Incremental cost definition

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What is Incremental Cost?

Incremental cost is the extra cost associated with manufacturing one additional unit of production. It can be useful when formulating the price to charge a customer as part of a one-time deal to sell additional units. The concept can also be applied to cost reduction analysis, to enhance company profits. An incremental cost analysis only reviews those costs that will change as the result of a decision. All other costs are considered irrelevant to the decision.

When to Use Incremental Cost Analysis

It can be of interest to determine the incremental change in cost in a number of situations. For example, the incremental cost of an employee’s termination includes the cost of additional benefits given to the person as a result of the termination, such as the cost of career counseling. Or, the incremental cost of shutting down a production line includes the costs to lay off employees, sell unnecessary equipment, and convert the facility to some other use. As a third example, the sale of a subsidiary includes the legal costs of the sale.

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Examples of Incremental Cost Analysis

There are several situations in which incremental cost analysis can be used to determine the best outcome. Here are several examples:

  • Overtime analysis. If a company consistently asks its employees to work a total of 200 hours of overtime per week, it should compare the incremental cost of these hours, with overtime costs and related payroll taxes included, in relation to the incremental cost of hiring five more employees, along with their benefits and payroll taxes. Bringing in the new hires would eliminate the overtime being worked. In this case, management could also consider several variations, such as the incremental cost of reducing just 40 hours of overtime versus hiring one more person who can take on these hours at normal pay rates, and so on.

  • Pricing analysis. If a company has room for 10 additional units in its production schedule and the variable cost of those units (that is, their incremental cost) is a total of $100, then any price charged that exceeds $100 will generate a profit for the company.

  • Make or buy decision. A manufacturing company is deciding whether to produce a component in-house or purchase it from an external supplier. Incremental cost analysis helps compare the additional costs of producing the component internally (labor, materials, overhead) against the purchase price from the supplier. The company can then select the option with the lower incremental cost to optimize profitability.

  • Expanding production capacity. Management is considering expanding the factory to meet higher demand. Incremental cost analysis examines whether the added costs of the expansion (new equipment, increased labor, additional materials) will be covered by the incremental profits generated from selling more products. This helps determine if the expansion will result in a positive return.

  • Discontinuing a product or business segment. A company is evaluating whether to discontinue an underperforming product. Incremental cost analysis helps identify if dropping the product will actually reduce overall costs more than it reduces revenue. If the incremental savings from avoiding production, marketing, and distribution exceed the lost revenue, discontinuing the product may improve profitability.

Terms Similar to Incremental Cost

Incremental cost is also known as marginal cost.