Class 5 & 6 - Incremental Analysis

Overview

• Topic: Short-run business decisions in changing markets
• Key Decision Types:
  • Special order decisions
    • เราจะ Accept หรือว่า Reject, special order?
    • Care about incremental cost, incremental revenue.

  • Make or buy decisions

  • Sell, scrap, or rebuild decisions

The Challenge of Changing Markets

Market Dynamics

• Product markets can change quickly due to:
  • Competitor price cuts
  • Changing customer preferences
  • Introduction of new products by competitors

Management Response

• Managers must make short-run decisions with a fixed set of resources to react to the changing marketplace

Analogy: Think of it like optimizing your code when you can't upgrade your hardware. You have to work with what you have (fixed resources) and make quick decisions about what features to prioritize or cut.

The Concept of Relevant Cost Information

Example: Florida Spring Break Decision

Scenario: Should you drive or fly to Florida for spring break?

Given Information:

• Motel cost: $80 per night
• Meal cost: $20 per day
• Car insurance: $100 per month
• Kennel cost for dog: $5 per day
• Round-trip gasoline: $200
• Round-trip airfare + rental car: $500
• Trade-off: Driving requires 2 days with overnight stay, cutting Florida time by 2 days

Cost Analysis (8 days total):

Key Insights:

• Costs that don't differ (motel, meals, kennel, car insurance) are NOT relevant to the decision
• Car insurance is not relevant because it's a past cost (sunk cost)
• Transportation costs differ between alternatives, so they are relevant

Key Question: Are the extra 2 days in Florida worth the 300 extra cost to fly? $$\text{Extra cost to fly} = 500 - $200 =$300$$

Analogy: Like choosing between two cloud hosting services - you only compare the features/costs that are different. If both offer the same storage, you ignore that and focus on what differs (price, speed, support).

Decision Making Process

Five Steps of Decision Making:

1. Define the problem
2. Identify the alternatives
3. Collect information on alternatives
4. Eliminate irrelevant information
5. Make a decision with the remaining relevant information

Analogy: Like debugging code:

1. Identify the bug
2. Think of possible fixes
3. Gather data (logs, test results)
4. Ignore irrelevant error messages
5. Implement the best solution

Relevant Information in Business Decisions

Definition

Relevant Information: Information that varies among the possible courses of action being considered.

• Also called: Incremental costs and revenues

Important Cost Concepts:

1. Opportunity costs
2. Sunk costs
3. Out-of-pocket costs

Opportunity Cost (ต้นทุนค่าเสียโอกาส)

Definition

The benefit that could have been attained by pursuing an alternative course of action.

Example: College Attendance

• If you were not attending college, you could be earning $20,000 per year
• Your opportunity cost of attending college for one year includes the $20,000

Key Characteristics:

• NOT recorded in accounting records
• ARE relevant to decisions because they represent a real sacrifice

Analogy: Choosing to work on a side project means you can't work on another project during that time. The potential income from the alternative project is your opportunity cost - even though you never see it on paper, it's a real trade-off.

Sunk Costs vs Out-of-Pocket Costs

Sunk Costs

Definition

All costs incurred in the past that cannot be changed by any decision made now or in the future.

Key Rule

$\boxed{\text{Sunk costs SHOULD NOT be considered in decisions}}$

Example: Car Purchase

• You bought an automobile that cost $10,000 two years ago
• The $10,000 cost is **sunk** because whether you drive it, park it, trade it, or sell it, you **cannot change** the$10,000 cost

Analogy: Like hours you've already spent on a project. Whether you continue or abandon the project, those hours are gone. The question is: "What's the best use of my time NOW?" not "How much time have I already invested?"

Out-of-Pocket Costs vs Sunk Costs Example

Scenario:

• Your car: Cost $10,000 two years ago (SUNK)
• New car: Costs $25,000 today
• Trade offer: Dealer will trade for $20,000 plus your car

Key Question:

What amount is relevant to your decision?

• ❌ The $10,000 sunk cost of your car
• ✅ The $20,000 out-of-pocket cash differential

Analogy: You spent 100 hours building a feature that users don't want. Do you:

• Consider the 100 hours (sunk cost) and keep the feature?
• OR focus on what it costs NOW to maintain vs rebuild (out-of-pocket cost)?

