Incremental AnalysisA useful tool when deciding on two or more courses of action

The primary purpose of starting and operating a business is to earn profits.

Eventually, you will want to earn more from your business.

This can be primarily done in two ways: increase revenue, or reduce costs.

Oh, there’s an even better third option: increase revenue AND reduce costs.

All these courses of action will most likely lead to an increase in the net profit that a business can earn.

As you continue to operate your business, you will eventually experience a situation where you have to choose between two or more courses of action.

For example, you might have to choose between creating a new department to do a particular function or outsourcing it to an external party.

Trusting in your gut feeling when making such decisions just won’t cut it anymore.

I mean, choosing the “wrong” course of action might result in you losing money rather than earning them. And so, for such a situation, incremental analysis can come in handy.

Incremental analysis is one of the tools that a business can use for decision-making.

With it, a business may determine the true cost difference between alternatives.

It can answer the question “which course of action can earn or save more money?”.

Knowing how to perform an incremental analysis during major business decisions is very favorable for the business.

So how does one perform an incremental analysis?

That’s what we’ll find out in this article.

We’ll learn the basics of incremental analysis as well as how to perform it.

We’ll also learn how it can be helpful to your business.

An example will be provided for an easier understanding of the topic.

By the end of the article, you should have a deeper understanding of what incremental is and what benefits it can provide to your business.

What is Incremental Analysis?

Incremental analysis is a decision-making tool that businesses use to assess financial information concerning two or more alternatives.

From such an analysis, the business can make a decision that benefits it the most.

We can also refer to incremental analysis as the relevant cost approach, marginal analysis, or differential analysis.

Businesses often use incremental analysis when comparing multiple courses of action.

With incremental analysis, a business can determine which is the most cost-effective choice between two or more options.

Incremental analysis can also determine the differences in revenue, cost, and profit between two or more alternatives.

That said, incremental analysis can also be useful for stand-alone business decisions.

Incremental analysis only accounts for relevant costs.

It does not account for sunk costs or any cost previous costs already incurred that are associated with a product, employee, or project.

For example, it does not account for the cost of equipment that the business already owns.

Since sunk costs will remain no matter what course of action the business goes with, they are typically excluded in incremental analysis.

Some of the relevant costs that incremental analysis may account for are the following:

Variable costs

This refers to costs that increase or decrease depending on the change in the level of activity.

This also refers to costs that might change from option to option.

Non-variable costs

This refers to costs that will remain the same across all options.

They are different from sunk costs as they will be incurred if the business goes with any of the options.

Opportunity costs

This refers to the costs of choosing one option over the other.

For example, let’s say that you have $100 in your pocket.

You have the option to invest the money in bonds or use them to purchase lottery tickets.

If you choose to invest the money in bonds, you lose the opportunity to potentially earn a huge amount of money if you were to purchase the lottery tickets.

If you choose to purchase the lottery tickets, then you lose the opportunity to earn the fixed income that the bonds offer.

How to Use Incremental Analysis

Using incremental analysis is pretty easy if you already have the data available.

You only have to perform simple calculations such as addition and subtractions.

Determining the data that you need is the hard part of performing an incremental analysis.

They change depending on what you’re comparing.

Here are the steps that will help you in determining what information you’ll need to complete an incremental analysis:

Determine the relevant costs

Start first by determining what your options are.

After determining what your options are, the next step is to identify the relevant costs between them.

Make sure to identify which costs are variable and which ones are non-variable.

Also, remember to not include any sunk costs when performing incremental analysis.

Only include the cost that the business may incur if it goes with any of the options.

For example, let’s say that your business currently sells an item for $250.

The total cost per unit allocated to the production of such an item is currently $200 which comprises $150 variable costs, and $50 fixed costs.

The $50 fixed costs are sunk costs since the business will incur them whether it produces more units of the item or not.

As such, we will not include them in the incremental analysis.

We will only include the $150 variable cost.

Determine if there are any opportunity costs.

The next step is to determine if there are any opportunity costs.

And if there are, identify what they are and how much they may amount to.

Let’s continue with our example above. Your business currently sells an item for $250.

A client of yours wants to make a special order: 500 units of such item for $175 each.

Historically, your business’s production capacity always exceeds your sales in units, in the range of 400 to 800 units per year.

Now since we already identified the relevant costs of producing more units ($150 per unit), we determine that accepting the special order will net your business $25 profit per unit.

However, accepting it will also mean that you’re letting go of earning more by selling the item at its normal price of $250.

Here, the opportunity cost of not accepting the special order amounts to a secure $25/unit or $12,500 profit.

However, the opportunity cost of accepting the order amounts to $75/unit or $37,500 revenue if you can sell the 500 units of the item at the normal price.

Add the relevant costs together

After determining the variable and non-variable relevant costs as well as the opportunity costs, the next step is to add them together.

Do mind though that you’ll only have to add the opportunity costs if it’s applicable.

If they don’t impact the decisions that much, you don’t have to add the opportunity costs. Do this step for every option.

For our example, we already added up the relevant costs together which amount to $150 for every unit of the item produced.

Compare the options

After adding up all the relevant costs for each option, the next step is to compare them.

If the options include the action to sell, you will also have to compute the potential revenue and profits that each option will generate.

For our example, the options are to accept the special order or not accept the special order and instead sell them at their normal price.

The relevant cost for both options remains the same, so rather than comparing the costs, let’s compare the potential revenue from each option.

Accepting the special order means that your business will be generating a secure $87,500 revenue.

However, if you don’t accept the offer and sell the items at their normal price, your business can potentially generate $125,000 revenue, which is a difference of $37,500 from the other options.

Seems like it’s the better choice right?

However, you must remember that historically, your business’s production capacity always exceeds its sales in units (400 to 800 units per year).

This means that $125,000 in revenue is not secured.

Given these facts, which option should you go with?

Make a Decision

The final step in an incremental analysis is to make a decision.

Use the information that you’ve gathered from the analysis and make a decision based on it.

From our example, given that your business historically has a production surplus of 400 to 800 per year, it would be wiser to accept the special order of 500 units at a special price.

This is because a secure $87,500 revenue is better than a speculative $125,000.

Besides, you’d only gain $37,500 more if you can sell the items at the normal price.

That’s $50,000 less than the secure $87,500 revenue.