Incremental cost is the additional cost incurred by a company if it produces one extra unit of output. The additional cost comprises relevant costs that only change in line with the decision to produce extra units.
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.
Therefore, incremental cost may involve more than the change in variable cost. It is also known as differential cost.
Understanding Incremental Cost
Incremental cost is important because it affects product pricing decisions. If incremental cost leads to an increase in product cost per unit, a company may choose to raise product price to maintain its return on investment (ROI) and to increase profit. Conversely, if incremental cost leads to a decrease in product cost per unit, a company can choose to reduce product price and increase profit by selling more units.
Thus, incremental cost is a product of an increase in production. It is usually made up of variable costs, which change in line with the volume of production. Incremental cost includes raw material inputs, direct labor cost for factory workers, and other variable overheads, such as power/energy and water usage cost.
To increase production by one more unit, it may be required to incur capital expenditure, such as plant, machinery, and fixtures and fittings. A restaurant with a capacity of twenty-five people, as per local regulations, needs to incur construction costs to increase capacity for one additional person.
Incremental cost is choice-based; hence, it only includes forward-looking costs. The cost of building a factory and set-up costs for the plant are regarded as sunk costs and are not included in the incremental cost calculation. Fixed costs are often not included in calculating incremental costs.
Costs included in the calculation are associated with those that change as a result of a decision to increase production, i.e., variable costs. However, as in the above example, if a company’s factory is operating at 100% capacity, the cost of an additional unit includes an investment outlay on a new plant and production line, cost of additional human and material resources, and other overheads.
Incremental cost is usually computed by manufacturing entities as a process in short-term decision-making. It is calculated to assist in sales promotion and product pricing decisions and deciding on alternative production methods. Incremental cost determines the change in costs if a manufacturer decides to expand production. In essence, it assists a company in making profitable business decisions.
Calculating Incremental Cost
The calculation of incremental cost shows a change in costs as production expands. For example, the production cost of a standard 100 units for a business is known but by adding a further 10 units, there is a need to calculate the incremental cost to show the change in the total cost of the additional units.
Therefore, calculating incremental cost is crucial for cost determination, cost accounting purposes, determination of profit margin, financial planning, and the overall profitability of operations at various levels of production. The formula for calculating incremental cost is as follows:
Alternatively, it can also be calculated as:
The above formula is similar to the marginal cost (MC) formula. It simply computes the incremental cost by dividing the change in costs by the change in quantity produced.
Costs are determined differently by each organization according to its overhead cost structure. The separation of fixed costs and variable costs and determination of raw material and labor costs also differs from organization to organization. Variable costs change according to different levels of production.
Incremental Cost Decisions
Incremental cost arises from the following managerial decisions:
Installation of new equipment and machinery
Replacement of existing production equipment
Increasing product output
Increasing the amount of raw material inputs on the production line
Changing production methods
Hiring additional labor in production
Changing to new distribution channels
Changes in variable costs
Introducing a new production line
Uses of Incremental Cost Computations
Incremental cost is used for analyzing the following decisions:
Deciding to change the price of a product
Allocation of available resources for optimal utilization
Deciding to introduce a new production line in-house or outsource it
Accepting or rejecting a one-off high-volume order
Accepting or rejecting a one-time selling price for additional units
The calculation of incremental cost needs to be automated at every level of production to make decision-making more efficient. There is a need to prepare a spreadsheet that tracks costs and production output. As output rises, cost per unit decreases, and profitability increases.
Incremental Revenue vs. Incremental Cost
Incremental revenue refers to the additional revenue earned from selling one additional unit, and incremental cost is the additional cost incurred by producing one additional unit of a product. The interaction between incremental revenue and incremental cost and how they affect each other can be illustrated as follows:
If incremental cost is lower than incremental revenue, selling an additional unit will earn the company a profit.
If incremental cost is higher than incremental revenue, selling an additional unit will cause the company to incur a loss.
Incremental revenue is compared to baseline revenue to determine a company’s return on investment. The two calculations for incremental revenue and incremental cost are thus essential to determine the company’s profitability when production output is expanded.
Incremental Cost vs. Marginal Cost
Incremental cost can also be referred to as marginal cost. However, there are slight differences between the two concepts.
Marginal cost is the change in total cost as a result of producing one additional unit of output. It is usually calculated when the company produces enough output to cover fixed costs, and production is past the breakeven point where all costs going forward are variable. However, incremental cost refers to the additional cost related to the decision to increase output.
Hence, both concepts are associated with a change in cost, but marginal cost refers to both an increase and a decrease in output. In contrast, incremental cost refers to a change in total production output due to changes in production methodology, improvement in production technologies, and changes in the distribution of additional units of output and use of superior sales channels.
In essence, incremental cost is mostly associated with decisions and business choices. Marginal cost is used for production optimization, while incremental cost is used for determining the profitability of operations.
Long-Run Incremental Cost Analysis
Long-run incremental cost (LRIC) is a forward-looking cost concept that predicts likely changes in relevant costs in the long run. LRIC is usually integrated into a company’s accounting system. It includes relevant and significant costs that exert a material impact on production cost and product pricing in the long run. They can include the price of crude oil, electricity, any essential raw material, etc.
The long-run incremental cost for lithium, nickel, cobalt, and graphite as critical raw materials for making electric vehicles are a good example. If the long-run predicted cost of the raw materials is expected to rise, then electric vehicle prices will likely be higher in the future. The attempt to calculate and accurately predict such costs assist a company in making future investment decisions that can increase revenue and reduce costs.
If the LRIC increases, it means a company will likely raise product prices to cover the costs; the opposite is also true. Forecast LRIC is evident on the income statement where revenues, cost of goods sold, and operational expenses will be affected, which impacts the overall long-term profitability of the company.
Benefits of Incremental Cost Analysis
Analyzing and understanding incremental cost enable companies to improve production efficiency.
Understanding incremental cost assists in decisions to manufacture a product or simply buy it from other suppliers.
It also helps in maximizing production output and increasing profitability.
Knowing the incremental cost helps in determining the price of a product.
Incremental cost analysis considers only relevant costs directly linked to a business unit when evaluating the profitability of that business unit.
Incremental cost analysis, together with the analysis of production volumes, helps companies attain economies of scale by optimizing production. Economies of scale occur when the average cost per unit declines as production increases.
Fixed costs remain unchanged when incremental cost is introduced, which entails that equipment costs do not vary with production volume.
Incremental cost analysis is used in choosing between alternatives, such as accepting or rejecting a one-off high-volume special order.
Incremental cost analysis is used in short-term decision-making.
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