What is Incremental Analysis
Incremental analysis is a decision-making 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. Incremental analysis is useful in the application of making business decisions including whether to self-produce or utilize outsourcing.
BREAKING DOWN Incremental Analysis
Incremental analysis is a problem-solving approach that utilizes accounting information to assist in decision making. It is applied when more than one alternative is present.
Relevant vs. Non-Relevant Costs
Only relevant costs are incorporated into analysis models, and these costs are typically broken into variable costs and fixed costs. Incremental analysis considers opportunity costs to make sure the most favorable option is pursued. Non-relevant sunk costs are charges that have already been incurred. Because the expenses will remain regardless of any decision, sunk costs are not included in incremental analysis. Relevant costs are also called incremental costs because they are only incurred when an activity of relevance has been increased or started.
Types of Incremental Analysis Decisions
Incremental analysis helps companies decide whether or not to accept a special order. This special order is typically lower than its normal selling price. It also assists with allocating limited resources among several product lines to ensure the scarce asset is utilized to return the greatest benefit. Incremental analysis entails decisions on whether to produce or buy goods, scrap a project or rebuild an asset. Finally, incremental analysis provides insight into whether to produce a good further or sell at a certain point during the manufacturing process.
Example of Incremental Analysis
A company sells an item for $300. The company pays $125 for labor, $50 for materials, and $25 total for variable overhead selling expenses. It also allocates $50 per item of fixed overhead costs. The company is not operating at capacity and will not be required to invest in equipment or overtime to accept a special order it received. The special order requests the purchase of 15 items for $225 each.
The sum of all variable costs and fixed costs per item is $250. However, the $50 of allocated fixed overhead costs are a sunk cost because they have already been incurred. The company has excess capacity and should only consider the relevant costs. Therefore, the cost to produce the special order is $200 per item ($125 + $50 + $25) and the profit per item is $25 ($225 - $200). While the company is still able to make a profit on this special order, the company must consider the ramifications of if it was operating at full capacity. If no excess capacity is present, additional expenses to consider include investment in new fixed assets, overtime labor costs and the opportunity cost of lost sales.