Incremental analysis definition
/What is Incremental Analysis?
Incremental analysis involves the examination of alternative choices, based on the cost differences between them. This analysis is solely concerned with the costs that will change if one alternative is selected over another. Any costs that do not change if either alternative is selected are ignored for the purpose of deciding which alternative to pursue. For example, costs that have already been incurred (known as sunk costs) are ignored. Also, if any type of cost will be incurred for both alternatives, then it also can be ignored. The result tends to be an extremely focused analysis.
How to Use Incremental Analysis
Incremental costing is frequently used for the following types of analyses:
Make or buy decisions. Companies use incremental analysis to decide whether to manufacture a product in-house or outsource production. The analysis compares costs such as materials, labor, and overhead with the price of purchasing from an external supplier. If outsourcing is cheaper while maintaining quality, the company may choose to buy instead of make.
Accepting or rejecting a special order. When a company receives a one-time special order at a lower price than usual, incremental analysis helps determine whether to accept it. The company considers additional revenues, variable costs, and any extra expenses required to fulfill the order. If the incremental revenue exceeds the incremental costs, accepting the order may be profitable.
Adding or eliminating a product line. Businesses use incremental analysis to decide whether to discontinue a product or service. The analysis compares the lost revenue from discontinuation against the cost savings from eliminating production expenses. If eliminating the product increases overall profitability, the company may choose to drop it.
Replacing equipment. Companies must decide whether to continue using old equipment or invest in new machinery. Incremental analysis compares the cost of purchasing and maintaining new equipment against the ongoing expenses and inefficiencies of the old equipment. If the savings from increased efficiency outweigh the investment, replacing the equipment is the better option.
Optimizing resource use. When resources are limited, incremental analysis helps businesses decide how to allocate them most efficiently. For example, a manufacturer with limited production capacity must choose which product to prioritize based on incremental profit per unit. The goal is to maximize overall profitability by focusing on the most profitable product.
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Key Concepts in Incremental Analysis
The key concepts to be aware of when conducting an incremental analysis are relevant costs and sunk costs. Relevant costs only relate to a specific management decision, which will change in the future as a result of that decision. The relevant cost concept is extremely useful for eliminating extraneous information from a particular decision-making process, and should be the main focus of an incremental analysis. Conversely, sunk costs have already been incurred and can no longer be recovered. They should not be considered when conducting an incremental analysis. Consequently, a key step in the analysis process is deciding whether a cost is relevant or sunk.
Example of Incremental Analysis
A company receives an order from a customer for 1,000 units of a green widget for $12.00 each. The company controller looks up the standard cost for a green widget and finds that it costs the company $14.00. Of this $14.00, $11.00 is variable cost and $3.00 is fixed cost. Since the fixed cost is being incurred irrespective of the proposed sale, it is classified as a sunk cost and ignored. This means that the incremental cost of the widget is $11.00. The company should accept the order, since it will earn $1.00 per unit sold, or $1,000 in total.
Terms Similar to Incremental Analysis
Incremental analysis is also known as differential analysis or marginal analysis.