Incremental Costs

Incremental costs are the costs linked with the production of one extra unit, and it considers only those costs that tend to change with the outcomes of a particular decision. In contrast, the remaining costs are deemed irrelevant.

In simple words, it is defined as an additional cost incurred by the company due to the corresponding changes in cost associated with the production, replacing machinery or equipment or adding a new product, etc. Business  use it to understand many situations including whether to allocate the available resources to optimize their utilization and Whether it is feasible to change the price of a product.

The term incremental cost refers to the cost that the business incurs for producing an extra unit. It is a process where the companies take into consideration different expenditures that are involved in the production process like procurement of raw materials, labor cost, packing and transportation or finished goods, utilities like electricity, etc.

This concept of incremental cost of capital is useful while identifying costs that are to be minimized or controlled and also the level of production that can generate revenue more than return. The moment one extra unit produced does not generate the required return, the business needs to modify its production process.

Organizations can do this analysis for incremental costs of obtaining a contract, in order to determine whether the concerned business segment is able to generate targeted profit and keep track of incremental revenue, always being more than the cost. It provides guidance regarding decision-making for the management in terms of pricing, allocation of resources, planning or production quantity, sales target, profit target, etc.

Thus, we see that factors taken into consideration in this concept are those that change with production volume. The fixed costs are not considered over here because they remain the same. at all production levels. For this reason, it is also known as marginal cost.

The standard method or formula for incremental costs of obtaining a contract, that a business will use to calculate this cost is as follows:

Incremental Cost = Total cost incurred for increased production  level – Total cost incurred in previous production level.

In the above formula, the total cost of increased production refers to the previous volume and the new units added to it. From this value, the cost of volume is deducted to get the cost. However, none of it will include the fixed costs since they will not change due to volume fluctuation.

Let’s take an example to understand the incremental cost of capital better:

Assuming a manufacturing company, ABC Ltd. has a production unit where the cost incurred in making 100 units of a product X is ₹ 2,000. The company wants to add another product, 'Y,' for which it incurs some cost in terms of salary to the additional labor force, raw materials, and assuming that there was no machinery, equipment, etc., added.

Let's suppose now, after adding the new product line, it can produce 200 units at  ₹ 3500, so here the incremental cost is ₹ 1,500

Like in the above example, it is evident that the per-unit cost of manufacturing the products has decreased from ₹ 20 to  ₹ 17.5 after introducing the new product line. However, this may not be true in all cases. Identifying such costs is very important for companies as it helps them decide whether the additional cost is in their best interest.

It is not necessary that such costs can only be variable. Even fixed costs can contribute to the incremental cost, for example, if there is a requirement for new machinery for adding the new product line 'Y.'

The basic method of allocation of incremental cost in economics is to assign a primary user and the additional or incremental user of the total cost.

If we look at our above example, the primary user is product 'X' which was already being manufactured at the plant and utilizing the machinery and equipment. The new product only added some extra cost to define 'X' as the primary user and 'Y' as the incremental user.

In the absence of any new product or any additional unit, the total cost that ABC Ltd. incurred while manufacturing only ‘X’ is ₹2,000, so we’ll allocate this cost to X,

The additional cost of ₹ 1,500, incurred only to introduce the new product, will be allocated to ‘Y.’

This allocation can even change in the future course of business of ABC Ltd. when supposedly, if it chooses to drop product 'X,' then product 'Y' or any other product might become the primary user of the cost.

Incremental costs are also associated with the changes in the product's pricing. Let’s suppose if the overall cost per unit of a product is also increasing by incurring such cost, then the company would want to change the price of the product to maintain or increase the profit. The incremental cost in economics might work in or against the favor of the company. Such companies are said to have diseconomies of scale, i.e., they have already reached the maximum limit of production volume.

But if the per-unit cost or average cost is decreasing by incurring the incremental cost, the company might be able to reduce the price of the product and enjoy selling more units. Such companies are said to have economies of scale, whereby there is some scope available to optimize the utility of production.

