2. Incremental analysis Information regarding current operations of the Farrell
ID: 2565706 • Letter: 2
Question
2. Incremental analysis Information regarding current operations of the Farrell Corporation is given below: $950,000 $450,000 S310,000 Sales Variable Costs Fixed Costs A proposed addition to Farrell's factory is estimated by the sales manager to increase sales by a maximum of $750,000. The company's accountants have determined that the proposed addition will add S320,000 to fixed costs each year. Variable costs are expected to be at the same percentage as they currently are before the proposed addition. (a) Explain why the existing $310,000 of fixed costs is a sunk cost while the $320,000 of fixed costs associated with the proposed addition is an out-of-pocket cost. (b) Calculate by how much the proposed adition will either increase or reduce operating income. Show all work.Explanation / Answer
a)
$310,000 is already being incurred by the organization. So, this fixed cost has no effect on decision making as it cannot be taken back or reduced due to the decision. So, it is termed as sunk cost
On the other hand, new fixed cost of $320,000 is an additional cost which is required to be done for the decision making. So, it is an additional cost
b)
Current operating income
= Sales – Variable costs – Fixed costs
= $950,000 - $450,000 - $310,000
= 190,000
Contribution margin
Contribution = Sales – Variable costs
= $950,000 - $450,000
= $500,000
Contribution margin ratio
= Contribution / Sales
= $500,000 / $950,000
= 0.5263 or 52.63%
New Sales = Current + $750,000
= $950,000 + $750,000
= $1,700,000
New Contribution
= Sales x Contribution margin ratio
= $1,700,000 x 52.63%
= $ 894,737
New Fixed costs = Current + $320,000
= $310,000 + $320,000
= $630,000
So, New Operating Income
= Contribution – Fixed costs
= $ 894,737 - $630,000
= $264,737
So, increase in operating income
= Current – Old
= $264,737 - $190,000
= $74,737
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