Total Incremental Cost: Calculation and Business Application
Learn to isolate the relevant expenses associated with a business choice to accurately assess its financial impact and guide effective decision-making.
Total incremental cost is the complete change in a company’s expenses from a specific management decision. It is not an accounting measure for historical reporting but a tool for analyzing a future action, like producing more goods or launching a new service. The concept isolates the financial impact of a single choice.
Identifying Relevant Costs for Analysis
To analyze a decision, a business must sort its expenses into relevant and irrelevant categories. Relevant costs are future expenses incurred only if the decision moves forward. The most common are variable costs, which fluctuate with production volume, including direct materials, direct labor, and variable manufacturing overhead like electricity for machinery.
Some fixed costs can also be relevant if they change due to the decision. These are often called step-fixed costs, which are fixed within a certain range of activity but increase when a threshold is crossed. For instance, if a large order requires hiring another supervisor or leasing new equipment, those new fixed expenses are relevant because they are prompted by the choice.
Conversely, some costs must be excluded from the analysis. Sunk costs are expenditures already made that cannot be recovered, regardless of future action. An example is the purchase price of a machine bought last year. Fixed costs that remain unchanged by the decision are also not included, such as monthly factory rent or executive salaries.
Calculating the Total Incremental Cost
The formula is Total Incremental Cost = (Change in Variable Costs) + (Change in Fixed Costs). This calculation aggregates all new spending a project will cause, focusing entirely on the change in costs from the current state, not the total costs of operating the business.
For example, a furniture company receives a special order for 50 custom chairs. The company determines its variable costs for each chair are $75 for wood, $100 for direct labor, and $25 for variable overhead, totaling $200 per chair. For 50 chairs, the total variable cost is $10,000.
This order also requires renting a specific tool for $500, which is a relevant fixed cost. Therefore, the total incremental cost for the order is the sum of the change in variable and fixed costs: $10,000 + $500 = $10,500.
Application in Business Decisions
Total incremental cost is compared against the incremental revenue associated with the decision. Incremental revenue is the additional income a company generates if it accepts the project. If the incremental revenue is greater than the total incremental cost, the decision is financially positive. If revenue is less than the cost, the order would result in a loss.
Continuing the furniture maker example, the total incremental cost for the 50-chair order is $10,500. The client has offered to pay $300 per chair, generating incremental revenue of $15,000. The incremental revenue of $15,000 exceeds the total incremental cost of $10,500, resulting in a profit of $4,500 from this order.
This logic applies to other business scenarios. In a make-or-buy decision, a company calculates the total incremental cost of manufacturing a component in-house and compares it to the cost of purchasing it from an external supplier. The lower-cost option is chosen.