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 an additional unit of product. It's calculated by analyzing the additional expenses incurred based on the addition of the unit. Incremental costs may be classified as relevant costs in managerial accounting.
Understanding Incremental Cost
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, then it's critical that the revenue received from the special order at least covers the incremental costs. Otherwise, the special order results in a net loss.
Incremental cost is also known as marginal cost.
Incremental costs are also useful for deciding 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 is often used to analyze business segments to determine their profitability. 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.
Example of Incremental Cost
If a company responds 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 cost for the additional 1,000 units is $5,000. The incremental cost, or cost of adding one unit, would be $5.
Incremental Cost vs. Incremental Revenue
Incremental costs (or marginal 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 incremental revenue (or marginal revenue) per product than the incremental cost of manufacturing or buying that product, the business earns a profit.
Alternatively, once incremental costs exceed incremental 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 meeting profit goals.
- Incremental cost is the amount of money it would cost a company to make an additional unit of product.
- Companies can use incremental cost analysis to help determine the profitability of their business segments.
- A company can lose money if incremental cost exceeds incremental revenue.