Incremental cost, also known as marginal cost, is a key concept in managerial accounting and financial analysis. It refers to the additional cost incurred when producing extra units of a product or service. Understanding how to accurately calculate incremental costs is important for making sound business decisions.
In this comprehensive guide, we will walk through the incremental cost definition, explain why it matters, outline the step-by-step calculation, and provide examples for different business scenarios
What is Incremental Cost?
Incremental cost is the variable cost associated with increasing output by one additional unit. It captures the direct labor and materials costs that go into producing extra units.
Incremental cost helps isolate the production costs directly tied to upsizing capacity or volumes. It excludes fixed overhead costs that don’t fluctuate with short-term changes in output.
Some key characteristics of incremental costs
- Variable cost that changes based on volume
- Direct production costs like materials and labor
- Does not include allocated fixed costs
- Often referred to as marginal cost
- Helps determine profitability of extra units
Understanding a company’s incremental costs is important for decisions like setting pricing, production levels, make vs. buy, adding product features, and more. It reveals the true economics of incremental activities.
Why Calculate Incremental Costs?
Here are some key reasons why accurately measuring incremental costs matters:
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Optimal pricing – Shows the real production costs of extra units to inform appropriate pricing.
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Production levels – Guides whether producing and selling additional units is profitable.
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Cost management – Highlights production drivers of cost for guiding reductions.
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Make vs buy – Compares the incremental cost of outsourcing production
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Sunk costs – Avoids allocating fixed costs that are irrelevant to decisions.
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New products – Quantifies the standalone cost of new product development.
For any business decision that involves changing volumes or adding products/services, incremental costs are vital for determining the financial impact.
How to Calculate Incremental Costs Step-by-Step
Here is a step-by-step guide to calculating incremental costs accurately:
Step 1: Define the Base Case Volume
The base case is your existing or normal volume level before any proposed volume increase. This is your starting point for comparison.
For example, if you normally produce 10,000 units of a product per month, this base monthly volume is 10,000 units.
Step 2: Determine the Total Cost at Base Volume
Add up all the production and direct labor costs involved with your base volume. Include material, labor, transportation, etc. required to sustain the base case output.
Continuing the example, let’s say it costs $100,000 to produce the 10,000 units in a typical month.
Step 3: Define the Incremental Volume Change
The incremental volume change is how much extra output is being proposed or considered for evaluation.
For instance, evaluating expanding monthly production from 10,000 units to 15,000 units means the incremental change is 5,000 units.
Step 4: Determine the Revised Total Cost
Calculate the new total cost if this incremental volume change is implemented. How much higher will total production costs be if volumes expand as proposed?
Expanding from 10,000 units to 15,000 units, let’s assume total monthly costs increase to $120,000.
Step 5: Subtract Old Cost from New Cost
The difference between the new total cost and old total cost is the incremental cost associated with the incremental volume change.
Mathematically:
New Total Cost – Old Total Cost = Incremental Cost
With our example figures:
$120,000 (new total cost) – $100,000 (old total cost) = $20,000
Therefore, the incremental cost of producing an extra 5,000 units is $20,000.
And there you have it – the five steps to determining incremental costs. While the calculation itself is straightforward, the key is identifying the right base and incremental volumes to analyze. Applying this methodology to your business decisions yields pivotal insights for profitability and strategy.
Examples of Incremental Cost Calculations
To provide more practical examples, here are some incremental cost calculations for different business scenarios:
Expanding Production Volumes
- Current output: 10,000 units per month at $100,000 total cost
- Evaluating: Increasing to 15,000 units per month
- New total cost: 15,000 units at $120,000 total cost
- Incremental cost: $120,000 – $100,000 = $20,000
This shows the incremental cost of scaling monthly production volumes by 5,000 units is $20,000.
Adding a Product Feature
- Current product cost: $50,000
- Proposed feature: Add premium support for $2,000 per unit
- New product cost: $50,000 + (2,000 x 1,000 units) = $70,000
- Incremental cost: $70,000 – $50,000 = $20,000
Here the $20,000 incremental cost reveals how much extra the premium feature addition will cost in total across 1,000 product units.
Manufacturing vs. Outsourcing
- Current in-house cost: $100,000 to manufacture 10,000 units
- Outsourcing quote: $75,000 for 10,000 units
- Incremental cost of outsourcing: $75,000 – $100,000 = -$25,000 savings
The negative $25,000 incremental cost signals that outsourcing would reduce production costs by $25,000 for this volume.
Incremental cost calculations reveal invaluable insights for production, pricing, make vs. buy decisions, and more. They isolate the true economics of changing output volumes or adding new products/features.
While the formula is simple, the key is structuring the analysis properly by:
- Choosing appropriate base and incremental volumes
- Focusing only on costs directly tied to production
- Avoiding allocation of sunk fixed costs
Taking a data-driven, incremental approach enables better decision making and drives operational improvements. Including incremental cost analysis in your managerial toolkit can elevate your strategic contributions.
Now that you’re equipped with an in-depth guide to incremental cost calculations, you can start applying this technique to boost profitability, cut costs, set optimal pricing, and make other key business decisions driven by the real economics.
What Is Incremental Cost?
Incremental cost is the total cost incurred due to an additional unit of product being produced. Incremental cost is calculated by analyzing the additional expenses involved in the production process, such as raw materials, for one additional unit of production. Understanding incremental costs can help companies boost production efficiency and profitability.
- Incremental cost is the amount of money it would cost a company to make an additional unit of product.
- Companies can use incremental cost analysis to help determine the profitability of their business segments.
- A company can lose money if incremental cost exceeds incremental revenue.
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Benefits to Incremental Cost Analysis
Understanding incremental costs can help a company improve its efficiency and save money. Incremental costs are also useful for deciding whether to manufacture a good or purchase it elsewhere. Understanding the additional costs of increasing production of a good is helpful when determining the retail price of the product. Companies look to analyze the incremental costs of production to maximize production levels and profitability. Only the relevant incremental costs that can be directly tied to the business segment are considered when evaluating the profitability of a business segment.
Analyzing production volumes and the incremental costs can help companies achieve economies of scale to optimize production. Economies of scale occurs when increasing production leads to lower costs since the costs are spread out over a larger number of goods being produced. In other words, the average cost per unit declines as production increases. The fixed costs dont usually change when incremental costs are added, meaning the cost of the equipment doesnt fluctuate with production volumes.
Incremental costs are relevant in making short-term decisions or choosing between two alternatives, such as whether to accept a special order. If a reduced price is established for a special order, then its critical that the revenue received from the special order at least covers the incremental costs. Otherwise, the special order results in a net loss.
Incremental cost is also known as marginal cost.
Incremental Cost Allocation Method
How is incremental cost calculated?
Incremental cost is calculated by analyzing the additional expenses involved in the production process, such as raw materials, for one additional unit of production. Understanding incremental costs can help companies boost production efficiency and profitability.
How do you calculate incremental costs of additional units?
Incremental Costs of Additional Units = Incremental Cost Per Unit * Additional Units Produced This straightforward calculation provides a clear picture of the financial impact of expanding production, aiding businesses in making informed decisions. Let’s say you are contrasting two different phone plans.
What is the difference between incremental cost and 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.
Does incremental cost include fixed costs?
Certain costs will be incurred whether there is an increase in production or not, which are not computed when determining incremental cost, and they include fixed costs. However, care must be exercised as allocation of fixed costs to total cost decreases as additional units are produced.
