Chapter 21
Incremental Analysis

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Incremental Analysis can be used for more than just complex business decisions. Here’s a good example of a personal decision that can be evaluated using a differential accounting approach.

Dorothy’s Car SOLUTION

In this example we have 2 alternatives - 
1) maintain the status quo and keep the car, or
2) sell the car and use public transportation
 

Costs	Keep car	Sell car
Gasoline	$ 625
Insurance	480
Maintenance	360
Parking	240
Lodging	200
Public Transportation		1000
Airfare		350
Totals	$ 1665	$ 1350
Costs if she keeps the car	$ 1665
Costs if she sells the car	1350
Annual Savings from selling car	$   351
One time revenue from selling car	$ 2000

Dorothy will save $ 351 per year if she sells her car. If money is the only consideration, her best option will be to sell the car. She might also consider what she can do with the revenue from selling the car. She will have to give up the convenience of having a car available at any time. She may have to adjust her schedule to accomodate using public transportation. As the car gets older it will need more maintenance, and may also need to be replaced. Will she be able to afford those costs? Parking is an expensive proposition in many cities. Increased traffic can be a problem from many elderly drivers. If Dorothy takes taxicabs she won't have to worry about driving in traffic, parking, fuel, maintenance, etc. 

A Stitch In Time SOLUTION

This one's a bit more difficult, but we can make it easy to understand using Incremental Analysis.

First we'll determine the daily overhead costs per work station.

Overhead per station per month
$12,000 monthly overhead / 30 stations = $400 per station per month

Overhead per station per day
$400 per station / 22 work days per month = $18.18 per station per day

The $18.18 per day in overhead costs applies to all workers. At a minimum each worker must produce enough product to cover their wages plus their station's overhead.

I decided to analyze this by looking at revenue and costs at different production levels. I especially wanted to look at the 24 and 20 dozen levels, so I decided to divide the range as follows, and calculate pay per day, based on different levels of output.

This chart shows that the company is losing money on workers producing below 12 dozen per day. They only make 3 cents per dozen for workers at the 12 dozen level. Clearly management should expect workers to produce above the 12 dozen level per day. A time limit should be set to train new workers. Management should expect new workers to improve quickly to keep their jobs.

The company can improve it's overall profit by eliminating low output workers, and replacing them with better workers. The incentive plan may work, if it encourages workers to achieve the 20 and 24 dozen levels. Even if they pay the bonus, the company still makes more money with excellent workers, compared with average workers. 

Also remember that dozen per day includes Seconds and Scrap. We can assume that better workers produce fewer Seconds and Scrap. The next step would be to analyze the cost of wasted materials from Seconds and Scrap, plus added inspection and handling costs from these sub-standard units of output. This would further tilt the scales in favor of better workers, and help management set clear, measurable expectations for workers. 
 

First let's calculate the daily overhead per chair. Under-utilized chairs cost Max money every day. 

$7,000 monthly overhead / 6 chairs / 26 days = $44.87 per day per chair
 

	Barbers	Stylists
Customers per hour	3	1
Revenue rate per customer	$  10.00	$  30.00
Revenue per hour (Rate x Customers)	30.00	30.00
Barber/Stylist wage per hour	12.50	15.50
Gross Profit per hour	$  17.50	$  14.50
TIMES Hours per day	8.00	8.00
Gross Profit per day	$ 140.00	$ 116.00
LESS Chair cost per day	44.87	44.87
PROFIT per day	$  95.13	$  71.13

From this analysis we see that hiring Barbers is more profitable than hiring Stylists. Max should hire as many Barbers as he can keep busy all day. Then he should hire Stylists to fill the remaining seats. 

If he isn't able to hire enough Barbers and Stylises, he can also rent chairs by the day to Barbers and Stylists working as independent contractors - a practice common to this industry. The miminum rental per chair would be $44.87 per day, just enough to cover his overhead costs and break even (i.e., not lose money on an empty chair).