What Is Incremental Analysis?

What Is Incremental Analysis?

Let me explain incremental analysis to you—it's a decision-making tool I use in business to identify the most profitable choice among different opportunities. You might hear it called marginal analysis, the relevant cost approach, or differential analysis. The key here is that it ignores sunk costs, which are past expenses, and instead focuses on ongoing costs and opportunity costs.

This method is particularly useful when you're figuring out business strategies, like whether to produce something in-house or outsource it.

Understanding Incremental Analysis

Incremental analysis is a problem-solving method that uses accounting information, especially costs, for strategic decision-making. When you apply it, you can identify the potential financial outcomes of one business action compared to another. This lets you make better-informed decisions that impact profitability.

Relevant Versus Non-Relevant Costs

Relevant costs, or incremental costs, are those you incur only when you start or increase a particular activity. Non-relevant sunk costs are expenses you've already paid, and since they're there no matter what decision you make, you shouldn't include them in incremental analysis.

Your incremental analysis models will only consider relevant costs, which are usually broken into variable and fixed costs. It also accounts for opportunity costs—the financial effects of missing out on one option when you choose another—so you pursue the best possible choice.

Uses for Incremental Analysis

You can use incremental analysis to decide whether to accept a special order, which is often priced below the normal selling price. It also helps allocate limited resources across product lines to get the most benefit from scarce assets.

Decisions like whether to produce or buy goods, scrap a project, or rebuild an asset all involve incremental analysis of opportunity costs. Additionally, it provides insight into whether to continue producing or sell a good at a certain manufacturing stage.

Important Note

Companies rely on incremental analysis for choices like accepting additional business, making or buying products, selling or processing further, eliminating a product or service, and allocating resources.

Example of Incremental Analysis

Take the Acme company, which sells an item for $300. They pay $125 for labor, $50 for materials, and $25 for variable overhead selling expenses, plus they allocate $50 per item for fixed overhead costs.

The company isn't at full capacity and won't need new equipment or overtime for a special order. A special order comes in for 15 items at $225 each. The total variable and fixed costs per item sum to $250, but the $50 fixed overhead is a sunk cost already spent.

With excess capacity, you only consider relevant costs, so the cost per item for the special order is $200 ($125 + $50 + $25), giving a profit of $25 per item ($225 - $200).

However, if there's no excess capacity, you must factor in costs like new fixed assets, overtime, and opportunity costs from lost sales.

Fast Fact

Incremental analysis only looks at the differences between courses of action—these differences, not the similarities, are what you base your comparison on.

What Is the Benefit of Incremental Analysis?

The main benefit is that it helps you make the best use of available resources and keeps your focus on profitability through cost examination.

What Costs Does Incremental Analysis Involve?

It examines relevant costs and opportunity costs, while noting sunk or non-relevant costs but excluding them from the analysis.

What's a Limitation of Incremental Analysis?

One limitation you need to watch for is the potential for wrong cost assumptions. You must make every effort to get accurate cost estimates so your chosen opportunity doesn't harm the company.

The Bottom Line

Incremental analysis is a crucial tool for understanding costs, using resources efficiently, and maximizing profit. By focusing on true costs including opportunities and stripping away irrelevant data, it reveals the most cost-effective options quickly to help you reach financial goals.