What is Incremental Cost
Incremental cost, also referred to as marginal cost, is the total change a company experiences within its balance sheet or income statement due to the production and sale of one additional unit of product. It is calculated by analyzing the additional charges incurred based on the change in a certain activity. Incremental costs may also be classified as relevant costs.
BREAKING DOWN Incremental Cost
Production activities, such as sales, machine hours or productive area dimensions, incur expenses. As these activities increase or decrease, total expenses to the company also change. For example, if a company responded to greater demand for its widgets by increasing production from 9,000 units to 10,000 units, it will incur additional costs to make the extra 1,000 widgets. If the total production cost for 9,000 widgets was $45,000, and the total cost after adding the additional 1,000 units increased 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, such as whether to accept a special order. If a reduced price is established for a special order, 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 a good or purchase it elsewhere. Only the additional costs associated with the manufacturing of the good should be considered and compared to the retail price in this scenario.
Incremental Cost Analysis
Incremental cost analysis is utilized to analyze business segments with the intent of determining the profitability of the segment. All fixed costs, such as rent, are omitted from incremental cost analysis because they do not change and are generally not specifically attributable to any one business segment. Only the relevant incremental costs that can be directly tied to the business segment, such as variable wages, utilities and materials, should be considered in evaluating the profitability of a business segment.
Marginal Cost and 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.