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Incremental analysis compares financial differences between options, taking into account revenue, costs, and savings. Relevant values are considered, and material costs are separated from irrelevant ones. Changes in revenue, costs, and savings are analyzed, and cost savings and opportunity costs are also considered.
An incremental analysis is done to determine the financial differences between the choices companies may make. Revenue, costs, and savings are calculated and taken into account as a whole for each option, and the options are compared. Values must be relevant, or directly linked to one of the decisions, to be included in an incremental analysis. Analyzing the different options in terms of revenue, costs or savings alone often paints an incomplete picture compared to looking at the effects of choices in all three areas.
When business managers perform an incremental analysis, they typically separate irrelevant and material costs. Fixed costs are often considered irrelevant, as the company will incur them regardless of the choice selected. For example, the option might be to use an existing production facility to produce “Product A” versus “Product B.” The rent of the production facility is irrelevant, while the projected revenue for each product is relevant.
Changes in the amount of revenue that different alternatives will generate are what must be considered in an incremental analysis. If manufacturing “Product A” results in $30,000 in gross revenue versus $40,000 in gross revenue from purchasing the product, the incremental change is $10,000. Buying the product versus making it in-house gives the company an additional $10,000 in gross revenue. An incremental analysis, however, usually does not analyze just one variable, but several that directly affect the results.
For example, if the purchase of “Product A” results in an increase in variable costs that exceed in-house production costs, this may affect the manager’s decision. Assuming the variable costs for the company to make the product itself are $10,000 and the costs to buy it are $30,000, incremental net revenue is now in favor of in-house production as variable costs highest product purchase costs outweigh the highest gross revenue costs. Subtracting the production versus manufacturing costs from the gross income for each shows that the company would make $10,000 more in profit if it continued to manufacture its own product.
In addition to changes in costs that may occur as a result of a decision, a manager must also consider any cost savings. This includes any costs that a decision eliminates. For example, if a manager’s decision is to choose between raw material suppliers, some of those costs might include volume discounts. One supplier may offer a certain percentage discount for a certain volume level, while the other does not.
Assuming the company consistently orders the volume that qualifies for the discount from the supplier, this savings amount would be factored into the incremental cost analysis. In addition to cost savings, any opportunity costs must be considered in an incremental analysis. An opportunity cost is the amount lost by choosing one option over another. Examples of opportunity costs include revenue from taking on a new line of business and revenue from producing raw materials.
Asset Smart.
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