter
2625 SO 6: Identify the factors to consider in retaining or replacing equipment. Eliminate an Unprofitable Segment
Ke Focus on Relevant Costs
y:
Ke Focus
C
onside e ct on re d product line
r ffe
late
s
Fixe costs allocate to theunprofitablese e must be
d
d
gm nt
absorbed by theothe se e
r gm nts
absorbed
Ne incom m decrease whe an unprofitablese e is
t
e ay decrease
n
gm nt
e inate
lim
d
De
cision Rule
:
Retain the segment unless fixed costs eliminated
Retain
exceed contribution margin lost
exceed
Chapter
2626 SO 7: Explain the relevant factors in whether to
SO
eliminate an unprofitable segment.
eliminate Eliminate an Unprofitable Segment
Example:
Martina C pany m
om
anufacture thre m ls of te racke
s e ode
nnis
ts:
Profitableline Pro and Maste
s:
r
Unprofitableline C p
: ham C nse I ncom S m nt data:
onde d
e tate e
Illustration 2610 Should Champ be eliminated? Chapter
2627 SO 7: Explain the relevant factors in whether to
SO
eliminate an unprofitable segment.
eliminate Eliminate an Unprofitable Segment
Example – Continued
I f C p is e inate allocateits $30,000 fixe costs:
ham
lim
d,
d
2/3 to Pro and 1/3 to Maste
r
Re d I ncom S m nt data:
vise
e tate e
Illustration 2611 Total incom has decreased by $10,000
e decreased
Chapter
2628 SO 7: Explain the relevant factors in whether to
SO
eliminate an unprofitable segment.
eliminate Eliminate an Unprofitable Segment
Example – Continued
I ncre e analysis of C p provide thesam re
m ntal
ham
d
e sults: Do Not
Eliminate Champ
Illustration 2612 De asein ne incom is dueto C p’s contribution m
cre
t
e
ham
argin ($10,000)
t hat will not bere d if these e is discontinue
alize
gm nt
d.
Chapter
2629 SO 7: Explain the relevant factors in whether to
SO
eliminate an unprofitable segment.
eliminate Allocate Limited Resources
Resources are always limited
Floor spacefor a re firm
tail
Raw m rials, dire labor hours,
ate
ct
or m
achinecapacity for a
m
anufacturing firm
Manage e m de which
m nt ust cide
products to make and sell to
maximize net income
maximize Chapter
2630 SO 8: Determine which products to make and sell when
SO
resources are limited.
resources Allocate Limited Resources
Example:
C
ollins C pany m
om
anufacture
s
de and standard pe and
luxe
n
pe se
ncil ts
Lim
iting re
source
:
3,600 m
achinehours pe m
r onth Illustration 2613 De se has highe contribution m
luxe t
r
argin: $8
S
tandard se take fe r m
t
s we achinehours pe unit
r
Chapter
2631 SO 8: Determine which products to make and sell when
SO
resources are limited.
resources Allocate Limited Resources
Example:  Continued
Must com
putecontribution margin per unit of limited
resource
Illustration 2614 S
tandard se havehighe contribution m
ts
r
argin pe unit of lim d
r
ite
re
source
s
Decision: Shift sales mix to standard sets or
increase machine capacity
Chapter
2632 SO 8: Determine which products to make and sell when
SO
resources are limited.
resources Allocate Limited Resources
Example:  Continued
Alte
rnative I ncre m
:
ase achinecapacity from3,600 to 4,200 m
achine
hours
Illustration 2615 To m izene incom , all theadditional 600 hours should beuse to
axim
t
e
d
producestandard se
ts
Chapter
2633 SO 8: Determine which products to make and sell when
SO
resources are limited.
resources Capital Budgeting
Theproce of m
ss
aking capital e nditurede
xpe
cisions in busine is
ss
The
known as
known
Capital Budgeting
Theam
ount of possiblecapital e nditure usually e e thefunds
xpe
s
xce ds
availablefor such e nditure
xpe
s
C
apital budge involve choosing am various capital proje
ting
s
ong
cts
t o find theone that will
(s)
Maximize a company’s return on investment Chapter
2634 Evaluation Process
Many com
s
fully pre
scribe proce in capital
d
ss
Many panie follow a care
budge
ting.
budge
At le oncea ye
ast
ar:
Proposals arere ste frome de
que d
ach partm nt
e
Thecapital budge com itte scre ns theproposals and
ting m e e
subm its findings to theoffice of thecom
its
rs
pany
Office se ct proje and subm list to theboard of
rs le
cts
it
dire
ctors for approval Chapter
2635 Evaluation Process
Providing m
m nt
le
Providing anage e with re vant data for
capital budge de
ting cisions re
quire fam
s iliarity
with quantitativete
chnique
s.
