Incremental Revenue

The primary purpose of starting and operating a business is to generate profit.

But for a business to earn a profit, it must earn revenue first.

To do so, a business must be able to sell goods or services.

For example, a convenience store earns revenue by selling various goods. 

A gasoline station earns revenue by selling gas.

A fastfood restaurant earns revenue by selling fast food.

From the revenue that the business earned, we deduct any costs and expense that it incurred. Only then can a business truly say that it earned a profit.

Usually, businesses measure revenue or profit as a whole.

If you look at a regular income statement, you would see the total revenue that the business earned for that period.

But remember that in order for the business to earn that revenue amount, it has to sell goods or services, sometimes unit by unit.

This is where the increment revenue comes in handy.

So what is incremental revenue?

Simply put, incremental revenue is the additional revenue that a business earns if it were to make an additional sale.

It helps a business assess how much it would earn if it were to increase sales.

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

How does one define the term “incremental revenue”?

What effect does it have on a business?

How does one calculate incremental revenue?

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

What is incremental Revenue?

Incremental revenue refers to the additional revenue that a business will earn from an increase in sales.

It can also refer to the additional return from one investment decision when compared with another.

We calculate it by dividing the change in total revenue by the change in sales quantity.

Put into formula form, it should look like this:

Incremental Revenue = Change in Revenue ÷ Change in Sales Quantity

So how do we determine the change in revenue and change in sales quantity?

First, we must establish a baseline revenue level. It will serve as our benchmark from which we measure the changes in revenue and sales quantity.

From there, we measure the increase of revenue and sales quantity from the baseline revenue level. 

Uses of Incremental Revenue

The calculation of incremental revenue is particularly useful in the following situations:

Incremental pricing (i.e. selling more goods or services at a lower price)

When a customer of yours has been dealing business with you for several periods, there might come a time when such a customer offers a special order where they purchase a certain quantity of products for a special (usually lower) price.

Accepting such an order would result in you earning less revenue on a per unit basis, but the increase in sales quantity may just be worth it.

This is where the calculation of incremental revenue comes in.

Before accepting the special order, the business must first determine if the additional revenue is just enough to produce a profit.

This is usually done by comparing the incremental revenue with the incremental cost.

Releasing a new product or increasing the production level of an existing product

Releasing a new product or increasing the production level of an existing one can potentially result in a profit increase.

However, it can also result in a loss if not studied properly.

One way to ensure that such an action would result in a profit is through the calculation of incremental revenue.

Ideally, the incremental revenue of such an action should be greater than its incremental cost. Such a scenario will result in the generation of profit.

Evaluation of marketing campaigns

Businesses do marketing campaigns to potentially increase their sales.

To evaluate the effectiveness of a marketing campaign, the business could calculate the incremental revenue.

There should be a discernible amount of incremental revenue from such a marketing campaign that would have not occurred without it.

Comparing investment options

Investors also use incremental revenue when assessing which investment option brings the best return.

This is usually done by comparing the incremental revenue of one investment option to the other.

Whichever has the highest incremental revenue will be the better choice.

This helps investors in allocating their limited pool of funds and ensures that they get maximum returns.

For example, an investor still has remaining funds that he can allocate for additional investments.

He studies the current trend in the stock market and determines that stock A and stock B are his best options.

As per last quarter, stock A was able to generate incremental revenue of 7%.

Whereas, stock B was able to generate incremental revenue of 5%.

Thus, the investor decides to invest in stock A as it was able to generate a higher amount of incremental revenue.

Incremental Revenue VS Incremental Cost

Incremental cost refers to the total additional costs that a business will incur should it increase its production level.

Whereas, incremental revenue refers to the additional revenue that a business will earn from an increase in sales.

In incremental analysis, incremental revenue and incremental costs will be compared with each other if applicable.

If incremental revenue is greater than incremental costs, the increase in production and sales level will result in a profit.

This is the ideal scenario for a business.

However, if the incremental cost is greater than the incremental revenue, then the increase in production and sales will generate a loss instead.

Businesses should avoid this scenario as much as possible as it’s bad from a financial perspective.

If incremental revenue and incremental costs are equal, then the result will be a break-even scenario.

The business does not earn a profit nor generate a loss.

Understanding incremental revenue and its relationship with incremental cost will help a business make decisions that usually produce profits.

Just because there is an increase in revenue doesn’t mean that it will automatically result in an increase in profits.

Incremental Revenue VS Marginal Revenue

Incremental revenue and marginal revenue are similar to each other in that they both calculate the additional revenue that a business will earn from an increase in sales.

Where they differ is in the number of sales that they cover. Marginal revenue measures the additional revenue from the sale of one additional unit product.

Whereas, incremental revenue measures the additional revenue from the total increase in sales quantity.

Marginal revenue is more useful for a business that sells unique goods or high-priced low-volume products (e.g. cars, personalized goods).

Whereas, incremental revenue is more useful for a business that sells homogenous products because you can expect that sale of each product generates the same amount of revenue.