Incremental Analysis and Cost Volume Profit …

1 Management Accounting | 175. Incremental Analysis and cost Volume Profit Analysis : special applications Incremental Analysis is a flexible decision-making tool that may be used in making many different kinds of decisions. Some of the decisions for which Incremental Analysis is appropriate include the following: 1. Open a new territory 2. Sell on credit 3. Sales people compensation 4. Additional Volume of business These four items are marketing decisions that may be made in The Management/. Accounting Simulation. Consequently, Incremental Analysis is an important decision-making tool in this simulation. Opening a New Territory The opening of a new territory decision is a common and important decision. Opening a new territory can bring in substantial additional revenue and net income. However, expanding a business too fast in a territory not responsive to the company's product can have the opposite effect. Before a decision is made to expand the business into a new territory, the potential revenues and expenses should be analyzed at different levels of estimated sales.

2 If the use of Incremental Analysis shows that substantial sales and additional income is likely to result, then the expansion of the business into a new territory may be a wise decision. Examples of expanding into new territories are granting of new franchises in areas where none exist, expanding the operations of the business into an adjacent state, and entering a foreign market. Although the same product is being marketed in each territory, it does not follow that all territories are equally profitable. The extent to which a new territory might be profitable must be explored very carefully. Distance from the main distribution center in many cases is a major problem. Territories can vary 176 | CHAPTER TEN Incremental Analysis and cost Volume Profit Analysis : special applications substantially in population density and income distribution. Also, cultural differences regarding tastes and preferences can play an important role in whether to expand or not expand the business.

3 For example, while catfish restaurants are very popular in the South they are not likely to be equally received in the Northeast. Differences in laws, state regulations, and tax structures also can have a bearing on the decision. Incremental Analysis can be used either to measure segmental net income or segmental contribution. The advantages and disadvantages of using segmental net income and segmental contribution is discuss in some depth in chapter 15. Which measure is best is somewhat controversial; however, in the example to follow segmental contribution will be the criterion. Segmental net income requires the allocation of common expenses and all allocations of costs tend to be somewhat arbitrary and can obscure the potential profitability of a segment. The segmental contribution approach is favored here. However, if done properly, both approaches can be used in the same Analysis . In using Incremental Analysis to evaluate potential decision, irrelevant revenue and expenses may be omitted in the final Analysis .

4 Irrelevant revenues and expenses are those items that will not be affected or changed by the making of the decision. What is relevant or irrelevant depends on the particular circumstances under investigation and can vary from situation to situation. For this reason, providing examples of irrelevant revenues or expenses is not always easy. However, in most cases, for example, it would be difficult to see how in the short run opening a territory would affect the salaries of top management Therefore the salaries of top management are likely to be irrelevant. The evaluation of the opening of a new territory generally involves the following steps: 1. Gather all relevant revenue information. An initial but tentative price should be set. The normal market potential should be estimated. Normal market potential can be defined as the number of customers likely to benefit from purchasing the product. 2. Factors that directly impact sales Volume should be evaluated.

5 These factors include such decisions as selling on credit, compensation of sales people, and advertising. The economic environment should be carefully evaluated. The impact that seasonal factors have on sales is important and should be examined. Analysis should be made in terms of quarters and some attempt should be made to estimate an seasonal index for each quarter. Based on the vari- ous market demand factors identified, a sales forecast of sales in units and dollars should be made. If sales of the product in the territory being evaluated tends to be seasonal in nature, then this fact can also have a major impact on available capacity. Opening a new territory must be based on the premise that the capacity to manufacture is adequate, given the increased demand from opening a new territory. Management Accounting | 177. 3. Analysis should be made of the sensitivity of customers to changes in price. Is it best to lower price and go after higher Volume or is it better to have a higher price with lower Volume ?

