When you hear the word "accounting" and automatically think about taxes, the Internal Revenue Service and company audits, you are considering only one type of accounting: financial accounting. While financial accounting focuses on providing information to other agencies, such as the IRS, managerial accounting provides information to leaders in a business to help them make sound decisions. A key tool in managerial accounting is incremental analysis.
Incremental analysis, also known as marginal or differential analysis, assesses the revenue and costs of each of the alternatives involved in a business decision. It also highlights the likely effects of a decision to a business's bottom line. This tool is useful for managers who need a summary of the main benefits, disadvantages and consequences of their options before they make a final decision.
Incremental analysis is a decision-making tool. Its usefulness lies on how it summarizes the benefits and disadvantages of a choice in contrast with other alternatives. The analysis ignores equivalent costs and benefits between options and focuses on their differences, which is why it is also called differential analysis. For example, a company using incremental analysis to decide which car to buy among three with similar prices would ignore the cost of the car and analyze the features that set the cars apart, such as maintenance costs and fuel efficiency.
Businesses use incremental analysis as part of their managerial accounting to help them make a wide variety of financial decisions. For example, when deciding whether to accept an order at a special price, to buy individual components or to opt for a finished product. Such analysis can help determine whether to keep or replace equipment and whether to eliminate, or not, an unprofitable sector of a business. You also can use incremental analysis to help you make decisions related to your personal finances.
Companies that use incremental analysis to make decisions may choose options that at first seem counterintuitive. For example, a packaging company may receive a request from a major company for a $1 million contract if it reduces the unit price of packages by 30 percent. The managers request a financial analysis of the offer and find that on the basis of total cost per unit, they would be losing money on each unit but that the order can be supplied in the current plant production capacity and that the fixed costs would not increase. If the managers base their decision entirely on product cost analysis, they will reject the offer. However, if they base their decision on incremental analysis and there is no effect on the sales volume of packages sold at the regular price, they may accept the offer because the net profit of the company would rise even though the individual cost to price ratio is not positive.