May 23, 2021

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Incremental Cost Explanation and Calculation

Incremental Cost Explanation and Calculation

Definition

Every business has costs. Costs are usually defined as the monetary value of goods and services that producers and consumers purchase. There are numerous types of costs that an accounting department calculates and records daily basis or less frequently if these are larger costs or costs that management calculates to make decisions.

Many business owners make a decision based on what cost lower. However, this is not always the best way to go about making decisions. You need to make decisions based on incremental cost. What is it? Incremental really means extra or additional. Thus, the incremental cost can be defined as the change in total cost as a result of a change in the level of output, investment, etc.

Incremental Cost Explanation and Calculation

The concept of incremental costs arises when the company’s management discusses the possibility of changing the provision of services or production of goods and the extra costs that this would lead to. The incremental-cost approach is a management approach focused on examining how costs change based on potential alternatives. What can lead to incremental costs? This can be a purchase of new or additional materials or machinery, a change in the amount of goods manufactured, hiring of extra labor or outsourcing of some processes.

The incremental cost is sometimes confused with marginal cost. However, these two terms have slightly different meanings. Marginal cost is the total cost of making an extra unit of product or service. Incremental cost, as was just explained, deals with the total additional financial cost that a company will incur if it decides to expand its services or product output or add a new product to the line, etc. In other words, the company evaluates the difference between two possible alternatives.

Incremental Cost Explanation and Calculation

Importance

The incremental cost is used in the incremental analysis, where a manager, business owner, or investor determines the worth of a decision on the basis of whether the incremental revenue is greater than the incremental cost. Incremental revenue here can be defined as the change in total revenue resulting from a change in the level of output, prices, etc.

A decision will bring profit if it:

  • increases the revenue more than it increases the cost
  • decreases costs more than it decreases revenue
  • increases some resources more than it decreases others
  • reduces some costs more than it increases others.

Example

For example, when you are comparing insurance companies. One company will cost you $300 a month and the other $250 a month. The difference is $50, so the insurance costs you should be looking at are $50 because you would need to pay at least $250 anyways. Are you going to get more with that $50?

Let’s look at another case. ABC Toys Inc. manufactured 100 units of toys. Variable costs are $50 and fixed costs add up to $4,600. The total cost for making these 100 toys would be $50 x 100 + $4,600 or $9,600. The same company decides to make 120 units of toys. The total cost, in such case, adds up to $50 x 120 + $4,600 or $10,600. The additional or incremental cost is $1,000.

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Author: Charles Lutwidge

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