Incremental Cost

Incremental cost, sometimes called differential cost, is the additional cost a business incurs because of a specific decision, compared with the cost it would incur if it did not make that decision. It might be the extra cost of producing another batch of goods, accepting a one-off order, opening a new branch, or extending opening hours. Costs that stay the same whichever choice is made are not incremental and can be ignored for that decision. Textbooks on decision-making often prefer the term differential cost.

Incremental cost is a core idea in managerial accounting and decision-making. It is closely related to marginal cost, the economist's term for the cost of producing one more unit, but incremental cost is broader, since it can refer to any change in activity, from a single unit to a whole new product line. It is set against incremental revenue to decide whether a course of action will add to profit.

The calculation compares total costs under two alternatives:

Here $\text{Total cost with the decision}$ is the expected cost if the business goes ahead, and $\text{Total cost without the decision}$ is the expected cost if it does not. In most cases, the incremental cost consists mainly of variable costs, such as materials, direct labor and sales commissions, but it can include fixed costs if the decision changes them, for example by requiring an extra machine, a new supervisor or additional warehouse space.

A furniture maker produces 10,000 chairs a year and has capacity for 13,000. Its normal selling price is $90, and its full cost per chair is $70, made up of $45 of variable cost and $25 of allocated fixed overhead. A hotel chain offers to buy 2,000 chairs at $60 each, provided the chairs carry its logo, which will cost an extra $3 per chair and a one-time set-up cost of $8,000.

• Incremental revenue is 2,000 times $60, which equals $120,000.
• Incremental costs are 2,000 times $45 of variable cost, 2,000 times $3 for the logo, and the $8,000 set-up, a total of $104,000.
• Fixed overhead of $25 per chair is not incremental, since it will be incurred whether or not the order is accepted.
• The order adds $120,000 minus $104,000, or $16,000, to profit.

If the company had used its full cost of $70 per chair, it would have wrongly concluded that a $60 price loses money. The example also assumes the special order will not cause regular customers to demand lower prices, and that capacity is available; if the factory were full, the lost contribution margin on displaced regular sales would be an extra incremental cost, effectively an opportunity cost.

Incremental costs are relevant costs: future costs that differ between alternatives. Two kinds of cost are not relevant. Sunk costs, such as money already spent on research or equipment, cannot be changed by the decision and should be ignored, however painful that may feel. Allocated costs that do not change in total, such as a share of head-office rent, are also not incremental, even though they may appear in product cost reports. Including them can make good opportunities look unprofitable.

Incremental cost analysis is used in many decisions, including whether to make a component in-house or buy it, whether to drop a product line, how to price special orders, whether to process a product further and whether to expand capacity. It is also used outside manufacturing, for example by airlines deciding whether to add a flight, where the incremental cost of one more passenger on a flight that is already scheduled is very small.

The approach has limits. Short-term incremental thinking can lead a company to price too much of its business below full cost, leaving it unable to cover fixed costs in the long run. Qualitative factors, such as quality, supplier reliability, effects on staff and customer relationships, may also outweigh the numbers. Finally, the analysis is only as good as the cost estimates and the understanding of cost behavior behind them, so managers often combine it with cost-benefit analysis and sensitivity testing.