Accounting Principles II – Incremental Analysis | Accounting

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Study GuideAccounting Principles II–Incremental Analysis1.Introduction to Incremental AnalysisMaking Managerial DecisionsManagers make decisions by looking at bothfinancialandnonfinancialinformation.Usually,financial information is checked first. This helps managers see whether an option is evenworth considering.If the numbers look good, managers then think about other important factors, such as:•The effect on employees•The company’s public image•Environmental impact•The community•Business partners or alliancesOnly after reviewingboth financial and nonfinancial factorsdo managers make a final decision.What Is Incremental Analysis?Incremental analysisis a tool used to help managers compare different options.It is also calledmarginal analysisordifferential analysis.The main goal of incremental analysis is to:•Identifyrevenues and costs that changebetween alternatives•Ignore revenues and costs that stay the same•Focus on how each option will affectfuture incomeThis makes decision-making clearer and more logical.

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Study Guide1.Everyday Example: Lease or Buy a CarA simple way to understand incremental analysis is to think about deciding whether tolease or buy acar.•Leasing a car:○Requires a regular monthly payment○The car is returned at the end of the lease unless a final payment is made○The car doesnotlegally belong to the person leasing it○Lease payments are recorded asexpenseson the income statementFor example, a lease payment of$300 per monthresults in an annual expense of$3,600.•Buying a car:○Requires paying the full purchase price, either in cash or through a loan○The car becomes anasset○If money is borrowed, aliabilityis also recorded○These amounts appear on thebalance sheet, not just as expensesBecause of these differences, the financial statements for leasing and buying look very different.2.Comparing Two Alternatives Using Incremental AnalysisIncremental analysis helps compare alternatives by focusing only on whatchanges.In the example shown in the table:•Alternative Bgenerates$23,000 more net incomethanAlternative A•From a financial perspective, Alternative B appears betterHowever, this isnot the final decision.Management must still evaluate nonfinancial factors before choosing which alternative to accept.

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Study Guide3.Key Concepts in Incremental AnalysisBefore applying incremental analysis, it is important to understand three key terms.1. Relevant Costs (and Revenues)•These arerevenues and costs that differ between alternatives•Only these amounts matter when making a decision•Costs or revenues that stay the same areignored•Some textbooks call changing revenuesrelevant benefits2. Sunk Costs•Asunk costis a cost that has already been incurred•Itcannot be changed or avoided, no matter what decision is made•Because of this, sunk costs areignoredin incremental analysisExample:The book value of a machine already owned does not change whether the company replaces it or not.3. Opportunity Costs•Anopportunity costis a benefit that isgiven upwhen one option is chosen over another•Even though it does not appear in accounting records, it is still important for decision-making

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Study GuideExample:Using factory space for one product means losing the chance to use it for another.2.Examples of Incremental AnalysisIncremental analysis (also calledmarginalordifferential analysis) helps managers make betterdecisions by focusing only onwhat changesbetween alternatives. Instead of looking at total costsand revenues, it comparesrelevant revenues and relevant costsand shows how each optionaffectsfuture operating income.This method is widely used in managerial accounting because it simplifies complex decisions andkeeps attention on the most important information.Common Uses of Incremental AnalysisIncremental analysis is commonly applied in the following situations:•Accepting additional (special order) business•Making or buying parts or products•Selling products now or processing them further•Eliminating a business segment•Allocating scarce resources (sales mix decisions)Each example below shows how incremental analysis is used in real business decisions.1. Accepting Additional Business (Special Orders)The SituationThe Party Connectionprepares complete party kits for celebrations. It is currently operating at75%of capacity.Key information:•Selling price (regular):$25 per packet

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Study Guide•Cost per packet:$20.50•Current production:84,000 packets•Full capacity:112,000 packetsA special overseas customer offers to buy15,000 packets at $20 per packet.This orderwill not affect current sales, and the company has enough unused capacity to fill it.1.Initial (Incorrect) AnalysisUsing the regular cost structure, selling at $20 appears to create aloss of $0.50 per unit, or$7,500total.This makes the order look unattractive—but this analysis isincorrectbecause it includes costs thatdo not change.

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