The incremental cost is an important calculation for firms to determine the change in expenses they will incur if they grow their production. These additional charges are reported on the company’s balance sheet and income statement. As a result, incremental cost affects the company’s decision to expand or increase output. In this post, we define incremental cost, learn how to calculate it with a formula and see an example of how it might assist a business make profitable decisions.
What is Incremental Cost?
The overall cost incurred as a result of producing an additional unit of product is referred to as incremental cost. The incremental cost is computed by examining the additional expenses incurred during the manufacturing process, such as raw materials, for each additional unit of output. Understanding incremental costs can assist businesses in increasing production efficiency and profitability.
Understanding Incremental Cost
Because incremental costs are the costs of producing one additional unit, they would not be incurred if output did not grow. To produce incremental costs, incremental costs are often lower than unit average costs. Incremental costs are always made up of variable expenses, which fluctuate with production levels. The following are examples of incremental costs:
- Inventory.
- Utilities, such as the extra electricity required to power the device
- Wages or direct labour involved solely in the production
- Packaging and shipping
In other words, incremental costs are exclusively determined by the amount of output. Fixed costs, such as rent and overhead, are excluded from incremental cost analysis since they normally do not vary with output quantities. Furthermore, fixed costs can be difficult to allocate to a certain business area. Incremental expenses are also known as marginal costs.
Advantages
Understanding incremental expenses can assist a business in improving its efficiency and saving money. Incremental costs can also help you decide whether to make a product or buy it elsewhere. Understanding the additional costs of increasing a product’s manufacturing is beneficial when deciding the retail price of the product. Companies seek to maximize production levels and profitability by analyzing the incremental costs of manufacturing. When evaluating a business segment’s profitability, only relevant incremental costs that can be directly linked to the business segment are examined.
Analyzing production volumes and incremental costs can assist businesses in achieving economies of scale in order to optimize production. Economies of scale occur when expanding production results in cheaper costs because the costs are spread out over a greater number of commodities produced. In other words, when output increases, the average cost per unit decreases. When incremental costs are added, the fixed costs normally do not change, implying that the cost of the equipment does not vary with production levels.
When making short-term decisions or selecting between two possibilities, such as whether to accept a special order, incremental costs are important. If a lower price is set for special order, it is vital that the income generated by the special order at least covers the incremental costs. Otherwise, the special order nets a loss.
How To Calculate Incremental Cost
The calculation of incremental cost shows how costs alter as production grows. For example, the production cost of a normal 100 units for a firm is known, but by adding an additional 10 units, the incremental cost must be calculated to demonstrate the difference in the total cost of the additional units.
As a result, estimating incremental cost is critical for cost determination, cost accounting, profit margin determination, financial planning, and overall profitability of operations at various levels of production. The following is the formula for determining incremental cost:
It can also be calculated as follows:
The preceding formula is analogous to the marginal cost (MC) formula. It simply divides the change in costs by the change in quantity produced to determine the incremental cost.
Each organization determines costs differently based on its overhead cost structure. The separation of fixed and variable costs, as well as the assessment of raw material and labor costs, varies by organization. Variable expenses vary depending on the degree of production.
Influencing Factors of Incremental Cost
The incremental costs will be influenced by variable and fixed costs. A fixed building lease, for example, does not alter in price as output increases. The fixed cost will be reduced in comparison to the cost of each unit made, enhancing your profit margin for that product. Variable expenses fluctuate based on production. A variable cost is a specific material utilized in production because the price increases as you order more. Bulk orders are frequently discounted, introducing a variable into your incremental calculation.
Decisions Regarding Incremental Cost
The following managerial decisions result in incremental cost:
- Installation of new machinery and equipment
- Replacement of existing manufacturing equipment
- Boosting product output
- Increasing the number of raw materials used on the production line
- Modifications to production methods
- Hiring more production workers
- Introducing new distribution channels
- Variable cost changes
- Introducing a new manufacturing line
Applications
The incremental cost method is used to analyze the following decisions:
- Making a decision to change the price of a product
- Allocation of existing resources in order to maximize the use
- Choosing whether to bring a new production line in-house or outsource it
- Accepting or declining a one-time large-volume order
- Accepting or rejecting a one-time selling price for more units
To improve decision-making efficiency, incremental cost calculation should be automated at all levels of production. There is a requirement to create a spreadsheet that tracks costs and output. As output increases, so does the cost per unit and profitability.
What Distinguishes Incremental Cost from Incremental Revenue?
While incremental cost is the price you pay for the higher production costs incurred when you decide to produce an additional unit of a product, incremental revenue is the additional money earned from selling that additional unit.
Companies typically use incremental cost to determine if they should:
- Boost their product output.
- Launch a new product line
- Maintain in-house production of the new product.
- Outsource the new manufacturing.
- Accept a one-time charge for additional units.
- Increase or decrease the product’s price.
Companies utilize incremental revenue as a comparative measure with their baseline revenue level to calculate their return on investment. They may then determine how much money they can afford to spend on marketing efforts and how much sales volume is required to generate a profit for the company.