The 100 hours are gone regardless - focus on future costs/benefits!

Special Order Decisions

Key Principle

The decision to accept additional business should be based on:

• Incremental costs
• Incremental revenues

Incremental amounts: Those that occur only if the company decides to accept the new business

Example: View Co.

Current Business (100,000 units):

Special Order Offer:

• Customer: Overseas company
• Quantity: 10,000 units
• Price: $8.50 per unit
• Additional costs if (offer) accepted:
  • Factory overhead: +$5,000
  • Selling expenses: +$2,000
  • Administrative expenses: +$1,000

❌ Incorrect Reasoning:

"Our cost is $9.00 per unit. I can't sell for$8.50 per unit."

• This ignores that some costs are fixed and won't increase with additional units

✅ Correct Analysis:

Calculations:

• Additional revenue: $10,000$\times$$8.50 = $85,000$
• Additional direct materials: $10,000$\times$$3.50 = $35,000$
• Additional direct labor: $10,000$\times$$2.20 = $22,000$

Conclusion: ✅ Accept the offer - net income increases by $20,000

Alternative Analysis Using Contribution Margin:

Analogy: A game developer can run servers for 100,000 players. They're offered a deal to host a special event for 10,000 players at a discounted rate. The server costs (like factory overhead) barely increase - they're mostly fixed. As long as the revenue covers the variable costs (bandwidth, support) plus any small fixed cost increases, it's profitable even at a discount.

Make or Buy Decisions

Key Questions:

1. Should I continue to make the part, or should I buy it?
2. How do I compare the outside purchase price with manufacturing costs?
3. What will I do with my idle facilities if I buy the part?

If we buy a part here, we will have free factory building, we can rent the factory to another company to use them, so we’ll get the revenue back or something. (CHECK!!)

Important Principles:

• Incremental costs are important in make-or-buy decisions
• The cost to produce must include:
  1. Direct materials
  2. Direct labor
  3. Incremental overhead (NOT the predetermined overhead rate)

Analogy: Should you write your own authentication system or use a third-party service? Consider:

• Your development time (direct labor)
• Any libraries/tools needed (direct materials)
• Extra server costs (incremental overhead)
• DON'T consider: Your salary (it's fixed/sunk), office rent, etc.

Example: Excel Company

Current Manufacturing Costs (20,000 chips per year):

Supplier Offer:

• Price: $25 per chip for 20,000 chips
• Fixed overhead costs: Will NOT be avoided if purchased
  • เช่น พวก Factory building, depreciation of factory building มันก็ไม่สามารถ avoid ได้อยู่แล้ว
• Idle facilities: No alternative use

Analysis - Differential Costs of Making:

Conclusion: ❌ Do NOT buy

• Don't pay $25/unit to avoid$15/unit of costs
• ==Fixed costs are irrelevant (they continue regardless)==
  • งั้นต้นทุน $13 นี้ ตัดทิ้งจากการตัดสินใจได้ เพราะ:
    • ทำเอง → ก็ต้องจ่าย
    • ซื้อ → ก็ยังต้องจ่าย
  • มัน ไม่เปลี่ยนตามการตัดสินใจ = irrelevant cost

\boxed{\text{Differential cost per unit} = $15.00 < $25.00 \text{ (supplier price)}}

ถ้าทำเอง → ประหยัดได้แค่ต้นทุนที่ “หลีกเลี่ยงได้” =
Direct Material 9 + Direct Labor 5 + Var OH 1 = $15 ถ้าซื้อ → ต้องจ่าย =$25
ถามว่า:
จะยอมจ่าย $25 เพื่อหนีต้นทุนแค่$15 ไหม?

New Information: Lease Opportunity

New scenario: If Excel buys chips, idle facilities could be leased for $250,000/year.

Should Excel buy the chips and lease the facilities?

Analysis:

Conclusion: ✅ NOW it makes sense to buy and lease!

Key Question: "What is the best use of Excel's facilities?"

