Incremental Cost

What is Incremental Cost?

Incremental Cost refers to the change in total cost resulting from producing one additional unit. Examining the additional costs related to the production process, including raw materials relevant to producing one additional unit, helps determine the incremental cost.

Understanding incremental costs becomes critical for businesses looking to increase their productivity and overall profitability.

Businesses can make informed decisions about production levels, pricing strategies, and resource allocation by carefully examining the additional costs associated with producing each additional unit.

Striking the right balance between overproduction and underproduction ensures efficient resource utilization.

Incremental Cost captures all pertinent costs impacted by the choice to increase production beyond a simple analysis of changes in variable costs. This holistic viewpoint is especially important for companies deciding on production levels strategically.

Since the costs directly affected by changes in production volume are dynamic, the term 'incremental cost' highlights how they differ from fixed costs.

Consequently, a thorough comprehension of incremental cost necessitates a meticulous evaluation of variable costs and acknowledging the complex correlation between fixed costs and their dynamic distribution in reaction to variations in production.

It's important to remember that some expenses, especially fixed costs, don't change whether production rises or falls.

The computation does not take these fixed costs into account. The distribution of fixed costs to total costs decreases proportionately with the number of units produced, so extra care must be taken.

Understanding Incremental Costs

The significance of incremental cost lies in its influence on product pricing decisions. When incremental costs contribute to the rise in product cost per unit, the company may decide to raise the product's price.

This strategic move is intended to increase overall profitability while maintaining the company's return on investment (ROI).

It is fundamentally linked to production expansion. It typically includes variable costs that vary with production volumes, such as raw material inputs, direct labor costs for factory workers, and other variable overheads, such as power/energy and water usage costs.

Expanding production by a single unit may necessitate capital investment in plant, machinery, fixtures, and fittings.

For example, in the case of a restaurant that is only allowed to seat twenty-five people due to local regulations, increasing capacity by just one person may necessitate incurring construction costs.

This nuanced understanding and its relationship to both variable and fixed costs is critical for making effective decisions in the dynamic realm of production expansion and pricing strategies.

The incremental cost is based on a choice-oriented principle that only includes prospective costs.

Costs associated with the construction of a factory and initial plant setup are excluded from the computation of incremental costs, as they are considered sunk costs. Fixed costs are frequently left out of the calculation as well.

However, when a company's factory is at full capacity, creating an extra unit goes beyond variable costs. It encompasses a broad spectrum, including the initial investment in new facilities and production lines, hiring more staff, purchasing additional supplies, and other overhead expenses.

This careful consideration shows how flexible and context-dependent incremental cost assessments are by acknowledging that incremental costs can differ depending on the production facility's unique circumstances and capacity limitations.

Calculation of Incremental Costs 

The computation of incremental cost is necessary to assess the changes in expenses related to a production increase.

For example, if a company already knows how much it costs to produce a standard quantity, say 100 units. It becomes necessary to figure out the incremental cost when considering adding an extra 10 units.

The change in the total cost related to the production of these extra units can be calculated using the following formula:

Incremental Costs Per Unit = Variable Cost / Units Produced

The total incremental costs for the additional units can then be obtained by multiplying the incremental cost per unit by the number of additional units produced:

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.

Incremental Cost Example 

Let's say you are contrasting two different phone plans. Each month costs $40 and $30 for Plan A and Plan B.

The difference is $10, and the minimum amount to spend is $30. In this case, the incremental cost of $10 is the relevant cost for comparison. You should consider whether Plan A's additional features and benefits outweigh the additional cost.

Let's now investigate a different situation. The 200 shirts that XYZ Clothing Company produces have variable costs of $8 each and fixed costs of $3,000. The manufacturing cost of these 200 shirts comes to 

$8 x 200 + $3,000, or $4,600

The business then chooses to raise production to 250 shirts. Making 250 shirts will cost you 

$8 x 250 + $3,000, or $5,000 total

In this instance, the extra expense involved in making 50 more shirts is $400.

The company can evaluate the financial effects of increasing production and decide whether increasing output will be profitable. 

Importance of Incremental Costs

An important component of incremental analysis, a framework for decision-making used by managers, entrepreneurs, and investors, is incremental cost.

1. Evaluation through Incremental Analysis: With this method of analysis, the viability of a decision is determined by whether the additional revenue earned outweighs the additional expense incurred. In this context, incremental revenue is the difference in total revenue due to adjustments made to prices, output levels, or other pertinent variables.
2. Growth in Revenue Outpaces Cost Increase: If a decision increases revenue more than the corresponding increase in costs, it is considered profitable. This case study highlights the significance of making decisions that positively affect the bottom line by increasing overall revenue relative to the rise in costs.
3. Cost Reduction Outweighs Diminished Income: A decision is considered profitable if it increases revenue more than the corresponding cost increase or reduces costs more than the decline in revenue. This demonstrates the cost-cutting and efficiency improvements that enhance the overall financial success.
4. Enhancing The Allocation of Resources: A profitable choice might be allocating more resources to some areas than others. Strategically allocating resources ensures that the choice positively influences specific areas, improving overall productivity and efficiency.
5. Adjusting for Changes in Cost and Resources: A decision can be considered profitable if it lowers some costs more than it raises others. Maintaining a favorable cost-benefit ratio and optimizing the cost structure depends on this balance.

Incremental cost Vs. Incremental Revenue

The following shows the relationship between incremental cost and incremental revenue 

The relationship between incremental revenue and incremental cost, as well as how their relative values affect the company's overall financial result, is shown in this table in a simplified manner.

• Profitable Scenario: The business makes money when additional revenue exceeds additional costs.
• Break-even Scenario: The business breaks even, meaning there is no profit or loss when additional revenue equals additional costs.
• Unprofitable Scenario: The business experiences a loss when incremental costs exceed incremental revenues.

Incremental Cost vs. Marginal Costs 

The following shows the distinction between Incremental Costs and Marginal Costs.

Conclusion 

Businesses that must navigate the intricacies of production and decision-making rely heavily on incremental cost.

Businesses can make well-informed decisions about production levels, pricing policies, and resource allocation by focusing on the shift in total costs related to producing an additional unit.

Strategic consideration of incremental costs becomes especially important to avoid the traps of overproduction or underproduction, maximize resource utilization, and maintain a balanced operational strategy.

Within the more general incremental analysis framework, where a decision's viability and profitability are determined by the ratio of incurred expenses to additional revenue, incremental cost analysis is deeply ingrained.

On the other hand, when incremental expenses exceed incremental revenues and a loss is incurred, an unprofitable situation results.

Additionally, defining incremental and marginal costs makes clear the distinct roles that each plays in making decisions.

Marginal cost is concerned with the additional costs associated with decisions to increase output, particularly when it comes to changes in production techniques and the distribution of additional units. 

Researched and Authored by Lavanya Purushothaman I Linkedin 

Reviewed and edited by Parul Gupta | LinkedIn

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources:

• Incremental Budgeting
• Interbank Market
• Key Currency
• Liquidity
• Nominal Interest Rate