Question

Using Incremental Analysis, create a situation where you are going to make a business decision on whether you have to sell a product or process said product further. Classify the specific costs as relevant or irrelevant.

Answer 1

ABC Ltd manufactures 20,000 units of Product A and 30,000 units of Product B with a joint cost of $150,000. The Sales Price of Product A is $8 and that of Product B is $10. Product A can be further processed with a cost of $25,000 which can be sold at $12.

Decision as to further process the product A:

Further Processing Cost = $25,000

Number of units of Product A = 20,000

Further Processing Cost per unit of Product A

= Further Processing Cost / Number of units

= $25,000 / 20,000

= $1.25

Increase in Sales price of Product A when further processed

= Sales Price after further processing of Product A - Sales Price of Product A without further processing

= $12 - $8

= $4

Increase in Net Income due to further processing of Product A

= Increase in Sales Price - Further Processing Cost

= $4 - $1.25

= $2.75

Since the net income gets increased after further processing, Product A should be further processed.

Costs till the split point i.e., the joint costs are irrelevant as they are to be spent even if the product is not further processed.

The Costs that are incurred for further processing i.e., further processing costs are the relevant costs in taking the decision as to further process the product.