Accounting DQ

This chapter covers various incremental analysis decisions. For short-run decisions (such as whether to accept special orders), the fixed cost component generally is not differential and should not be considered. The use of full cost for some short-run decisions will erroneously render the alternative option less attractive, creating what is known as "the full-cost fallacy." Consider the following example of a special order decision in which fixed costs are unitized:

Example: On a particular month, U-Develop receives a special order from an out-of-town merchant who is willing to pay $4,000 for 10,000 photo prints developed, or $0.4 per print. An analysis of U-Develop's cost structure shows that it incurs variable cost of $0.36 per print and $1,500 monthly fixed cost. U-Develop can handle the special order without affecting its regular business.

The full cost of the special order is calculated by an employee as follows.

$1,500 + $0.36 x 10,000 / 10,000 = $0.51 per print.

By unitizing the fixed cost, the full cost calculation gives the impression that the special order is not a profitable one as the unit cost of $0.51 per print is higher than the unit price offered of $0.4. However, since the monthly fixed cost of $1,500 remains the same with or without the special order, the differential cost relevant for this decision context is the variable cost of $0.36 per print. Therefore, the special order should be accepted, netting an additional profit of $400 (= ($0.4 - $0.36) × 10,000 prints) for the month. The "full-cost fallacy" is avoided.

In the long run, however, all costs must be covered or the company will fail.

Any thoughts?

Author's Corner Video "Incremental Analysis"

The concept of "Cost-Benefit" permeates smart decision making and accounting principles. How does this concept relate to incremental analysis? Provide an example to prove your point.

Author's Corner Video "Relevant, Opportunity, and Sunk Costs"

Discuss the concepts of relevant costs and incremental costs. How do they relate? Provide examples.

Author's Corner Video "Conclusion"

In this video, the author provides a very good review of all the key concepts presented during this course and how they all tie together to help a manager make more informed financial and business decisions. Please share what you will take-a-way from this course and how you will utilize what you have learned in the future.