No business plans to remain stagnant. This results to the need to increase the number of output sold at every point in time. In doing this, it must consider its incremental cost. This is the focus of this article.
Definition — What is Incremental Cost?
1. The cost incurred for producing an extra unit of a product or in adding another product line.
2. Additional amount spent for increasing the quantity of the entity’s product or number of clients served in the case of a service firm.
The additional cost incurred. This excludes sunk and past costs. Only explicit cost, opportunity costs and future costs are considered here. Why? You are determining the future price or total cost of the product(s). So, you should be concerned with present expenses, opportunity costs and future expenses. These are what will affect the increment of production units.
Extra units or number of clients. For production businesses, the term extra units is used. Also for a trading firm. However, for service entities the number of clients served should be considered. Increases in outputs usually come with the benefits of economies of scale. It means you can buy more raw materials at lower prices. Use the same property, plants and equipment. And probably the same number of labour or a slight increase in achieving higher production units at lesser cost of production. Note: this may not be true in all cases.
Example of Incremental cost
By increasing the units, it may result in an increase in revenue and profit. Thereby, improving production efficiency. For example, assuming Mohit decided to increase the sale of its product, Abisca, from 100 units to 150 units. The total cost for the product is currently 20,000 Naira. And the selling price per unit is 320 Naira. By increasing the units, Mohit is expected to see production cost increased to 27,500 Naira.
From here, we can deduce the following.
The cost per unit @100 units is NGN 200.
The Selling price per unit is NGN 320.
This gives a profit of NGN 120.
By increasing to 150 units, the firm will incur NGN 27,500. That’s an additional or incremental cost of NGN 7,500.
Cost @150 units becomes NGN 183.33.
Selling price remains NGN 320.
The profit per unit is NGN 136.67.
This implies that the entity has an incremental profit of NGN 16.67.
In conclusion, by increasing production units by 50, it results in an incremental cost of NGN 7,500 and incremental profit of 16.67 Naira.
Benefits of applying Incremental Cost to business
What are some benefits of incremental costs?
It improves production efficiency. The cost per unit may decrease as a result of increase in units produced. As you can see in the example, the cost per unit before the increase in units was 200 Naira. Upon increment, the cost/unit falls to 183.33 Naira. This means that when considering an increase in quantity, this analysis should be done to know if it will benefit the business.
It also helps answer the following questions. Should the entity purchase additional units of the product to meet clients demands or make the product? Can the entity add another product type using the same resources and how can the resources be allocated? And should the firm increase or reduce the selling price of the product or maintain the current price?
Aid preparing weekly or monthly budget. When you know the extra income from the increase in units produced, you can prepare a daily budget that fits in.
On a final note, incremental cost is the additional expenses incurred for every extra units product. By calculating Incremental expenses, it helps improve production efficiency, understand certain costing questions and know how to budget for expenses incurred daily for the business.