Analogy: You could maintain your own email server (make) or use Google Workspace (buy). Initially, maintaining your own costs less. BUT if using Google Workspace frees up your team to build a new feature that generates $250k/year, suddenly buying makes sense! The opportunity cost changed the equation.

Sell, Scrap, or Rebuild Decisions

Key Principles:

• Costs incurred in manufacturing defective units are sunk costs and cannot be recovered
• As long as rebuild costs are recovered through sale AND rebuilding doesn't interfere with normal production, we should rebuild

Example: Servo Company

Scenario:

• Defective units: 10,000 units
• Original cost: $1.00 each (SUNK)
• Options:
  • Scrap now: $0.40 each
  • Rebuild: $0.80 additional cost per unit, then sell for$1.50 each
• Trade-off: Rebuilding prevents production of 10,000 new units that would also sell for $1.50

Cost Analysis Without Opportunity Cost (WRONG):

This makes rebuild look good ($15,000 vs$4,000)!

Correct Analysis (WITH Opportunity Cost):

Calculations:

• Scrap revenue: $10,000$\times$$0.40 = $4,000$
• Rebuild revenue: $10,000$\times$$1.50 = $15,000$
• Rebuild costs: $10,000$\times$$0.80 = $8,000$
• Opportunity cost: $10,000$\times$($1.50 - $1.00) =$5,000$
  • This is the profit from 10,000 new units you CAN'T make if you rebuild

Conclusion: ✅ Scrap the units now

\boxed{\text{Net return from scrapping} = $4,000 > $2,000 \text{ (net return from rebuilding)}}

Warning: If Servo fails to include opportunity cost, rebuild shows $7,000 return, making it appear favorable!

Analogy: You have buggy code deployed that's generating some revenue ($4k). You could:

• Leave it running (scrap/accept it as-is)
• Spend time fixing it to make it better ($8k cost) and earn more ($15k)

BUT if fixing it means you can't build a new feature that would earn $5k profit, you need to factor that in! Sometimes the "opportunity cost" of time spent fixing old code is higher than the benefit.

Non-financial Considerations

Important Factors Beyond Numbers:

Even with clear financial analysis, managers must consider:

1. Legal issues
   • Compliance requirements
   • Contractual obligations
   • Labor laws
2. Reputation
   • Brand impact
   • Customer perception
   • Market position
3. Environmental impacts
   • Sustainability
   • Carbon footprint
   • Waste management
4. Ethical implications
   • Fair treatment of suppliers
   • Labor conditions
   • Social responsibility
5. Distinguishing fact from opinion
   • Verify assumptions
   • Question biases
   • Seek objective data

Key Principle:

"It would be irresponsible for me to base my decision entirely on revenue and cost figures."

Analogy: When choosing a tech stack, you don't just look at licensing costs. You consider:

• Community support (reputation)
• Security compliance (legal)
• Energy efficiency (environmental)
• Open-source ethics (ethical)
• Long-term viability (not just current cost)

Summary Formulas

Relevant Costs Decision Rule:

$\boxed{\text{Only consider costs that DIFFER between alternatives}}$

Incremental Analysis:

$\boxed{\text{Incremental Profit} = \text{Incremental Revenue} - \text{Incremental Costs}}$

Contribution Margin Approach:

$\boxed{\text{Contribution Margin} = \text{Revenue} - \text{Variable Costs}}$

Make-or-Buy Decision:

$\boxed{\text{Make if: Differential Cost to Make} < \text{Purchase Price + Opportunity Cost}}$

Opportunity Cost:

$\boxed{\text{Opportunity Cost} = \text{Benefit of Best Alternative Foregone}}$

Key Takeaways

1. Ignore sunk costs - They're gone regardless of your decision
2. Focus on incremental changes - What actually changes between alternatives?
3. Consider opportunity costs - What are you giving up?
4. Fixed costs often don't matter - They continue regardless
5. Look beyond the numbers - Consider legal, ethical, and reputational factors

Final Analogy: Incremental analysis is like Git branching - you're comparing different paths forward from the current state, not dwelling on the history (sunk costs) behind you. The question is always: "Which branch leads to the best outcome from HERE?"