When owners and managers assess whether or not to take a particular action, they need a way of evaluating the impact of that action on the company. Some companies use incremental earnings, as a forecast of incremental earnings tells managers how a particular project or decision will impact the company's profits.
Incremental earnings are the starting place for the analysis of any revenue-producing project, because they quantify a project’s impact on earnings. Incremental earnings are the amounts by which a company expects its earnings to change as a consequence of an investment decision -- for example, the purchase of a business line or asset or the launching of a project. Incremental earnings equal the sum of incremental revenues minus incremental costs and depreciation. After-tax incremental earnings equal incremental earnings multiplied by the sum of one minus the company's tax rate.
Companies must capitalize large costs -- in other words, convert these large expenses into an asset -- and depreciate them over time. As the asset depreciates, the depreciation expense appears on the income statement and accumulated depreciation increases on the balance sheet. Companies do not use the upfront capital expenditures in the calculation of incremental earnings. Instead they use the yearly depreciation expense associated with those capitalized expenses.
Incremental revenues are the additional amounts of sales revenue a company expects to generate from its investment decision. It includes the actual revenue produced by the sale of a particular product or service or by the sale of goods produced by a new piece of machinery. The incremental revenue is determined by multiplying the additional products or services sold by their price, which often rises over time after the initial market introduction.
Incremental costs are the additional costs a company incurs as a result of its investment decision. It includes any additional direct production costs, material costs, personnel expenses, marketing and selling expenses. Incremental costs also include rent and utilities paid for a new location or the portion of rent and utilities attributed to the investment decision if the company moves into a larger space. Incremental costs often also include opportunity costs. For example, if a company introduces a new product that will cannibalize sales of an existing product, the company must quantify those expected lost revenues and include them as an incremental cost for the project.
In addition to calculating incremental earnings overall, companies can break down earnings, or earnings components, into a per-product or per-service calculation. More often, this method is used for marginal earnings calculations but, if minimal development costs are involved, then incremental earnings approximate marginal earnings. In addition, companies must factor in the tax consequences. A project with negative incremental earnings in its first year may have a less negative impact on earnings because of the associated reduction of its tax burden.