Incremental analysis is an accounting tool used to help a business make short-term decisions. The process looks at the incremental changes in costs and revenues arising from the alternative options available, and selects the one which gives either the lowest cost or the highest net income.
Incremental analysis is often referred to as differential analysis or marginal analysis.
Incremental Analysis Cost and Revenue Factors
Incremental analysis relies on being able to correctly identify the costs and revenues relevant to the decision making process. By looking at only the relevant costs it eliminates the need to produce comparative data for non-relevant costs and therefore speeds up the decision making process.
We have listed below the main cost and revenue components which need consideration.
Relevant Cost and Revenue
Relevant costs and revenues are those which will change depending on the decision made.
Sunk Cost
A sunk cost is a cost which a business has already incurred and which cannot be recovered in the future. As these historical costs cannot change, they should not be taken into account when making future decisions, and are not relevant to the incremental analysis approach.
Suppose for example, a business has already incurred significant costs in research and development for a new product. If it is concluded that the future revenues from the product will not cover the future costs, and the product will be loss making, then the business should ignore the sunk costs and cancel the future development of the product.
The tendency to keep going with future investment due to the substantial sunk costs is referred to as the sunk cost effect.
Opportunity Cost
Opportunity costs are the benefits lost as a result of taking the decision. They are normally relevant costs for incremental analysis.
Types of Incremental Analysis
Incremental analysis accounting can be used in many business situations including the following.
- Accept or reject decision
- Sell or process further decision
- Make or buy decision
- Repair or replace decision
- Keep or drop decision
Each application is considered in detail below.
Accept or Reject a Special Order
The incremental analysis approach can be used by a manufacturing business to decide whether or not to to accept a special order from a customer.
Suppose for example a business has received a special order for 3,000 units of one of its products. The product normally sells at 8.00 but the customer has requested a price of 5.00.
The unit product cost is 6.00 comprising direct material and labor costs of 3.50, variable overhead costs of 0.90 and fixed overhead costs of 1.60.
The business has adequate capacity to manufacture the additional 3,000 units and needs to decide whether to accept or reject the special order.
At first glance the special order should be rejected. The order selling price is 5.00 and the product costs 6.00 to manufacture giving a loss a 1.00 for each unit sold. However, by using incremental analysis and reviewing only the relevant costs a different outcome becomes apparent.
Incremental Analysis Approach Relevant Costs and Revenue
The relevant costs and revenues are those which will change as a result of deciding to accept the order.
For each additional unit manufactured and sold the business will receive revenue of 5.00 and incur costs for direct material and labor of 3.50 and for variable overhead of 0.90. These costs and revenue are therefore relevant to the decision.
The fixed overhead by its nature will be incurred whether or not the special order units are manufactured and is therefore not relevant in making the decision. For example the cost might relate to rent for manufacturing premises which will remain fixed irrespective of the number of units manufactured.
The incremental analysis is summarized in the table below.
| Normal | Special | |
|---|---|---|
| Direct costs | 3.50 | 3.50 |
| Variable overhead | 0.90 | 0.90 |
| Fixed overhead | 1.60 | |
| Total cost | 6.00 | 4.40 |
| Selling price | 5.00 | |
| Net income | 0.60 | |
| Units | 3,000 | |
| Incremental net income | 1,800 |
The fixed overhead cost is not relevant and is therefore excluded from the incremental analysis. The unit net income is 0.60, and the special order will generate an incremental net income of 1,800 (3,000 x 0.60). The analysis shows that the special order should be accepted.
Sell or Process Further Decision
Another decision facing management is whether or not to sell a product in its current state or process it further in the hope of selling at a higher price.
Suppose a business has a product which sells for 10.00 and costs 7.60 to manufacture. The costs include direct material and labor costs of 6.40 and fixed overhead costs of 1.20.
The business needs to make a decision as to whether or not to process 8,000 units of the product further at an additional direct variable cost of 1.60 on the basis that they can then be sold for 12.50 each.
The business could look at comparative income statements for the two options as follows.
| Current | Process | |
|---|---|---|
| Selling price | 10.00 | 12.50 |
| Direct costs | 6.40 | 8.00 |
| Fixed overhead | 1.20 | 1.20 |
| Total cost | 7.60 | 9.20 |
| Net income | 2.40 | 3.30 |
| Units | 8,000 | 8,000 |
| Total net income | 19,200 | 26,400 |
| Incremental net income | 7,200 |
The incremental net income from processing further is 7,200 and therefore the decision should be made to process further.
While the comparative income statements provide the correct answer the process involved reviewing all costs and revenues irrespective of whether they were relevant or not.
Incremental Analysis Approach Relevant Costs and Revenue
The relevant costs and revenues are those which will change as a result of deciding to process further.
If the product is processed further the incremental revenue is 2.50 (12.50 – 10.00) and the incremental direct costs are 1.60 (8.00 – 6.40). Both the revenue and direct costs are therefore relevant for the incremental analysis.
The total fixed overhead will remain fixed irrespective of whether the product is processed further or not and is therefore not relevant to the analysis.