Here’s how incremental cost and incremental revenue interact:
- Your company makes a profit if the incremental cost of making a product unit is less than the incremental revenue earned from selling that unit.
- If the incremental cost of manufacturing a product unit exceeds the incremental revenue earned from selling that unit, your company loses money.
That is why it is critical to understand the incremental cost of any more units. You can then compare these to the price you earn for selling the units to see whether your business is profitable enough.
Example of incremental revenue vs. incremental cost
This is an example to further appreciate the distinction between incremental cost and incremental revenue. Imagine you own a smartphone manufacturing company that expects to sell 20,000 devices. Each smartphone costs you $100 to produce, and your selling price each smartphone is $300.
Incremental cost
You calculate your incremental cost by multiplying the number of smartphone units by the production cost per smartphone unit.
- As a result, in this situation, you will have:
- 20,000 multiplied by 100 equals 2,000,000
- As a result, the incremental cost is $2,000,000.
Increased revenue
You calculate your incremental revenue by multiplying the number of smartphone units by the selling price per smartphone unit.
As a result, you will have:
- 20,000 multiplied by 300 is 6,000,000
- As a result, the incremental revenue is $6,000,000.
When the two are compared, it is evident that the incremental revenue exceeds the incremental cost. So, you get a profit of $4,000,000 by deducting the incremental cost from the incremental revenue.
You may estimate how much you should budget for your firm and how much profit you might make by conducting this type of cost analysis ahead of time. So, you can then assess whether or not it makes business sense to expand operations.
Jobs with an Incremental Cost
Several positions demand you to make calculations to determine the incremental cost. Here are some examples of positions where incremental cost may be used:
- Chartered accountant
- Product manager
- Production helper
- Shipping expert
- Manufacturing expert
- The inventory clerk
- Sales supervisor
- Account manager
- Coordination of logistics
- Financial expert
Marginal Cost vs. Incremental Cost
The incremental cost is also known as marginal cost. However, there are minor distinctions between the two conceptions.
The change in overall cost as a result of producing one additional unit of output is referred to as the marginal cost. It is often computed when a corporation creates enough output to cover fixed costs and has progressed past the breakeven threshold, where all future costs are variable. However, incremental cost refers to the extra cost incurred as a result of the decision to expand output.
As a result, while both ideas are related to a cost shift, marginal cost relates to both a rise and a decrease in production. In contrast, incremental cost refers to a change in total production output caused by changes in manufacturing methods, advancements in manufacturing technologies, changes in the distribution of more units of output, and the use of superior sales channels.
Essentially, the incremental cost is largely related to decisions and business decisions. The marginal cost is used to optimize output, whereas the incremental cost is used to determine the profitability of activities.
Long-Term Incremental Cost Analysis
Long-run incremental cost (LRIC) is a cost concept that forecasts expected changes in relevant costs over time. LRIC is typically linked to an organization’s accounting system. It covers important and significant costs that have a long-term impact on manufacturing costs and product pricing. They could include the price of crude oil, electricity, or any other key raw commodity, for example.
A notable example is the long-run incremental cost of lithium, nickel, cobalt, and graphite as important raw materials for creating electric vehicles. If the long-run estimated cost of raw materials rises, electric car prices will most likely rise in the future. The endeavour to calculate and precisely estimate such expenses aids a corporation in making future investment decisions that can boost revenue while decreasing costs.
If the LRIC rises, it is likely that a corporation will boost product pricing to meet the costs; the inverse is also true. Forecast LRIC is visible on the income statement, where revenues, cost of goods sold, and operational expenses will be altered, affecting the company’s total long-term profitability.
The Advantages of Incremental Cost Analysis
- Companies can increase manufacturing efficiency by analyzing and comprehending incremental costs.
- Understanding incremental cost can help you decide whether to develop a product or just purchase it from another supplier.
- It also aids in enhancing production output and profitability.
- Knowing the incremental cost aids in determining a product’s price.
- When evaluating the profitability of a business unit, incremental cost analysis evaluates only relevant costs that are directly related to that business unit.
- Incremental cost analysis, in conjunction with production volume analysis, assists businesses in achieving economies of scale by optimizing production. So, when manufacturing increases, the average cost per unit decreases, resulting in economies of scale.
- When incremental costs are included, fixed costs remain unchanged, implying that equipment costs do not vary with production volume.
- When deciding between options, such as accepting or rejecting a one-time high-volume special order, incremental cost analysis is utilized.
- In short-term decision-making, incremental cost analysis is applied.
Incremental Cost FAQs
What is the meaning of variable cost?
A variable cost is a corporate expense that varies in relation to the amount of product or service produced or sold. Variable costs rise or fall in relation to a company’s production or sales volume, rising as production increases and falling as production drops.
What is incremental cost analysis?
Incremental analysis is a business decision-making technique that determines the genuine cost difference between alternatives. Incremental analysis, also known as the relevant cost approach, marginal analysis, or differential analysis, disregards any sunk or prior cost.
What is incremental principle?
According to the incremental principle, a decision is profitable if revenue increases more than costs; costs decline more than revenues; increases in some revenues are bigger than decreases in others, and decreases in some costs are greater than increases in others.
