Businesses need to find out incremental costs to stay informed about the investment in producing extra units or providing services. It helps businesses to identify profits and losses, which is beneficial in financial management. In this article, we will understand incremental costs in detail.
What Is Incremental Cost?
You can understand incremental costs as the additional cost invested by businesses to produce extra units or to deliver extra units of service. For example, imagine a company that makes 1000 bulbs in a day. If this company increases its production from 1000 bulbs to 1500 bulbs, then the cost involved in making each extra bulb is an incremental cost. Businesses calculate incremental costs to analyze whether it is profitable or causes loss. This information helps businesses to fix the price of the product or service they provide. Understanding incremental costs is beneficial in making the right decisions, making profits, and preventing losses.
Understanding Incremental Cost
Understanding incremental costs is figuring out how much more money you need to invest if you make an extra unit of your product or deliver an extra unit of services. These additional investments in production include raw materials, payment of workers, and usage of extra electricity, gas, and other resources. Figuring out incremental costs is important because if the cost of making a product increases, then you will have to increase the price of the product to prevent loss and make a profit. Similarly, if the cost of manufacturing extra products or delivering extra service decreases, then you can lower the price of your product to increase your sales and make more profit.
Calculating Incremental Cost
For calculating incremental costs, you can use a simple incremental cost formula. Incremental costs = Total cost in production after adding extra units - Total cost in producing units before changes For example,
- Suppose a manufacturer of gears invests Rs.50,000 to make 100 gear components. It means the cost per gear is Rs.500.
- If the manufacturer receives an order for an additional 50 gears, then the total cost to make 150 gears reaches Rs.84,000.
- This means the per-gear cost will be Rs.560.
Now, the total incremental cost to make an extra 50 gears would be (Rs.84,000 –Rs.50,000) = Rs.34,000. To find the incremental cost per gear, we divide the total incremental cost by the number of additional gear components. So, Rs. 34,000 divided by 50 additional gears results in an incremental cost per gear of Rs. 680. Therefore, when the company was producing 100 gears, the cost per gear was Rs. 500, but when it started fulfilling additional orders, the cost per gear increased to Rs. 680. This shows how incremental cost can change as the manufacturer of gears increases the production. Sometimes, the cost per unit of original production volume can be less than the cost per unit of additional production volume and vice-versa. This will help businesses to make informed financial decisions.
Benefits of Incremental Cost Analysis
Analyzing incremental costs helps businesses understand if producing more units makes them extra money or if they should stick to the original production volume. For example, imagine an electrical manufacturer who wants to make more fans in the summer season. In this situation, figuring out incremental costs will help them see if it's a good idea or if it will cause a loss for their business.
- The incremental costs allow businesses to make decisions about production, pricing of products, and utilization of resources.
- Suppose a company calculates that the incremental costs of producing additional units are higher than that of the original units. In that case, the company may decide to stop producing additional units.
- If incremental costs are lower than the original production volume, then businesses can increase production.
- Policymakers of companies can also make decisions to reduce the price of their product if incremental costs are lower. Price reduction of a product can increase sales if the quality of the product is the same.
- Incremental cost analysis helps businesses to make strategies to offer discounts to increase their sales and make a profit.
- Companies can compare the incremental costs of offering a discount to the revenue they generate, and if it seems profitable, they can go on with their plan.
Incremental Cost vs. Incremental Revenue
Incremental cost focuses on the money that companies have to invest in producing additional units. It can be related to the usage of resources, raw materials, labour costs, etc. However, Incremental revenue focuses on the money that businesses make after selling extra products or providing extra services. If incremental revenue is higher than incremental cost, then it can be considered a good idea to produce extra products or provide additional services. Business is all about making money, and you have to manage your finances smartly. Knowledge of incremental cost and incremental revenue will help you expand your business and make extra profit.
Incremental Cost Example
Now, we will try to understand it more clearly with examples. Imagine an industrial machinery manufacturer that makes 500 hydraulic cylinders per day, and the cost of making 500 cylinders is Rs.1,00,000. Further, business owners noticed that there was more demand for hydraulic cylinders in the market, and they decided to make 1000 cylinders per day. The cost of making 1000 cylinders is Rs.1,25,000, which means incremental costs for making additional cylinders are Rs.25,000. Here, you can notice that earlier, the cost of making 1 hydraulic cylinder was Rs.200, but after producing additional cylinders, the incremental cost of making 1 cylinder was Rs.50. You can see that this is a profitable decision for business owners to make extra hydraulic cylinders.
Incremental Cost vs. Marginal Cost
Both incremental cost and marginal cost deal with additional costs that are involved in making additional products or providing additional services. However, there is a slight difference between marginal cost and incremental cost.
| Incremental Cost | Marginal Cost |
|---|---|
| Incremental cost focuses on the impact of producing extra products. | Marginal cost focuses on the broader picture and helps to analyze the overall impact of producing extra products or providing additional services. |
| The incremental cost is typically used in the everyday decision-making process. | Marginal cost is commonly used in economics and analyzing the overall decision of producing additional units. |
| Incremental costs provide valuable information about whether producing additional units is profitable for the business or not. | Marginal cost considers all the costs involved in producing additional units, which helps policymakers understand how increasing or decreasing production affects the overall cost structure. |
A Perfect Solution To Manage Incremental Cost Calculation
We have explored what incremental costs are in detail to make you understand how important it is to efficiently manage your finances. However, calculating incremental costs requires too much information, such as raw materials used in production, workers involved in the production, and usage of other resources like electricity. Keeping all such information in place can be challenging, but TranZact is here to help you out. You must contact TranZact to opt for the best cost management solution that will help you make the right decisions and increase your business revenue.
FAQs
Q1. How to calculate incremental manufacturing cost?
Incremental manufacturing cost is the difference between the cost of producing additional units and the cost of producing units that was decided before. The incremental manufacturing costs = Total cost in production after adding extra units - Total cost in producing units before changes
Q2. What is the significance of incremental cost in decision-making?
It provides valuable insight into decisions like whether producing additional units is profitable or should be stopped.
Q3. How does incremental cost differ from sunk cost?
The incremental cost is the additional cost of producing extra units. Sunk cost is a cost that has already been spent and has no role in decision-making for the future.
