A D V E R T I S E M E N T
Managers often face complex business decisions.
Incremental analysis provides a way to simplify even the most complex decisions.
Incremental analysis (IA) is not a formula,
but rather an approach to problem-solving. It relies heavily on variable
accounting concepts: using variable & fixed costs. You have already studied
variable costing concepts; IA will show you a way to make these concepts even
Relevant Costs and Revenues
The key to IA is identifying and using only
relevant costs and revenues in a decision. Non-relevant costs will not change,
regardless of the decision made, so they can be ignored. However, all costs and
revenues that will or may change, are relevant to the decision and must be
Since we are using variable costing, we will
classify all costs are either variable or fixed. This greatly simplifies the
analysis because we are just using only two sets of numbers.
Some decisions involve cash inflows, or
revenues. These may be incidental to the decision, or they may be a significant
element. Either way, if they are relevant they must be included in the analysis.
Revenues or inflows that won't be effected by the decision can be ignored.
Opportunity costs represent the
benefit (income, gain, profit or expense reduction) that could be realized by
pursuing an alternate course of action. IA can help identify the BEST course of
action, among several. So giving up the alternates would be preferable, and we
would be justified in giving up the benefits of these alternatives.
For instance, you may graduate and get a job
as an accountant, system administrator, business manager, etc. You will weigh
your job options, select the BEST one, and reject the others. The income you
could have made from the rejected jobs, represents your opportunity costs.
But you can only take one job, so you choose to take the BEST one and
give up the potential, but lesser income and satisfaction, that would come from
the other jobs.
Sunk costs have already been incurred,
you can't go back and change that, they won't affect the current decision, so
they are NOT relevant.
Out of pocket costs ARE relevant to
decisions. They often represent small or incidental costs relevant to a
decision, such as hauling, set-up or clean-up costs, minor construction costs,
and the like.
This chapter demonstrates several different
"textbook" style problems. They represent common business decisions, and the
text shows how these decisions could be approached, using Incremental Analysis.
Does that mean that IA is the only approach
or the best approach? No, not necessarily. But in most cases it IS the best
approach, because it helps managers identify the relevant parts of a decision.
And it takes much less time than other types of analysis, based on full costing
You should also realize that a decision can
be analyzed using full costing, and there may be a difference between the
results of the two methods. Is one way more reliable than the other? Probably
not, in most cases. Incremental analysis can easily be adjusted to include any
relevant items that should be considered using full costing. Since IA is much
quicker and more direct, managers usually prefer to use it.
Fixed costs are frequently a key to IA
decisions. Managers often allocate fixed costs in an arbitrary manner. This can
lead to material errors in decision making. Fixed costs may not affect a
decision at all, or may do so only in a very specific way. Once fixed costs are
treated correctly in a decision, the effects of mis-allocations can be clearly
Layout of an IA decision
Several approaches are presented in the text.
The simplest decision involves only two alternatives. One alternative is
(usually) to maintain the status quo. In other words, make no change. So a
simple decision would be to change or not to change. Several layouts could be
used equally well. We often look at the two alternatives, and compute the
difference between the two amounts. One will outweigh the other, by the amount
of the difference.
Decisions often look at a reduction of
costs, rather than an increase in revenues. In the examples below, one would
select the greatest cost reduction.
Below Alternative A incurs costs of $750,
while Alternative B incurs only $50, a savings of $700 over Alternative A. In
this case Alternative B is preferable.
| var costs
| fixed costs
I call the above method the "classic approach" - it's been
taught for many years and is always a good method to learn. The text illustrates
other methods as well. We can also expand the classic approach to include many
alternatives, as illustrated in the 4-part decision below.
When a decision has more than two options or
alternatives, it is usually better to create a table, consisting of one column
for each decision, and a row for each relevant item to be considered. Once
again, the lowest cost is the best solution. But we can also rank the options,
best, next best, and so on.
| var costs
| fixed costs
Types of IA decisions
Several types of decision are illustrated in the
text. These are common decisions. Others can be made as well. There is no end to
the types of decisions that can be made using IA. You should try to understand
HOW to approach an IA problem.
Special Order decision - should the
company accept a special order for products, at a price significantly lower than
its normal selling price?
Limited Resource (production
constraint) decision - the company has a limited resource it must allocate among
several products. Which product should it favor?
Make or Buy decision - the company
currently makes a part or product. It wants to evaluate whether it should buy
the item instead. Of course, the reverse decision could be analyzed in exactly
the same manner.
Sell, Scrap or Rebuild decision -
defective or obsolete products must be dealt with in some way. The company
should try to minimize its loss on these items.
Joint Products decision - several
products come from the same raw materials, but are processed in different ways.
Maple syrup and maple sugar both come from the same batch of sap. Different
grades of syrup can be extracted during the production process. Syrup can be
further processed into maple sugar or candy, expanding the product line. The
cost of the original batch of sap must be allocated among the various finished
The best way to learn IA is to look at a
number of examples and work along with the problem in your own mind. It even
helps to take a piece of paper and write down the solution as you are reading
and looking at it on your monitor. The process of writing it down will greatly
reinforce your learning.