What is 'Incremental Cost'
Incremental cost, also referred to as marginal cost, is the encompassing change a company experiences within its balance sheet or income statement due to the production and sale of one additional unit of production. It is calculated by analyzing the additional charges incurred based on the change in a certain activity.
BREAKING DOWN 'Incremental Cost'
This activity, for example, may be production levels, sales, machine hours or area dimension. As the activity increases or decreases, the resulting change in the related expense is the incremental cost. For example, if production increased from 9,000 units to 10,000 units and the associated costs increased from $45,000 to $50,000, the incremental cost for the additional 1,000 units is $5,000.
Usefulness of Incremental Costs
Incremental costs are relevant in making short-term decisions or choosing between two alternatives. This includes whether to accept a special order. If a special price is established for a special contract, it is critical the revenue received from the special order at least covers the incremental costs or the special order results in a net loss. Incremental costs are also useful for decisions on whether to manufacture or purchase a good. Only the additional costs associated with the manufacturing of the good should be considered and compared to the retail price.
Unprofitable Business Segment
Incremental cost analysis is utilized to analyze business segments. Certain costs, such as the rent on an office building, are fixed and not attributable to any specific segment. Therefore, only the relevant incremental costs such as variable wages, utilities and materials must be considered in evaluating the profitability of a business segment.
Incremental costs are also called relevant costs because they encompass only the items necessary for analysis. All fixed costs are omitted from incremental cost analysis because they do not change. Therefore, fixed costs are sunk costs that should not be considered. Only variable costs such as materials or labor are considered in incremental costs.
Marginal Cost Equaling Marginal Revenue
Incremental costs help determine the profit maximization point for an organization. This point occurs when marginal costs equal marginal revenues. If a business is earning more marginal revenue per product than the incremental cost of manufacturing or buying that product, the business earns profit. Alternatively, once incremental costs exceed marginal revenue for a unit, the company takes a loss for each item produced. Therefore, knowing the incremental cost of additional units of production and comparing it to the selling price of these goods assists in maximizing profit.