with
Them com on te
ost
m
chnique are
s:
Annual Rate of Return
Cash Payback
Discounted Cash
Discounted
Flow
Flow
Chapter
2636 Evaluation Process
These techniques will be illustrated using the following data for
These
Tappan Company:
Tappan
Investment in new equipment: $130,000
Useful life of new equipment: 10 years
Zero salvage and straightline depreciation
The expected annual revenues and costs of the new
product that will be produced from the investment are:
Illustration 2616 Chapter
2637 Annual Rate of Return
Theannual rateof re
turn te
chniqueis base dire on accounting
d ctly
The
data
data
I t indicate theprofitability of a capital e nditure
s
xpe
Theform is:
ula
Illustration 2617 Thee cte annual ne incom is fromtheproje d I ncom
xpe d
t
e
cte
e
S m nt
tate e
Chapter
2638 SO 9: Contrast annual rate of return and cash payback in
SO
capital budgeting.
capital Annual Rate of Return
Theave inve e is de d fromthefollowing form
rage stm nt
rive
ula:
Illustration 2618 For Tappan C pany theave inve e is:
om
rage stm nt [($130,00 + $0) ÷ 2] = $65,000 Chapter
2639 SO 9: Contrast annual rate of return and cash payback in
SO
capital budgeting.
capital Annual Rate of Return
Thee cte rateof re
turn for Tappan C pany’s inve e in
om
stm nt
The xpe d
ne e
w
e
ne quipm nt is: $13,000 ÷ $65,000 = 20% Thede
cision ruleis:
A project is acceptable if its rate of return is greater than
management’s minimum rate of return. When choosing
among several acceptable projects, the project with the
higher rate of return is generally more attractive. Chapter
2640 SO 9: Contrast annual rate of return and cash payback in
SO
capital budgeting.
capital Annual Rate of Return
Principal advantage of theannual rateof re
s
turn te
chnique
:
S plicity of calculations
im
Manage e fam
m nt’s iliarity with accounting te s use in the
rm d
calculation
Major lim
itation of thete
chnique
:
It does not consider the time value of money
As note in Appe
d
ndix C re
, cognition of thetim valueof m y can
e
one
m a significant diffe ncebe e thepre nt and futurevalue
ake
re
twe n
se
s
of an inve e
stm nt. Chapter
2641 SO 9: Contrast annual rate of return and cash payback in
SO
capital budgeting.
capital Cash Payback
I de
ntifie thetim pe re
s
e riod quire to re r thecost of the
d
cove
inve e
stm nt
Use thene annual cash flow produce fromtheinve e
s
t
d
stm nt
Ne annual cash flow can beapproxim d by taking ne incom
t
ate
t
e
and adding back de ciation
pre
Theform for com
ula
puting thecash payback pe is:
riod Illustration 2619 Chapter
2642 SO 9: Contrast annual rate of return and cash payback in
SO
capital budgeting.
capital Cash Payback
Example:
Tappan C pany has ne annual cash inflows of $26,000 ( Ne
om
t
t
I ncom $13,000 + De ciation $13,000)
e
pre
Thecash payback pe is:
riod $130,000 ÷ $26,000 = 5 ye
ars
$130,000 Chapter
2643 SO 9: Contrast annual rate of return and cash payback in
SO
capital budgeting.
capital Cash Payback
Example:
C n C pany has une n ne annual cash inflows
he om
ve t
Now thecash payback pe is de rm d whe thecum
riod
te ine
n
ulativene
t
cash flows e
qual thecost of theinve e
stm nt
Illustration 2621 Chapter
2644 SO 9: Contrast annual rate of return and cash payback in
capital budgeting.
capital Cash Payback
BE269: Adle C pany is conside purchasing ne e
r om
ring
w quipm nt
e
f or $300,000. I t is e cte that thee
xpe d
quipm nt will produceannual
e
ne incom of $10,000 ove its 10ye use life Annual de ciation
t
e
r
ar ful .
pre
will be$30,000.
