Definition of Incremental Costs
The additional cost incurred by the company due to the production of an additional unit or additional service or in other words, the additional cost incurred by the company as the result of the extra cost of production, replacement of the machinery or equipment, or due to the addition of any new product, etc. is called as incremental costs.
The incremental cost is nothing but the production costs of producing an additional unit by the company. It does not take into account the fixed costs already incurred by the company because generally the fixed costs like rent of the factory, salary of the employees do not get changed due the additional unit produced by the company. Only variable costs of production like raw material, variable labor costs are included for the calculation of incremental cost.
How Does Incremental Costs Work?
- The incremental cost of production only takes into account the variable costs incurred for the production of additional units produced by the company thus ignoring the fixed costs of production already incurred by it.
- The method of calculating the incremental cost is Total cost of production of existing units-Total cost of production of an additional unit= Incremental Cost.
- Firstly, the total cost of production of existing units is calculated. After that, the cost of producing the additional unit is calculated taking into account the raw material cost, and other variable cost. Then we subtract the cost of the additional units from the cost of existing units.
- Then the total cost is compared. Generally, the total costs of the product get increased due to the increase in variable costs. However, when we consider per unit cost of the product, it get reduced due to the improved economies of scale.
Example of Incremental Costs
Let’s consider Company ABC Ltd which is the manufacturing company. It produces product A and the total cost of production of 1,000 units of product A is $5,000. Considering the demand of the market, company decides to produce one more product B in its factory and with this, the total production increased to 2000 units. The company has to incur some additional costs to produce product B in the form of raw material, labor cost, salary, etc. Product B will be produced from the same machinery and equipment from which Product A was produced. The company decides to produce product B and the total cost of production of total2000 units by the company comes to $7,500.So, the incremental cost will be calculated as:
|No. Of units of Product A||1000|
|Cost of Production of Product A||$5,000|
|Total number of units of production||2000|
|Total cost of production by the company||$7,500|
|Total Incremental cost ($7,500 – $5,000)||$2,500|
|Units||Cost||Per unit cost|
From the above example, it can be seen that total incremental cost is $2,500, but when we calculate per unit cost of production, it get reduced from $5 to $3.75.
Factors Influencing Incremental Costs
The Fixed costs and the variable costs are mainly two factors affecting the incremental costs. The fixed costs of the production does not change or increase with the increase in the production volume. Hence per unit fixed costs of the product get reduced. Thus, the profit margin of the product gets improved. Variable cost of production changes with the volume of the production units. The more is the production units, the more is the variable costs of production.
Following are the advantages of Incremental Costs:
- The incremental cost helps the companies in the analysis of the cost of production with the production of the additional units produced by it.
- Such costs analysis helps the company to improve the efficiency of its production units, thus encouraging savings in the costs and improvement in profitability.
- Incremental costs helps the company in its decision making regarding the production of the units like whether it can produce the additional units or it will be feasible for the company to purchase it from outside.
- Also, once the incremental costs are determined by the company, the retail price of the product can also be easily calculated.
- The company can have a clear picture of its profitability statement for the present as well as for future perspectives.
- Generally, per unit of cost of the product get reduced with the production of additional units and by incurring incremental costs, and hence it improves the economies of scale of the company by improving its production volume.
- Incremental Costs also helps the company in comparative analysis between two alternatives available to it. When the other costs of the two alternatives are the same, the company can take the decision considering its incremental costs.
Following are the disadvantages of Incremental Costs:
- The company faces a lot of difficulty in the analysis of the fixed and variable costs of production. Thus, it results in a lot of time wastage in this activity.
- The time factor is ignored while taking into consideration the fixed and the variable cost of production. Sometimes, the cost that is fixed today can be variable in the long run.
- Generally, the fixed cost is ignored in the calculation of the incremental cost. While in reality, the fixed cost occupies the major portion of the total cost of production.
The incremental cost of the company helps the company in the analysis of various decisions like the decisions regarding the production of the new product line in the company, the decisions regarding the acceptance of the offered orders from the customers, decision regarding the price changes of the product or the service, and the decision regarding the allocation of various resources to optimize the utilization of these resources, etc. So, the proper allocation of the incremental costs helps the company in various decision making processes as well as for the proper presentation of its accounts.
This is a guide to Incremental Costs. Here we also discuss the introduction and how does incremental costs work? along with advantages and disadvantages. You may also have a look at the following articles to learn more –