6 4. Gather all the relevant information concerning operating expenses in the new territory. The territorial expenses should be also be measured in terms of fixed and variable components. Expense factors such as number of sales people needed, compensation plan for sales people, cost of credit terms, and the need for additional advertising should be analyzed in some depth 5. After all relevant information about revenue and expenses has been gathered and the analyzed data has been converted to variable cost rates and total fixed expenses, then a work sheet similarly to the one shown in Figure 10-1. should be prepared. Figure 10-1. Opening New Territory Sales (units). 50,000 100,000 150,000 200,000. Sales (price - $100) $ 5,000,000 $ 10,000,000 $ 15,000,000 $ 20,000,000. Variable Expenses cost of goods sold ($60) $ 3,000,000 $ 6,000,000 $ 9,000,000 $ 12,000,000. Sales people travel expense ($5) 250,000 500,000 750,000 1,000,000. Sales commissions ($10) 500,000 1,000,000 1,500,000 2,000,000.

7 Credit expenses ( $3) 150,000 300,000 450,000 500,000. Total variable expenses ($78) 3,900,000 7,800,000 11,700,000 15,600,000. Contribution margin $ 1,100,000 $ 2,200,000 $ 3,300,000 $ 5,000,000. Fixed expenses (direct). Salaries (additional factory workers) $ 2,000,000 $ 2,000,000 $ 2,000,000 $ 2,000,000. Advertising 500,000 500,000 500,000 500,000. Sales people salaries 1,000,000 1,000,000 1,000,000 1,000,000. Credit department salaries $ 150,000 $ 150,000 $ 150,000 150,000. Other fixed expenses1 350,000 350,000 350,000 350,000. Total fixed expenses 4,000,000 4,000,000 4,000,000 4,000,000. Total expenses $ 7,900,000 $ 11,800,000 $ 15,700,000 $ 19,600,000. Segmental contribution ($2,900,000) ($1,800,000) ($ 700,000) $1,000,000. 1. Other fixed expenses could include such expenses as additional home office staff needed such as accounting, credit department, marketing department employees, additional staff needed in the production department.

8 178 | CHAPTER TEN Incremental Analysis and cost Volume Profit Analysis : special applications The above Analysis reveals the following: 1. At the sales Volume range of 50,000 - 150,000 the territory is not profitable. 2. At a Volume of 200,000 or greater the territory appears to be profitable. The question that must be asked and answered is this: Does a sales level of 200,000 appear reasonable or likely to happen? If the most optimistic esti- mate is that sales will not in the distance future ever exceed 150,000, then the decision not to open the territory would be the right decision. Illustrative Problem The management of the L. K. Widget Company is considering opening a new territory to be called the Western Territory. In the last quarter, the company's sales of 8,500 units were far below the Volume required to make the company profitable. The marketing department through marketing research and Analysis of internal financial data has made available the following information relevant to the opening of the Western Territory.

9 Direct Costs Selling: General and administrative Variable Per Unit Variable cost of goods sold $ Travel $ Packaging $ Supplies $ Sales people travel $ Sales people commission $ Bad debts expense of sales Credit department $ Direct fixed (Selling) Direct fixed (Manufacturing) none Salaries of sales people $ _____ (Opening this territory will not Sales people training $ _____ require any new plant capacity Advertising $ _____. Territorial office operating $ 50,000 Home office sales expense $ 30,000. If the Western Territory is opened, then approximately 600 sales people would be hired at a per quarter salary of $2,000 per sales person. The training of each new sales person will cost $200. After the initial hiring of the full sales force, it is expected each quarter, because of some sales people quitting for various reasons that on the average 50 new sales people will be hired each quarter. The market potential of this territory is estimated to be 110,000 customer per quarter.)

10 On the average, each customer will purchase one Gadget a a price of $200. An Analysis of demand indicates approximately 28% of the potential customers would request demonstrations per quarter. If the Western territory is opened, management will seriously consider granting customers three months of credit. These credit terms would be offered in all territories. If three months credit is granted, then sales should increase at least 20%. Last quarter Management Accounting | 179. the sales-calls ratio without credit was 30%. The amount budgeted for advertising would be $ per potential customer and the selling price of the Gadget would be $200. Based on the information provided, a what-if profitability Analysis as shown above may be made. It is important for management to estimate sales for the first operating period. Based on the provided information above, this estimate may be computed as follows: Normal market potential 110,000. Percentage requesting demonstration.