will
Compute the cash payback period. Chapter
2645 Cash Payback
First, calculatene annual cash inflows:
t
Ne incom + de ciation
t
e
pre
$10,000 + $30,000 = $40,000 Second, dividecapital inve e by annual cash flows
stm nt
$300,000 ÷ $50,000 = 6 years Chapter
2646 Discounted Cash Flow
Discounte cash flow te
d
chnique ge rally re
s ne
cognize as be
d
st
approach to m
aking capital budge de
ting cisions
Te
chnique conside both:
s
r
Estim d total cash inflows, and
ate
Thetim valueof m y
e
one
Two m thods ge rally use with thediscounte cash flow
e
ne
d
d
te
chnique are
s
Net Present Value Method
Internal Rate of Return Method Chapter
2647 SO 10: Distinguish between the net present value and
SO
internal rate of return methods. Net Present Value Method
NPV m thod com s thepresent value of the cash
e
pare
inflows t o thecapital outlay required by theinve e
stm nt
inflows
Thedifference be e thetwo am
ounts is re rre to as the
fe d
difference twe n
net present value
net
Theinte st rateuse to discount thecash flow is there
re
d
quire
d
m umrateof re
inim
turn
A proposal is acce
ptablewhe theNPV is zero or positive
n
zero
Thehighe thepositiveNPV, them attractivetheinve e
r
ore
stm nt Chapter
2648 SO 10: Distinguish between the net present value and
SO
internal rate of return methods. Net Present Value Method
Net Present Value Decision Criteria
Illustration 2622 Chapter
2649 SO 10: Distinguish between the net present value and
SO
internal rate of return methods. Net Present Value Method
Example: Equal Annual Cash Flows
Annual cash flows of $26,000 uniformove asse use life
r
t’s ful
C
alculation of pre nt valueof annual cash flows (annuity) at 2
se
diffe nt discount rate
re
s:
Illustration 2623 Chapter
2650 SO 10: Distinguish between the net present value and
SO
internal rate of return methods. Net Present Value Method
Example: Equal Annual Cash Flows  Continued
Analysis of proposal using ne pre nt value
t se
s Illustration 2624 NPV positive f or both discount rate
s
Accept propose capital e nditureat e r discount rate
d
xpe
ithe Chapter
2651 SO 10: Distinguish between the net present value and
SO
internal rate of return methods. Net Present Value Method
Example: Unequal Annual Cash Flows
Diffe nt cash flows e ye ove asse use life calculation of
re
ach ar r
t’s ful ;
PV of annual cash flows at 2 diffe nt discount rate
re
s:
Illustration 2625 Chapter
2652 SO 10: Distinguish between the net present value and
SO
internal rate of return methods. Net Present Value Method
Example: Unequal Annual Cash Flows  Continued
Analysis of proposal using ne pre nt value
t se
s Illustration 2626 NPV positive f or both discount rate
s
Accept propose capital e nditureat e r discount rate
d
xpe
ithe Chapter
2653 SO 10: Distinguish between the net present value and
SO
internal rate of return methods. Internal Rate of Return Method
I RR m thod finds theinte st yie of thepote
e
re
ld
ntial inve e
stm nt
I RR – ratethat will causethePV of thepropose capital
d
e nditureto equal t hePV of thee cte annual cash inflows
xpe
xpe d
Two ste in m thod
ps
e
1.
2. Chapter
2654 C putetheinte rateof re
om
rval
turn factor
Usethefactor and thePV of an annuity of 1 tableto find the
I RR. SO 10: Distinguish between the net present value and
SO
internal rate of return methods. Internal Rate of Return Method
Example:
Example:
Step 1: Theform for com
ula
puting theI RR factor:
Illustration 2627 I RR factor for Tappan C pany, assum e
om
ing qual annual cash inflows:
$130,000 ÷ $26,000 = 5.0 Chapter
2655 SO 10: Distinguish between the net present value and
SO
internal rate of return methods. Internal Rate of Return Method
Example  Continued
Example
Step 2: I RR is thediscount factor close to theI RR factor for the
st
t im pe cove d by theannual cash flows.
e riod
re C st discount factor to 5.0 is 5.01877; thus I RR is approxim ly
lose
ate
15% Chapter
2656 SO 10: Distinguish between the net present value and
SO
internal rate of return methods. Internal Rate of Return Method
C pareI RR to m
om
anage e re
m nt’s quire m umrateof
d inim
re
turn
Decision Rule:
Accept the project when the IRR is equal
to or greater than the required rate of
return.
Assum a m umrateof re
ing inim
turn for Tappan of 10%
,
proje is acce d sinceI RR of 15%is gre r than the
ct
pte
ate
re
quire rate
d. Chapter
2657 SO 10: Distinguish between the net present value and
SO
internal rate of return methods. Internal Rate of Return Method
Illustration 2628 Chapter
2658 SO 10: Distinguish between the net present value and
SO
internal rate of return methods. Comparison of Discounted Cash Flow
Comparison
Methods
Methods
Illustration 2629 Chapter
2659 SO 10: Distinguish between the net present value and
SO
internal rate of return methods. ...
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 Net Present Value, Incremental Analysis

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