Lisa Borga
Last Updated: May 11, 2022
Date Published: May 11, 2022

Incremental analysis, also known as the relevant cost approach, differential analysis, and marginal analysis, is a tool for deciding between two or more courses of action.

This decision-making method analyzes the cost differences presented between different possible courses of action while disregarding past and sunk costs.

This allows for an accurate and unbiased analysis of the potential revenue and costs offered by different possible choices.

The ability to calculate incremental analysis is a valuable skill for managers and accountants in order to help identify courses of action which offer the greatest potential benefits.

## Understanding Incremental Analysis

Incremental analysis is a tool to assist decision-makers in choosing the best possible outcome by identifying and comparing the costs associated with each option available.

This incorporates all of the relevant costs and opportunity costs associated with the available options and requires significant accounting and financial information in order to make an informed analysis of the alternatives.

This tool offers a tool for considering the possible courses of action based solely on their unique costs allowing decision-makers to choose the option that offers the lowest possible costs to benefits.

## How to Perform Incremental Analysis

Once suitable accounting and financial data is available, performing incremental analysis requires only basic arithmetic calculations.

However, identifying the appropriate figures for comparison can be more or less challenging.

Here are the necessary steps to identify information and perform incremental analysis.

### Identify the Relevant Costs

The first step in performing incremental analysis is to identify each available option and its relevant costs.

Eliminate all irrelevant costs such as sunk costs and include only the costs that are directly related to the decision to be made.

### Consider Opportunity Costs

Identify any opportunity costs associated with each decision.

These include the potential revenues that may be generated by choosing to pursue a particular course of action.

Take all of the costs associated with each alternative and add them together individually.

This will arrive at an incremental cost for each option.

### Compare Results

Now that there is a result for each option, it is time to analyze the findings.

This could be simply comparing multiple results to identify the one offering the best financial outcome or comparing it against a set figure or cost.

### Arrive at a Decision

Now that the results are available, they should allow the decision-maker to identify the option that offers the most optimal financial outcome.

Based on this information, it is time to make a decision.

## Identifying Relevant and Irrelevant Costs

When using incremental analysis, it is crucial to only consider relevant costs, which are the costs that are different and will be incurred among each distinct option.

Costs that remain the same between each option are irrelevant to this calculation.

Opportunity costs, which are the costs incurred by not pursuing an opportunity, are relevant to this equation.

A common type of opportunity cost for businesses is the potential revenue that is lost by not pursuing a particular business opportunity.

It is crucial to avoid including past or sunk costs in this analysis as these costs have already been incurred and cannot be affected by current decisions.

These should not be considered.

## Potential Uses of Incremental Analysis

Businesses can use incremental analysis to help them determine whether they should accept any special orders they receive.

Special orders generally offer a company a price that is lower than the company’s typical sales price.

Incremental analysis is also useful for a business that needs to decide how to allocate scarce resources among a number of product lines in the most efficient manner.

Additionally, a company could do an incremental analysis of opportunity costs to help it decide whether or not it wants to rebuild an asset, buy or produce needed goods, or end a project.

Incremental analysis can also supply management with useful information when they are trying to decide whether or not to sell a good at its current stage in the production process or to process it further before selling it.

There are many uses for incremental analysis, including whether to continue selling a specific product or service, to buy or produce a needed good, to process a product further before selling it, or even how to allocate scarce resources.

## Incremental Analysis Example

For an example, suppose a business sells one of its products for \$550.

The business needs to pay labor costs of \$240, material costs of \$100, and variable overhead expenses of \$50.

The business has received an offer to special order 20 of these products at a price of \$500 a piece.

This order would not necessitate the purchase of any additional equipment.

Nor would the order require any overtime for employees because the company is not operating at capacity.

The variable costs necessary to produce one item are \$390.

The fixed costs of \$70 have already been spent and are thus a sunk cost.

Since the company has some excess capacity available, it only ends up taking into account the applicable costs, which are the variable costs.

This is the \$240 in labor costs, the \$100 in materials costs, and \$50 in variable overhead costs, which amounts to a cost of \$390 per item ( \$240 + \$100 + \$50).

The business can make a profit, so it should choose to accept this special order.

However, they should consider the effect that operating at full capacity may have.

If the business should end up running short of capacity, it may need to buy new fixed assets.

The business also risks having to pay overtime if its orders increase more than expected.

Or, if the business chooses to decline orders rather than increasing capacity or paying overtime, it could lose sales.

## Pros and Cons of Incremental Analysis

There are several distinct advantages and disadvantages that should be considered when using incremental analysis to arrive at a decision.

### Pros

• Optimizes Resource Allocation: Incremental analysis can help to identify relevant costs associated with decisions. This can help to ensure that scarce resources are allocated optimally.
• Helps Utilize Excess Capacity: Incremental analysis can help manage excess capacity that generally remains unused. By identifying only the unique costs of pursuing a particular course of action, a company can determine whether or not an opportunity to use excess capacity would be beneficial.
• Improves Profit Margins: Incremental analysis can improve profit margins by ensuring that when multiple profitable options are available, a company chooses the one that offers the higher margin.

### Cons

• Only Considers Costs: Incremental analysis only considers costs without taking other factors into account. This means that factors such as quality may suffer, which could lead to damage to reputation and client relationships.
• Relies on Accurate Assumptions: The ability for incremental analysis to offer an accurate picture of costs and assist in decision-making relies completely on the accuracy of the financial assumptions and accounting data used to make them. Because of the difficulty in creating accurate forecasts of future costs and revenues, this can result in inaccurate information for decision-makers.

## Key Takeaways

• Incremental analysis is a tool to assist decision makers in assessing relevant costs between two or more alternative courses of action.
• Incremental analysis uses accounting and financial information to project the outcomes of different courses of action to assist in decision-making.
• Incremental analysis does not include past costs or sunk costs that are already spent and are unlikely to affect future spending.

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1. Pacific Lutheran University "Incremental Analysis" Page 1 . May 11, 2022

2. Lone Star College Montgomery "Cost Analysis and Decision Making" Page 1 . May 11, 2022

3. ACL Anthology "An Experiment On Incremental Analysis Using Robust Parsing Techniques" White paper. May 11, 2022