Considering that the price of each unit of product ‘X’ is ₹ 25, the profit initially was

Net Profit = ₹ 500

Also, considering after introducing the new product line, the price for both 'X' and 'Y' is kept at ₹ 25, the profit here will be:

• Net Profit =(200 X 25) – (200 X 17.5)
• Net Profit = ₹ 1500

To increase the sales to gain more market share, the company can leverage the lower cost per unit of the product to lower the price from ₹ 25 and sell more units at a lower price.

Some benefits of this type of cost are as follows:

• Resource allocation – This process helps in resource allocation for the business. Resources are never unlimited. There is always a limitation to the amount of resource that can be procured and applied in the production process. It is necessary to use them to their optimum capacity without wastage. Incremental cost analysis ensures that resources are used wherever it is needed. Rise in this cost means resources are being channalized in wrong direction.
• Plan production levels- Production planning is extremely important for every business so that goods and services are available on time and as per demand in the market, with extra stocking up of finished goods and services which not only occupies space but increase cost and lead to wastage. Analysis of incremental or marginal cost helps in this process.
• Decision making- The entire production and planning process require decision making regarding price, volume, sales, revenue target, demnd and supply analysis, etc. Analysis of incremental or marginal cost contributes to this.
• Budgeting- Budgeting is of huge importance for every business process, which requires fund allocation for smooth working. Cost analysis regarding extra production helps in getting an idea about how much budget needs to be allocated so that revenue and sales increases leading to better profitability.
• Profit target- Every company needs to set their own profit target for different departments, which requires planning for increase in output and how much level of production volume will actually be profitable for the enterprize.
• Cost control – The analysis of incremental or marginal cost involves identifying the areas that will involve higher cost during production and either minimize them or optimize them. This helps in surviving the competition and improving the efficiency of the process.
• Risk minimization- This concept helps in minimizing the risk associate with expansion of production volume which is useful while launching new or improved goods and services in the market. It identifies the addition funds that has to be invested and design useful risk management practices.

Thus, the above are some benefits that the procedure of marginal cost analysis contributes to the entire manufacturing process.

Incremental costs are also referred to as marginal costs, but there are some basic differences between them.

• Incremental costs are mostly associated with choices or decisions and therefore include only those additional costs caused due to the decision made; for example, it does not consider the cost of machinery or equipment which was already there in the production unit, which is also referred to as sunk cost because these costs will remain regardless of any decision.
• On the other hand, Marginal cost specifically takes into account the increase in cost for producing one additional unit. It is often used to optimize production, while the incremental cost is not an optimization tool.

As the name suggests, both are meant to calculate the cost and revenue for extra or addition production of goods and services. Let us look at the differences between them.

• The incremental cost analysis deals with analysis of cost for producing extra output and the latter deals with the analysis of revenue earned for producing extra output.
• The former calculates the how much more cost will be incurred for increase in the output unit and the latter does the same with the revenue.
• In the field of decision making, the incremental cost analysis suggests that if the analysis shows increase in cost, that production should not be accepted, whereas the latter suggests that if the analysis shows increase in revenue, such a production should readily be accepted.
• The aim of the business should be to minimise the former, whereas the aim of the business should be maximise the latter.

Thus, from the differences given above we can understand that both the concepts have a lot of differences but are equally useful for the organization for the purpose of production planning and ensuring growth and expansion.

Companies can broadly use the incremental cost to analyze whether to produce the new product line in the house or to outsource it and whether to accept a one-off high volume order from the customer or business partner.

This has been a guide to what is Incremental Costs. We explain it with example, formula, differences with marginal cost & incremental revenue & benefits. You can learn more about it from the following articles –

• Examples of Sunk Cost
• Top Industry Examples of Period Cost
• Fixed Cost Calculation
• Period Cost vs Product Cost