Incremental Analysis

Incremental Analysis

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 more useful.

Relevant Costs and Revenues

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 concepts.

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 seen. 

Layout of an IA decision

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. 
 

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. 
 

Types of IA decisions

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 products.
 

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.