Incremental analysis is a
technique used in business to determine the true cost difference between alternatives. Also called the relevant cost approach, marginal analysis, or differential analysis, incremental analysis disregards any sunk cost or past cost.
Decision Making using Incremental analysis
When to use the types of incremental analysis
Companies can compare costs in a variety of circumstances using incremental analysis. The following are some of the most popular kinds of incremental analysis:
What is incremental analysis?
A comparative decision-making process, incremental analysis is also known as cost approach, marginal analysis, and differential analysis. When deciding between two or more options, businesses frequently use incremental analysis to compare the options and determine which is the most cost-effective course of action.
Incremental analysis is a true cost comparison. Sunk costs or previous costs related to a product, employee, or project are not taken into account. Relevant costs covered in an incremental analysis might include:
How to calculate an incremental analysis
Calculating an incremental analysis requires only simple addition and subtraction. However, depending on what you’re comparing, the variables and numbers in the calculation will vary. Some calculations are more complicated than others. To determine what data you require and how to conduct an incremental analysis, follow these steps:
1. Determine the relevant costs
Start by determining what your options are. Establish the relevant costs, both variable and non-variable, once you have a list of options. Just keep in mind that you shouldn’t factor in previous expenses; instead, focus only on costs that are directly related to the decision at hand.
Example: Happy End Furnishings wants to determine whether they should manufacture a new line of dining tables internally or contract out production by performing an incremental analysis. They want to sell the new tables for $500 each. In-house production costs include materials ($200) and labor ($100). Outsourced costs include materials ($150), labor ($75) and shipping ($100).
2. Identify any opportunity costs
Consider any opportunity costs that might apply to the options. Opportunity costs are potential profits that the company could forego for a variety of reasons.
For instance, Happy End Furnishings is aware that making the tables in-house will prevent them from increasing the output of their coffee tables. The opportunity cost is estimated to be $75 for each dining table.
3. Add costs together
Take the relevant costs and add them together. Depending on how they affect the calculation, you can either add or subtract the opportunity costs. Do this for all options individually.
Example: By adding the pertinent costs determined in step 1 ($300), Happy End Furnishings first determines the cost to manufacture the dining tables internally. The opportunity cost of making the tables themselves ($375) is then added. Since they can use their production space to produce other goods, they add the applicable costs ($325) and the opportunity cost ($75) to determine the cost of outsourcing production. The total cost of outsourcing production is $250.
4. Compare the options
To determine which offers a better financial result, compare the results to one another or against a fixed amount, such as the cost of hiring a new employee or the price of the product for sale.
Example: Happy End Furnishings estimates that manufacturing the dining tables in-house will cost $325 and outsourcing the task will cost $250. Happy End Furnishings will make a profit of $175 per table if they produce the tables themselves and $250 per table if they outsource production, with the tables retailing for $500 each.
5. Make a decision
Make a choice based on the data gathered from the incremental analysis.
Example: For two reasons, Happy End Furnishings chooses to outsource the manufacturing of their dining tables. First, the profit margin is higher with outsourced production. They’ll earn an extra $75 per table and employ their resources to produce other goods.
Examples of incremental analysis
Companies can apply incremental analysis to several business decisions. To better comprehend how to calculate incremental analysis in various scenarios, use the following examples:
In-house or outsourced personnel
To determine whether using a separate human resources company or maintaining an internal HR department is more cost-effective, Greensworth Holdings wants to use incremental analysis. They calculate the following monthly maintenance costs for an internal department:
They obtain a quote from an HR firm and discover that the price to satisfy their HR needs is $2,500 per month. They decide to outsource HR responsibilities to the HR company.
Repair or replace an asset
Simple Brothers Towing has a broken tow truck. To determine whether to buy a new tow truck or repair the old one, they choose to use incremental analysis. They calculate the following costs to repair the outdated tow truck:
The cost of a new tow truck would be $40,000. Arnold Brothers Towing calculates an additional $5,000 of opportunity cost because they could buy the new truck right away and wouldn’t need to pay for repairs for a while.
The cost to repair the old truck is $4,300. In order to account for opportunity loss, the price of a new truck is $44,000. Arnold Brothers Towing decides to fix the old repair truck.
FAQ
What is incremental analysis when making a decision?
- Determine the relevant costs.
- Identify any opportunity costs.
- Add costs together.
- Compare the options.
- Make a decision.
What is marginal and incremental analysis?
Financial data required for decision-making is analyzed using incremental analysis, also known as marginal analysis or differential analysis. It lists the pertinent revenues and/or costs of each alternative and estimates how that alternative will affect future income.
Is incremental analysis the same as CVP analysis?
Definition. Analysis of additional benefits from an activity in comparison to additional costs associated with the same activity is known as marginal analysis. However, incremental analysis is a method used in business to identify the real cost of various options.
