Incremental Cost (Definition, Example) | How to Allocate Incremental Cost?

Incremental Cost Definition

Incremental Cost is defined as an additional cost incurred by the company due to the corresponding changes in cost associated with production, replacing machinery or equipment or adding a new product etc. These costs can be direct cost or indirect cost to the production depending on the situation.

Nevertheless, these additional costs cause a change in the balance sheet and income statement of the company and are an important managerial accounting tool used for analysis and management decision-making process.

Example of Incremental Costs

Let’s take an example to understand this better:

Assuming a manufacturing company ABC Ltd. has a production unit where the total cost incurred in making 100 units of a product X is ₹ 2,000. The company wants to add another product ‘Y’ for which it incurs some cost in terms of salary to the additional labour force, raw materials and assuming that there were no machinery, equipment, etc added.

Let’s suppose now after adding the new product line it is able to produce 200 units at ₹ 3500, so here the incremental cost is ₹ 1,500

Identifying the incremental cost is very important for companies as it helps them to decide whether the additional cost is really in their best interest. Like in the above example it is evident that the per unit cost of manufacturing the products has actually decreased from ₹ 20 to ₹ 17.5 by introducing the new product line, although this may not be true in all cases.

It is not necessary that the incremental cost can only be variable in nature, even fixed cost can contribute to the incremental cost for example if there is a requirement of new machinery altogether for adding the new product line ‘Y’.

Allocation of Incremental Costs

The basic method of allocation of incremental cost is to assign a primary user and the additional or incremental user of the total cost.

If we look at our above example, the primary user is product ‘X’ which was already being manufactured at the plant and which had been utilizing the machinery and equipment, the new product only added some extra cost so we can define ‘X’ as the primary user and ‘Y’ as the incremental user.

In the absence of any new product or any additional unit, the total cost that ABC Ltd. incurred while manufacturing only ‘X’ is ₹2,000 so we’ll allocate this cost to X,

While the additional cost of ₹ 1,500 which was incurred only to introduce the new product will be allocated to ‘Y’.

This allocation can even change in the future course of business of ABC Ltd. when supposedly if it chooses to drop product ‘X’ then product ‘Y’ or any other product might become the primary user of the cost.

Incremental costs are also associated with the changes in the pricing of the product. Let’s suppose if by incurring incremental cost the overall cost per unit of a product is also increasing then the company would want to change the price of the product to maintain or increase the profit. This might work in or against the favour of the company. Such companies are said to have diseconomies of scale i.e. they have already reached the maximum limit of production volume.

But if the per unit cost or average cost is decreasing by incurring the incremental cost, the company might be able to reduce the price of the product and enjoy selling more number of units. Such companies are said to have economies of scale, whereby there is some scope available to optimize the utility of production.

Considering that the price of each unit of product ‘X’ is ₹ 25, the profit initially was

Net Profit = ₹ 500

Also considering after introducing the new product line, the price for both ‘X’ and ‘Y’ is kept at ₹ 25, the profit here will be:

Net Profit =(200 X 25) – (200 X 17.5)
Net Profit = ₹ 1500

To increase the sales in order to gain more market share the company can leverage the lower cost per unit of the product to lower the price from ₹ 25 and sell more number of units at a lower price.

Incremental Costs vs Margin Costs

Incremental costs are also referred to as marginal costs but there are some basic differences in between them.

Incremental cost are mostly associated with choices or decisions and therefore include only those additional costs which were caused due to the decision made, like for example it does not consider the cost of machinery or equipment which was already there in the production unit which is also referred to as sunk cost, because these costs will remain regardless of any decision.
Marginal cost on the other hand specifically takes into account the increase in cost for producing one additional unit. It is more often used to optimize production while incremental cost is not an optimization tool.

Conclusion

Incremental cost can broadly be used by companies to analyze the following:

Whether to produce the new product line in the house or to outsource it
Whether to accept a one-off high volume order from the customer or business partner
Whether to allocate the available resources to optimize their utilization
Whether to change the price of a product

Incremental Costs