What is Incremental Analysis?
Incremental Analysis is referred to the financial analysis undertaken by the company to evaluate the available options, with the objective of improving the profitability by optimizing the capacity utilization and workforce of the business.
In most cases, companies utilise incremental analysis to choose between bulk orders and new business opportunities. The additional business opportunities are received on account of lower than the normal selling price of the company’s product. As the orders are received in bulk, so the purchaser would claim for a lower rate.
XYZ Ltd. manufactures a particular product (running at ~70% capacity) and sells at a net profit marginNet Profit MarginNet profit margin is the percentage of net income a company derives from its net sales. It indicates the organization's overall profitability after incurring its interest and tax expenses. of 20%. However, XYZ ltd received an order which states the company will be able to make a net profit margin of 10%. However, if the company with its full capacity can supply the product, it may lead to a higher margin than its forecasted ~10%.
This is because the fixed expenses will remain the same, and after a particular unit manufactured, the business will not require any extra expenses. Thus, it might turn into a value proposition, while proper incremental cost analysisIncremental Cost AnalysisIncremental costs are the additional costs associated with the production of one additional unit, and it only considers costs that are likely to change as a result of a specific decision, such as replacing machinery or equipment or adding a new product, and so on. has to be done by the finance manager.
A manufacturing company produces a product at $5.5 per unit and sells at $7.5 per unit. The company received a bulk order where the company would get a bulk order of 5000 pieces if it sells at $7 per unit. The finance manager calculated that it would hit the margin of the company as the company was running at full capacity.
However, if they outsource the entire order except for the packaging part, the company would be able to retain its margin. Thus, the finance manager has to take a call based on incremental analysis, if he would take the call or not?
If the company takes the order and the outsourcing simultaneously, the company will get higher earnings which would ultimately increase the reserves, and the company would be able to expand its capacity based on the market conditions and its order book.
Advantages of Incremental Analysis
- It helps to determine the costing of the business based upon the available resources of the company. The best utilization of available resources and improving profitability metrics are achieved through incremental analysis.
- It helps to utilise the excess capacity, which remains unutilised in case of the normal business process. The fixed cost remaining the same, the business gets benefited from the extra income, which is earned by the company, which aids in improved profitabilityProfitabilityProfitability refers to a company's ability to generate revenue and maximize profit above its expenditure and operational costs. It is measured using specific ratios such as gross profit margin, EBITDA, and net profit margin. It aids investors in analyzing the company's performance..
- In the case of high-value products, decisions arise from incremental analysis helps to add a margin for the business in the long term. Between two options Plan A and Plan B, the company will choose whichever would provide higher profit along with higher margins.
Disadvantages of Incremental Analysis
- The situation of incremental analysis arises when there is an increase in the order book apart from the normal orders. The excess order book, however, comes at a price for the manufacturer. The manufacturer has to take a margin hit, whereas the volume of the business tends to rise.
- In several instances, the business chooses for cheap outsourcing option to retain its client relationship. Thus, the original quality of the product may differ from the actual unit produced by the manufacturing site. Thus, it can hinder the goodwill of the business.
- In case of any wrong assumption, the entire order can backfire the business and its process and hinder the normal business. The finance manager has to be very alert while choosing the apparently best alternatives available to the company.
- An increase in production costs may affect the production process and as well the business negatively. However, in most cases, the company cannot pass the extra cost to the client, which results in lower earnings and lower profit margin for the company.
This has been a guide to What is Incremental Analysis & its Definition. Here we discuss its examples, advantages and disadvantages. You can more learn about from the following articles –