Incremental Analysis: Definition, Types, Importance, and Example

What Is Incremental Analysis?

Incremental analysis is a decision-making tool used in business to determine the true cost difference between alternative business opportunities.

Also called marginal analysis, the relevant cost approach, or differential analysis, incremental analysis disregards any sunk cost (past cost).

Incremental analysis is useful when a company works on its business strategies, including the decision to self-produce or outsource a process, job, or function.

Understanding Incremental Analysis

Incremental analysis is a problem-solving method that applies accounting information—with a focus on costs—to strategic decision-making.

The use of incremental analysis can help businesses identify the potential financial outcomes of one business action or opportunity compared to another. With that information, management can make better-informed decisions that can affect profitability.

Relevant Versus Non-Relevant Costs

Relevant costs (also called incremental costs) are incurred only when a particular activity has been initiated or increased.

Non-relevant, sunk costs are expenses that already have been incurred. Because the sunk costs are present regardless of any opportunity or related decision, they are not included in incremental analysis.

Incremental analysis models include only relevant costs, and typically these costs are broken into variable costs and fixed costs.

Incremental analysis also considers opportunity costs—the financial implications of a missed opportunity when choosing one alternative over another—to ensure that a company is aware of and can pursue its most favorable option.

Uses for Incremental Analysis

• Incremental analysis helps companies decide whether or not to accept a special order. A special order product is typically priced lower than the item's normal selling price.
• Incremental analysis also assists with allocating limited resources to several product lines to ensure that a scarce asset is used to maximum benefit.
• Decisions on whether to produce or buy goods, scrap a project, or rebuild an asset call for incremental analysis of the opportunity costs.
• Incremental analysis also provides insight into whether a good should continue to be produced or sold at a certain point in the manufacturing process.

Example of Incremental Analysis

The Acme company sells a particular item for $300. The company pays $125 for labor, $50 for materials, and $25 for variable overhead selling expenses. The company also allocates $50 per item for fixed overhead costs.

The company is not operating at capacity and will not be required to invest in equipment or overtime to accept any special order that it may receive. Then, a special order arrives requesting the purchase of 15 items at $225 each.

The sum of all variable costs and fixed costs per item is $250. However, the $50 of allocated fixed overhead costs are a sunk cost and are already spent. The company has excess capacity and should only consider the relevant costs. Therefore, the cost to produce the special order is $200 per item ($125 + $50 + $25). The profit per item would be $25 ($225 - $200).

While the company is able to make a profit on this special order, the company must consider the ramifications of operating at full capacity.

If no excess capacity is present, additional expenses to consider include investment in new fixed assets, overtime labor costs, and the opportunity cost of lost sales.

The Bottom Line

Incremental analysis is a crucial decision-making tool that can help businesses better understand their costs, utilize resources efficiently, and maximize profit.

Its focus on true costs, including opportunity costs, and its stripping away of irrelevant information, can reveal in a less effort-intensive amount of time the most cost-effective options for companies to choose from to reach important financial goals.