A simple way of describing incremental cost is as the additional money a business must spend to produce one additional unit. It is essential for companies to calculate the average cost per unit of production in order to set prices at a level that covers costs and allows for profit.
However, the best pricing policy doesn't cover every possible situation. Firms often need to set special prices for sales promotions or one-time orders. This is where incremental cost comes into play. Incremental cost analysis is a valuable tool for tailoring prices to fit special circumstances.
The Concept of Incremental Cost
Incremental cost is the difference between the total expenditures required to produce a given number of units and the total expenditures a business incurs to produce those units plus one. Suppose a company produces 100 units at a cost of $5,000. Then, it produces 101 units at a total cost of $5,040. The incremental cost of the additional unit is $40. Incremental cost is also referred to as marginal cost.
All of the costs of production are not included to calculate incremental cost. Some of the costs of production are fixed, meaning they do not change when the number of units produced increases or decreases. Examples of fixed costs include rent, insurance and property taxes.
Other costs are variable, such as direct labor and raw materials. Some costs may fall into either category. For instance, if a manufacturing process uses a great deal of energy, then utility cost would be a variable cost. Only variable costs are included when you calculate incremental cost. Fixed costs do not change when additional units are produced, so they should be excluded.
The Value of Calculating Incremental Cost
Incremental cost is commonly computed by manufacturing companies as an aid to short-term decision making. One example is to make a pricing decision for a sales promotion. Incremental cost is also useful for choosing between certain alternatives.
Suppose a firm has the opportunity to secure a special order if it offers a discounted price per unit. Managers must decide whether or not to accept the order. If managers calculate the incremental cost per unit, they might find it is $25 compared to an average cost of $40. The company can discount the special order by up to $15 per unit. However, if management offers a deeper price cut, it won't cover the cost, and the firm will take a loss on the deal.
Alternatively, the company might use incremental cost figures to decide between making the additional units or contracting out the work to another firm and simply purchasing the required units.
Incremental Manufacturing Cost Example
To calculate incremental cost, begin by reviewing the existing production cost records. The information is normally available on a firm's income statement and balance sheet.
Determine the total cost of normal production and then compute what the total cost will be if one or more additional units are produced. Complete the calculation by taking the difference between the two figures and applying the incremental cost per unit formula. The formula is the difference in total cost divided by the number of additional units produced.
Suppose the Deluxe Widget Company has a one-time order for 500 units. Normal production is 5,000 units at a total cost of $500,000. Analysis of the cost data shows that adding another 500 units will increase total cost to $530,000. Subtracting the regular production cost leaves $30,000. Divide $30,000 by 500 and you have an incremental cost of $60 per unit. If the price offered by the customer is at least this much, management should accept the order. If the offer is less, the company would take a loss.
Based in Atlanta, Georgia, William Adkins has been writing professionally since 2008. He writes about small business, finance and economics issues for publishers like Chron Small Business and Bizfluent.com. Adkins holds master's degrees in history of business and labor and in sociology from Georgia State University. He became a member of the Society of Professional Journalists in 2009.