Incremental costs are additional expenses a business spends to expand production. It is the total amount of money paid for producing an additional unit of a product.
Profitable business decisions include knowing when is the best opportunity to produce more goods and sell at a lower price. Or sell a lower volume at a higher price. This is why incremental cost calculation is essential for decision-makers.
This way, companies develop a realistic production roadmap, with an exact number of goods to be produced and the pricing per unit, to achieve profit goals in a business quarter.
Let us assume you are in the shirt manufacturing business and spend $100,000 to make 10,000 shirts. Now, let’s say you are considering expanding your production capacity for maximum raw materials, labor, and location utilization.
The first step in calculating the incremental cost is determining how many units you want to add to your normal production capacity.
If you increase your output to 15,000 shirts at a total cost of $120,000, your incremental cost will be $20,000. This means the $20,000 additional cost will produce 5,000 extra units on your product line.
Simply put, the incremental cost formula is:
In this example, the formula for incremental cost would be:
To give you an idea of how knowing your incremental and marginal cost leads to better financial planning, let’s get back to the shirt business example.
You can produce 10,000 units of shirts at $100,000. This means the cost of production to make one shirt is at $10 in your normal production capacity.
But then you are looking at making 5,000 more shirts as your labor, machinery, and production input tells you you can. The cost of producing 15,000 units is $120,000, meaning the additional cost to expand your production to this level is at an incremental cost of $20,000. It has lowered as some of your fixed costs have already been covered by your normal production volume.
If you are making 5,000 more shirts for a $20,000 cost increment, your marginal cost is $4 per unit. Marginal cost is expressed as:
In the case of our shirt business example above:
This is an example of economies of scale, or the cost advantage companies get when production becomes efficient. And the more units sold at marginal cost, the higher its contribution to the net income.
Where manufacturing expansion leads to an increase, either minimal or significant, in the cost of producing additional units, incremental cost calculation helps companies decide at which profit margin per unit will get them to their return on investment or a net income target.
In a low-cost pricing strategy where the incurred incremental cost decreases production cost per unit, the company may opt to reduce its selling price to stimulate demand and gain a competitive advantage.
Incremental costs change at different scales of production, and so do their benefits. Businesses must determine the exact volume at which they can get the greatest value.
Let’s assess a tobacco manufacturing company’s production capacity. Here are some incremental cost examples based on different scales of production.
Case 1: Normal production capacity
Case 2: First incremental cost
Case 3: Second incremental cost
From this example, you can observe not all increase in production capacity leads to a higher net income. Incremental costs are expenses, and producing more units at a particular volume can outweigh the benefits.
As seen in Case 2, incremental cost increased significantly by $55,000 to produce 5,000 more units of tobacco. This happens in the real world as prices of raw materials change depending on the quantity bought from suppliers.
The tobacco business has seen the significant benefits of the economies of scale in Case 3. The incremental cost was kept lower at $70,000 while producing twice its production capacity, leading to a higher net income.
Getting all relevant information about your operational expenses lets you know whether you are in the right financial state to cover additional production costs before starting any project. Incremental cost analysis will save you from engaging in unprofitable business ventures that can ultimately damage your financial state.
Incremental cost guides you in choosing when to make your product and when to outsource. Often, it is more cost-efficient to outsource from a specialty company instead of doing it from scratch.
Incremental cost specifically tells business owners about the worthiness of allocating additional resources for a new production volume. Economies of scale show that companies with efficient and high production capacity can lower their costs, but this is not always the case. Some ventures waste time and resources, and calculating the incremental cost versus projected sales at a particular volume avoids that.
Companies need to make profitable business decisions when aiming for operational expansion. A revenue and expense analysis from production, defined by incremental cost, will save you a lot of financial troubles.
Incremental cost includes a cost-to-benefit analysis to guide businesses in smartly choosing battles. Producing more does not always lead to profitability (i.e. your incremental cost can far exceed your incremental revenue), and knowing your numbers at different scales of production ensures you do not fall for this trap.