The incremental analysis is summarized in the table below.
| Process | |
|---|---|
| Incremental selling price | 2.50 |
| Incremental direct costs | 1.60 |
| Incremental net income | 0.90 |
| Units | 8,000 |
| Incremental net income | 7,200 |
By considering only the relevant costs the incremental analysis provides the same answer as before. By deciding to process further the net income is increased by 7,200 and the decision should be taken to continue processing.
Make or Buy Decision
The make or buy or outsourcing decision is one in which the business needs to decide whether to continue to manufacture a product using its own facilities or to outsource the manufacturing to a third party and buy the products from them.
Suppose a business manufactures a product with the following cost structure; direct material and labor 12.00, variable overhead 4.00, fixed overhead 10.00.
The business can purchase 5,000 units of the product from a third party manufacturer at a cost of 20.00 but will still incur fixed overhead of 8.00 a unit.
The decision can be made by carrying out an incremental analysis of the make or buy decision.
Incremental Analysis Approach Relevant Costs
The relevant costs are those which will change as a result of deciding to outsource the manufacture of the product.
If the business decides to outsource then for each unit the direct manufacturing costs (12.00) and the variable overhead costs (4.00) will be saved. In addition the fixed overhead costs will reduce by 2.00 (10.00 – 8.00). However the business will now need to purchase the product at a cost of 20.00.
The incremental analysis is summarized in the table below.
| Outsource | |
|---|---|
| Incremental direct costs | -12.00 |
| Incremental variable overhead | -4.00 |
| Incremental fixed overhead | -2.00 |
| Incremental purchase costs | 20.00 |
| Incremental unit cost | 2.00 |
| Units | 5,000 |
| Incremental total costs | 10,000 |
The incremental analysis shows that the unit cost increases by 2.00 and the total cost increases by 10,000. The business should continue to manufacture the product in house.
Repair or Replace Decision
The repair or replace decision is used when a business needs to decide whether to continue with its current machinery or replace it with a new machine. By replacing the machine the business will incur the purchase cost however the costs of repair and maintenance should decrease to reduce the impact.
Suppose the business has a machine which originally cost 120,000 and has annual repairs and maintenance costs of 80,000. It is considering purchasing a new machine at a cost of 125,000 and will receive salvage value on the old machine of 65,000. The annual repairs and maintenance costs for the new machine is 64,000, and the machine will have a 4 year useful life.
Incremental Analysis Approach Relevant Costs and Revenue
The relevant costs are those which will change as a result of deciding to purchase the new machine.
If the new machine is purchased the repairs and maintenance cost will be reduced by 16,000 (80,000 – 64,000) a year for 4 years giving a total incremental cost saving of 64,000 (16,000 x 4). The purchase cost of the new machine of 125,000 is also an incremental cost.
The salvage value from the sale of the old machine can be viewed as either an incremental revenue or more likely as an opportunity cost which will be lost if the machine is not replaced and sold. Either way the salvage value is a relevant item for the incremental analysis.
The original cost of the current machine (120,000) was incurred in the past and is a sunk cost, it has no relevance to the decision.
The incremental analysis is summarized in the table below.
| Replace | |
|---|---|
| Annual incremental variable overhead | -16,000 |
| Years | 4 |
| Incremental variable overhead | -64,000 |
| New machine purchase cost | 125,000 |
| Old machine salvage value | -65,000 |
| Incremental total costs | -4,000 |
The incremental analysis shows that the total costs decrease by 4,000 if the business makes the decision to replace the equipment.
Keep or Drop Decision
The keep or drop decision is used to decide whether to eliminate an unprofitable business segment or product.
Suppose a business currently operates in two segments A and B. The business is considering dropping loss making segment B which has the following income statement.
| Segment B | |
|---|---|
| Revenue | 40,000 |
| Variable costs | 31,000 |
| Direct fixed costs | 6,000 |
| Allocated fixed costs | 7,000 |
| Total cost | 44,000 |
| Net income | -4,000 |
The income statement above shows segment B loses 4,000 each year and therefore at first glance should be dropped.
Using incremental analysis only relevant costs should be considered.
Incremental Analysis Approach Relevant Costs and Revenue
The relevant costs are those which will change as a result of deciding to drop the segment.
Revenue, variable costs, and direct fixed costs (those relating and attributable directly to the segment) will all fall to zero if the segment is dropped. They are therefore all relevant costs and revenue for incremental analysis.
The allocated fixed costs are the portion of the businesses general overhead which have been allocated to segment B. These costs will remain even if the segment is dropped and are therefore not relevant in making the decision.
The incremental analysis is summarized in the table below.
| Drop | |
|---|---|
| Incremental revenue | -40,000 |
| Incremental variable costs | -31,000 |
| Incremental direct fixed costs | -6,000 |
| Incremental total cost | -37,000 |
| Incremental net income | -3,000 |
If segment B is dropped the net income of the business decreases by 3,000, the incremental analysis shows that the business should keep segment B.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Double Entry Bookkeeping. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a degree from Loughborough University.