Sell or process further decision
The rule here is we should process further as long as the incremental revenue exceeds the incremental costs.
Single product
Planterz sells oak tree saplings for $4 apiece. The cost of producing a sapling is:
| Direct materials | $0.25 |
| Direct labour | 1.00 |
| Variable manufacturing overhead | 0.50 |
| Fixed manufacturing overhead | 0.25 |
| Manufacturing cost per unit | $2.00 |
Planterz currently has unused productive capacity that is expected to continue indefinitely. Some of this capacity could be used to grow the saplings into small trees which can be sold for $7. For a small tree, direct materials and direct labour will increase by $1 each. Variable manufacturing overhead costs will increase by $0.50 and fixed manufacturing overhead will increase by $0.25 per unit.
Should Planterz sell the saplings, or should it process them further? The incremental analysis on a per unit basis is as follows:
Multiple products
StarBright Enterprises mines and imports mineral-rich ores from space. Currently, it sells ten pounds of ore for an average price of $5,000, which results in an average profit of $2,500. Starbright is thinking about processing the ore further in the hopes of making bigger profits. The expected products from the refining of ten pounds of ore are two ounces of gold ($2,250 sale price per ounce) and three pounds of silver ($500 sale price per pound).
Assuming the following incremental costs for refining gold and silver, should Starbright continue with refining?
| Refining costs | Gold (1 oz) | Silver (1 lb) |
| Direct materials required per unit | $450 | $200 |
| Direct labour required per unit | 800 | 250 |
| Variable manufacturing overhead required per unit | 150 | 60 |
| Fixed manufacturing overhead per 10lb ore (new refining operations) | $200 | |
Repairing, retaining, or replacing equipment
A business often has to decide whether to replace an asset or continue using it. As an example, let’s look at A-Plus Airlines. Management must decide whether to replace old jets with new, more fuel-efficient ones. A jet originally cost $80 million and now has an Accumulated Depreciation balance of $65 million. It has a remaining useful life of four years, with no salvage value. The company is considering replacing this plane with a new Boeing 747, which would cost $110 million. If the new plane is acquired, variable operating costs are expected to decrease from $10 million to $6 million annually, and the old unit could be sold for $5 million. The company’s plan is to sell the 747 four years from now for $90 million. Prepare the incremental analysis for the four-year period:
In the realm of business, making informed decisions can be a complex process. One of the crucial techniques used for such decision-making is incremental analysis, a method that involves comparing the additional revenue gained against the additional costs incurred. This principle guides companies towards optimizing their operations and maximizing profits. In this essay, we will delve into three scenarios where incremental analysis plays a pivotal role in decision-making: “Sell or Process Further,” “Multiple Products,” and “Repairing, Retaining, or Replacing Equipment.”
Sell or Process Further
Planterz, a company specializing in oak tree saplings, is faced with a critical choice: whether to sell saplings outright or to invest in further processing for potential additional revenue. This scenario encapsulates the fundamental principle of incremental analysis: comparing the incremental revenue against the incremental costs. By assessing the added cost of growing saplings into small trees ($2.00 to $4.00), Planterz can determine if the higher selling price ($7.00) justifies the increased expenses.
Multiple Products
StarBright Enterprises, a pioneer in mining space ores, is at a crossroads where processing the ores further might lead to increased profitability. Applying incremental analysis here entails calculating the incremental revenue and costs of refining gold and silver from the initial ore. By comparing the anticipated sales revenues from these refined products against the added costs of refining, StarBright can gauge the viability of this strategic shift.
Repairing, Retaining, or Replacing Equipment
A-Plus Airlines is grappling with the classic dilemma of whether to replace old aircraft with more efficient models. Incremental analysis can be harnessed to determine if acquiring new aircraft, with their lower operating costs, outweighs retaining the existing ones. By comparing the costs of operating the current aircraft against the potential benefits of the new Boeing 747, including reduced operating costs and the resale value of the old unit, A-Plus Airlines can make a calculated decision.
In conclusion, incremental analysis serves as a guiding compass for businesses, helping them navigate intricate decisions that can have far-reaching implications. By meticulously comparing the additional revenue and costs incurred through different courses of action, businesses can align their strategies with profit optimization. Whether it’s determining whether to process products further, choosing between multiple product lines, or making equipment replacement decisions, incremental analysis offers a rational framework for effective decision-making. In an ever-evolving business landscape, the principle of incremental analysis stands as an invaluable tool for strategic success.
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