Incremental CostThe additional costs of producing an extra unit of product

Producing goods to sell incurs costs or expenses.

There is the cost of the materials.

Then there is the cost of labor to transform said materials into sellable products.

Of course, let’s not forget the overhead expenses such as electricity to power up the manufacturing equipment.

And after completely processing the materials, there’s also the cost of packaging.

Assuming that the fixed costs of production remain the same, the average cost of producing a unit of a product should go down.

Think of this. Let’s say the cost of renting a plant is $8,000.

Now if we only produce one unit of a product, then it will absorb the whole cost of renting the plant, making the average fixed cost $8,000 per unit.

If we produce 10 units, then the average fixed cost for each unit becomes $800.

If we produce 100 units, then the average fixed cost will further go down to $80 per unit.

As you can see, average cost of production goes down the more units of the product we produce.

However, when we talk about incremental costs, we disregard any costs that don’t change when the level of activity (e.g. production) changes.

These costs are typically fixed costs (up until the next step cost situation).

Thus, incremental costs only include the additional costs that a business will incur if it increases the level of activity, such as increasing the production level.

In this article, we will be exploring what incremental cost is.

How does one define the term “incremental cost”?

How does one calculate incremental costs?

What effect do incremental costs have on certain business decisions?

We will try to answer these questions and more as we go along with the article.

What is Incremental Cost?

The term “incremental cost” (a.k.a. incremental costs or differential costs) refers to the total additional costs that a business will incur if it increases the level of activity, such as increasing the production level.

In manufacturing, incremental costs refer the additional costs that a manufacturer will incur if it produces an extra unit of product.

The calculation of incremental costs only includes relevant costs – those that change if the business proceeds with increasing the production output.

That means that the costs that will remain whether or not there is an increase in production do not count towards the calculation of incremental costs.

These are typically fixed costs such as the cost of rent, the cost of indirect labor, etc.

These could also include sunk costs such as the cost of machinery that the business already owns.

Typically, incremental costs will include variable costs such as the cost of raw materials, direct labor, and variable overhead costs.

It makes sense as you will only incur these expenses if you produce additional units of product.

Do note that certain fixed costs may change when the change in the activity level reaches a step cost situation.

For example, let’s say that your production plant is already operating at its maximum capacity.

This means that if you want to increase the production level, you either have to rent another plant or acquire a new one.

Both of these actions typically incur  fixed costs. But since you will incur either of them if you proceed with increasing the production level, either cost will count as a relevant cost.

Understanding incremental costs will greatly help in improving the production efficiency and production of a business.

Understanding Incremental Cost

Just knowing how to calculate incremental costs isn’t enough.

To fully utilize the information that incremental costs provide, one must understand them.

The calculation of incremental costs is particularly useful in deciding whether or not to increase the current production level.

Analyzing incremental costs is also useful in product pricing decisions.

For example, a business may choose to increase or decrease prices depending on the incremental costs.

Say, the incremental costs of producing extra units lead to a lower average cost per unit of product.

The business may then choose to increase the production level and reduce product price.

While this may reduce the profit per unit of product, reducing the product price will increase the sales volume, thus increasing the overall profit.

Since incurring incremental cost is choice-based, we should only consider forward-looking costs in its calculation.

Thus, we have to disregard any sunk costs when we calculate incremental costs.

For example, the cost of building a plant is a sunk cost.

Whether we decide to increase production or not, the cost of building a plant will remain the same.

Thus, we should not consider it in the calculation of incremental costs.

Incremental costs typically include variable costs as these are the costs that usually change if a business decides to increase production.

However, some fixed costs may also count as relevant costs in the computation of incremental costs.

For example, a business’s only product is already operating at maximum capacity.

If it wants to increase the production level, it either has to rent another plant or build a new one.

Both courses of action incur typically fixed costs.

However, since the business will only incur either of these costs if it wants to increase the production level, either will count towards the calculation of incremental costs.

Incremental Cost VS Incremental Revenue

Incremental revenue refers to the additional revenue a business will earn if it sells an additional unit of a product.

Whereas, incremental cost refers to the additional costs that a business will incur if produces an additional unit of a product.

The calculation of incremental cost should go hand in hand with the calculation of incremental revenue.

The ideal scenario is when the increase in the production level produces a profit.

In order for that to happen, the incremental revenue must be greater than the incremental cost.

If the opposite occurs where the incremental cost is greater than the incremental revenue, the production and sale of an additional unit will generate a loss instead.

Another scenario is when incremental revenue equals incremental costs.

This scenario results in neither a loss nor profit.

Thus, knowing the incremental cost of increasing the production level can help businesses gauge whether such action will result in profit or loss.

Just because it may produce more sales doesn’t mean that it automatically results in a profit.

Incremental Cost: An Example

The JD company is considering increasing its production of goods.

However, before it does so, the management wants to confirm the incremental costs that such an action will incur.

The production of its goods incurs both variable and fixed costs.

Below are the total costs at two different production levels:

• The production of 8,000 units results in a total cost of $200,000 or $25 per unit
• The production of 12,000 units results in a total cost of $264,000 or $22 per unit

From the above data, we derive that the incremental cost to produce additional 4,000 units amount to $64,000 ($264,000 -$200,000).

This results in an incremental cost per unit of $16 ($64,000 ÷ 4,000). We can also arrive at this figure using the following formula:

Incremental Cost (per unit) = Change in Total Cost ÷ Change in Units

Thus,

Incremental Cost (per unit) = ($264,000 – $200,000) ÷ (12,000 – 8,000)

= $64,000 ÷ 4,000

= $16

As per calculation, the incremental cost of producing an additional unit product is $16.