Incremental Cost Definition
Incremental costs are the additional costs that are linked with the production of one extra unit and it takes only those costs into consideration that have the tendency to change with the outcomes of a particular decision while the remaining costs are deemed irrelevant with the same. In simple words it is defined as an additional cost incurred by the company due to the corresponding changes in cost associated with the production, replacing machinery or equipment or adding a new product, etc.
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 labor 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 such costs 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. However, this may not be true in all cases.
It is not necessary that such costs can only be variable in nature. Even fixed costsFixed CostsFixed Cost refers to the cost or expense that is not affected by any decrease or increase in the number of units produced or sold over a short-term horizon. It is the type of cost which is not dependent on the business activity. 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 costAllocate This CostCost Allocation is the procedure of recognizing & assigning costs to different cost objects like a product, department, program, customer, etc., as per the cost driver serving as the base for this process. 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 such 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 favor of the company. Such companies are said to have diseconomies of scaleDiseconomies Of ScaleDiseconomies of scale is a state that generally occurs when an enterprise expands in size. The average operating cost increases due to inefficiency in the system, employee incoordination, administration & management issues, and delayed decisions., 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 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 units at a lower price.
Incremental Costs vs. Margin Costs
Incremental costs are also referred to as marginal costsMarginal CostsMarginal cost formula helps in calculating the value of increase or decrease of the total production cost of the company during the period under consideration if there is a change in output by one extra unit. It is calculated by dividing the change in the costs by the change in quantity., but there are some basic differences 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 the incremental cost is not an optimization tool.
The incremental cost can broadly be used by companies to analyze the following:
- Whether to produce the new product lineProduct LineProduct Line refers to the collection of related products that are marketed under a single brand, which may be the flagship brand for the concerned company. Typically, companies extend their product offerings by adding new variants to the existing products with the expectation that the existing consumers will buy products from the brands that they are already purchasing. 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
This has been a guide to Incremental Costs. Here we discuss its definition, allocation of Incremental costs, and also an example to understand this in a better manner. You can learn more about from the following articles –