What is Incremental Cost?

What is Incremental Cost?

Incremental cost is the total cost incurred due to an additional unit of product being produced. Incremental cost is calculated by analyzing the additional expenses involved in the production process, such as raw materials, for one additional unit of production. Understanding incremental costs can help companies boost production efficiency and profitability.

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.

How is Incremental Cost or Marginal Cost Used?

Incremental Cost is otherwise called a marginal cost, it is an important cost that helps businesses decide between the production of two products. It is also helpful in making decisions as to whether producing a good is cheaper than buying it elsewhere and vice versa.

The incremental cost is also useful in the analysis of the profitability of business segments. Incremental cost analysis does not include fixed costs, rather, it is the cost associated with the production of an additional unit of product. Here are some things to know about Incremental cost;

  • The incremental cost is the amount of money or cost a company will incur when an additional unit of product is produced.
  • Incremental cost analysis is important in managerial accounting.
  • This cost helps in determining how profitable the segments of a business are.
  • When Incremental costs exceed Incremental revenue, a company will be in loss.

Uses of Incremental Cost Computations

Incremental cost is used for analyzing the following decisions:

  1. Deciding to change the price of a product
  2. Allocation of available resources for optimal utilization
  3. Deciding to introduce a new production line in-house or outsource it
  4. Accepting or rejecting a one-off high-volume order
  5. Accepting or rejecting a one-time selling price for additional units
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The calculation of incremental cost needs to be automated at every level of production to make decision-making more efficient. There is a need to prepare a spreadsheet that tracks costs and production output. As output rises, cost per unit decreases, and profitability increases.

Benefits of Incremental Cost Analysis

  • Analyzing and understanding incremental cost enable companies to improve production efficiency.
  • Understanding incremental cost assists in decisions to manufacture a product or simply buy it from other suppliers.
  • It also helps in maximizing production output and increasing profitability.
  • Knowing the incremental cost helps in determining the price of a product.
  • Incremental cost analysis considers only relevant costs directly linked to a business unit when evaluating the profitability of that business unit.
  • Incremental cost analysis, together with the analysis of production volumes, helps companies attain economies of scale by optimizing production. Economies of scale occur when the average cost per unit declines as production increases.
  • Fixed costs remain unchanged when incremental cost is introduced, which entails that equipment costs do not vary with production volume.
  • Incremental cost analysis is used in choosing between alternatives, such as accepting or rejecting a one-off high-volume special order.
  • Incremental cost analysis is used in short-term decision-making.

Example of Incremental Cost

Picture a busy factory that is producing machinery parts. For purposes of the example, it takes an employee an hour to make one large part. Production costs for one part would include the employee’s rate of pay (calculated hourly) plus the cost of all the materials used to produce a part or unit. To be more precise, you would also include other costs, such as utilities consumed if the factory was required to remain open for one extra hour and the cost of shipping the unit to the customer.

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Calculate the cost of producing one unit. As mentioned above, this cost includes fixed costs (building lease or mortgage) and variable ones. Production costs like labor, setting up the machines in the factory, raw materials and utilities would be placed in the variable expense category. Assume the cost of producing one unit is $100.00.

Next, work out the cost of producing two units. Production costs for two units produced at the same time may run lower than if you decided to make them separately, since you may be able to use raw materials more efficiently and save on shipping costs. You also wouldn’t have the expenses associated with setting with the machinery a second time. The cost for producing two items simultaneously may come in at $180.00.

To determine the incremental cost, calculate the cost difference between producing one unit and the cost of producing two of them. Take the total cost of producing two units ( $180.00) and subtract the cost of producing one unit ($100.00) = $80.00. The sum you are left with is the marginal cost.