Incremental Marginal Differential AnalysisWhat is incremental analysis? It is 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. Managerial decisions are choices made based on financial and non-financial information. Typically, financial information serves as the first hurdle in identifying a possible course of action as an alternative. If the financial hurdle is met, then management must consider the impact of the alternative on the environment, the company’s employees, its image, the community, its partners or alliances, and so on before making a final decision.

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In this post I discuss the concept of “incremental” or “marginal” or “differential” analysis, a decision making purposed analysis that applicable in certain areas of business and its situations. With some implementation examples I show in this post, you should be able to understand the concept and may adopt some of them for your best uses.

 

To illustrate the concept, think about the decision to lease or buy a car. Leasing involves a regular payment and the return of the vehicle at the end of the lease unless a one-time payment is made. This arrangement means the car does not legally belong to the person leasing it. To buy a car requires payment of the purchase price. The payment may be made in cash or by signing a note payable for the amount owed. If you were to prepare financial statements under each alternative, they would look very different. An operating lease for a car with payments of $300 per month would result in the annual cost of the lease, $3,600, being reported as an expense on the income statement. The purchase of a car results in an asset — and a liability, if a note was signed — being recorded on the company’s balance sheet.

Another example is the choice between alternatives A and B, given the following relevant revenues and expenses:

                        Alternative A    Alternative B        Net Income
                                                                                Increase/
                                                                                (Decrease)

Revenues        $100,000            $150,000                $50,000
Expenses            78,000               105,000                (27,000)
Net Income     $  22,000             $ 45,000                $23,000

 

Conclusion: This example shows alternative B generates $23,000 more net income than alternative A. Management must now consider the non-financial information to determine whether alternative B should be accepted.

Several concepts are incorporated into incremental analysis and need to be defined before discussing some specific applications of incremental analysis.

  • Relevant cost. Those revenues and costs that differ among alternatives, as opposed to revenues and costs that stay the same, which are ignored when analyzing alternatives. Note: Some texts refer to the revenues that change as relevant benefits.
  • Sunk cost. A cost that has already been incurred and, therefore, has no impact on future decisions because the cost will not change or go away in the future. The book value of a previously purchased and currently owned asset will not change whether or not a new asset is purchased to replace it.
  • Opportunity cost. A potential benefit that is lost when a company chooses another alternative.

 

 

Examples of Incremental Analysis

  • Accepting additional business.
  • Making or buying parts or products.
  • Selling products or processing them further.
  • Eliminating a segment.
  • Allocating scarce resources (sales mix).

 

Accepting Additional Business

The Lie Dharma Party Organizer  prepares complete party kits for various types of celebrations. It is currently operating at 75% of its capacity. It costs The Lie Dharma $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:

                                        Per Unit                 Annual Total
Sales                                 $ 25.00                  $2,100,000
Direct Materials                   12.00                   1,008,000
Direct Labor                          6.00                       504,000
Overhead                               0.50                         42,000
Selling Expenses                   1.75                        147,000
Administrative Expenses       0.25                         21,000
Total Costs and Expenses    20.50                    1,722,000
Operating Income               $ 4.50                    $ 378,000

 

The Lie Dharma 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 Lie Dharma accept this special order?

 

Using its current cost information, the answer would be no because accepting the order would generate a $7,500 loss.

                                        Per Unit             Totals

Sales                                  $20.00             $300,000
Direct Materials                   12.00              180,000
Direct Labor                           6.00                90,000
Overhead                                0.50                  7,500
Selling Expenses                     1.75               26,250
Administrative Expenses        0.25                 3,750
Total Costs and Expenses     20.50             307,500
Operating Income                 $ (.50)            $(7,500)

 

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.

 
                               Per Unit               Totals
Sales                       $ 20.00                $300,000
Direct Materials         12.00                 180,000
Direct Labor                6.00                    90,000
Overhead                     0.25                     3,750
Selling Expenses                                      7,000
Total Costs and Expenses                    280,750
Operating Income                               $ 19,250

 

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.

Lie Dharma Putra Company uses part #56 in several of its products. Lie Dharma Putra 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 Lie Dharma Putra Company 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.
                                           Make          Buy        Incremental
                                                                            Increase/
                                                                           (Decrease)
Purchase ($0.75)               $37,500                      $(37,500)
Direct Materials ($.30)     $15,000                          15,000
Direct Labor ($0.20)           10,000                         10,000
Overhead ($0.10)                  5,000                          5,000
Total Relevant Costs         $30,000    $37,500    $ (7,500)

 

If Lie Dharma Putra 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.

                                       Make         Buy         Incremental
                                                                         Increase/
                                                                         (Decrease)

Total Relevant Costs  $30,000       $37,500    $ (7,500)
Opportunity Cost          20,000                          20,000
Total Costs $50,000    $37,500                        $12,500

 

 
Selling Products Or Processing Further

Some companie’s product can be sold at different stages in their production cycle. For example, the LDP 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 LDP 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, LDP should assemble the gyms (process further). LDP 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.
                             Sell                       Process          Operating
                             (Unassembled)     Further           Income
                                                          (Assembled)  Increase/
                                                                                 (Decrease)

Revenue                 $1,000                $1,500             $500

Costs
Direct Materials         300                     300                   0
Direct Labor              150                      250             (100)
Overhead                   100                     125                (25)
Total Costs                 550                     675              (125)

Operating Income   $ 450                  $ 825               $375

 

On a per unit basis, the incremental analysis shows that LDP 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:

Sales Price if Process Further (assembled) $1,500
Sales Price if Sell (unassembled)                  1,000
Incremental Revenue                                      500

Costs to Process Further
Direct Labor                                 $100
Overhead                                          25
Total Costs to Process                                   125
Incremental Operating Income                    $ 375

 

 
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 LDP, 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.

 

                                                 LDP, Inc.
                                   Segment Income Statement
                                                  20X0
                      Economy       Standard          Deluxe          Total

Revenues    $1,200,000     $1,500,000   $2,500,000    $5,200,000
Variable
Expense           900,000      1,000,000      2,200,000      4,100,000
Contribution
Margin             300,000         500,000         300,000      1,100,000
Fixed
Expenses         180,000         250,000         500,000         930,000
Operating
Income         $ 120,000      $ 250,000 $    (200,000)      $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:

                                       Economy      Standard      Total

Revenues                       $1,200,000   $1,500,000  $2,700,000
Variable Expense               900,000      1,000,000    1,900,000
Contribution Margin         300,000       500,000          800,000
Fixed Expenses                 405,000*     525,000**       930,000
Operating Loss             $ (105,000)     $ (25,000)   $ (130,000)

 

Note:

* $180,000 + (45% × $500,000)
** $250,000 + (55% × $500,000)

 

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.

                                  Economy      Standard          Total
Revenues                  $1,200,000    $1,500,000      $2,700,000
Variable Expense           900,000      1,000,000        1,900,000
Contribution Margin      300,000         500,000           800,000
Fixed Expenses              270,000*       360,000**        630,000
Operating Income         $ 30,000      $ 140,000        $ 170,000

 

Note:

*$180,000 + (45% × $200,000)
**$250,000 + (55% × $200,000)

 

Conclusions

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 Lie Dharma Golfers 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.

                                     Standard    Set Deluxe Set

Contribution Margin        $150         $270
Machine Hours per Set     0.75            1.5

 

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.

 

                                                  Standard      Set Deluxe Set

Contribution Margin                  $150                $270
Machine Hours per Set                0.75                  1.5
Contribution Margin per Hour    $200               $180

Conclusions:

  • 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.