Corporate Finance & Accounting

Incremental analysis

What is Incremental Analysis?

Incremental analysis is a decision-making technique used in business to determine the true cost difference between alternatives. Incremental analysis, also known as correlated costing, marginal analysis or variance analysis, does not take into account any sunk or past costs. Incremental analysis is useful for business strategy, including deciding to produce or outsource functions in-house.

Incremental Analysis Explained

Incremental analysis is a problem-solving method that applies accounting information to decision making. Incremental analysis can identify potential outcomes of one alternative compared to another.

Related and unrelated costs

Analytical models include only relevant costs, which are usually divided into variable and fixed costs. Incremental analysis considers opportunity cost — the missed opportunity in choosing an alternative — to ensure that the company pursues the most beneficial option.

Unrelated sunk costs are expenses that have already been incurred. Since sunk costs will remain the same regardless of any decision, these charges are not included in the incremental analysis. Related costs are also called incremental costs because they only occur when the related activity increases or starts.

Types of Incremental Analysis Decisions

Incremental analysis helps companies decide whether to accept special orders. This special order is usually less than its normal selling price. Incremental analysis also helps allocate limited resources across multiple product lines to ensure that scarce assets are used for maximum benefit.

Decisions about whether to produce or buy commodities, scrap projects, or rebuild assets require incremental analysis of opportunity costs. Incremental analysis also provides insight into whether goods should continue to be produced or sold at a certain point in the manufacturing process.

Companies use incremental analysis to decide whether to accept additional business, manufacture or buy products, sell or process products further, retire products or services, and decide how to allocate resources.

Incremental Analysis Example

As an example of incremental analysis, suppose a company sells an item for $300. The company pays $125 in labor, $50 in materials, and $25 in variable indirect selling expenses.

The company also allocates a fixed overhead of $50 per project. The company is not operating at full capacity and does not need to invest in equipment or work overtime to take the special orders it receives. Then, a special order calls for 15 items for $225 each.

key takeaways

  • Incremental analysis helps determine the cost impact of the two alternatives.
  • It is also known as correlated costing, marginal analysis or variance analysis.
  • Unrelated sunk or past costs are not included in the analysis.
  • Incremental analysis also helps allocate limited resources to product lines to ensure that scarce assets are used for maximum benefit.

The sum of all variable and fixed costs per project is $250. However, the allocated fixed overhead of $50 is a sunk cost and has already been used up. The company has excess capacity and only considers related costs. Therefore, the cost of producing a special order is $200 per unit ($125 + $50 + $25) and the profit per unit is $25 ($225 – $200).

While the company will still be able to profit from this special order, the company must consider the consequences of operating at full capacity. If excess capacity does not exist, additional costs to consider include investment in new fixed assets, overtime labor costs, and the opportunity cost of lost sales.

Incremental analysis only focuses on the differences between the two courses of action. These differences—rather than similarities—form the basis of the comparison.

Related Posts

1 of 2,105

Leave A Reply

Your email address will not be published.