Incremental analysis involves the examination of alternative choices, based on the cost differences between them. This analysis is solely concerned with the costs that will change if one alternative is selected over another. Any costs that do not change if either alternative is selected are ignored for the purpose of deciding which alternative to pursue. For example, costs that have already been incurred (known as sunk costs) are ignored. Also, if any type of cost will be incurred for both alternatives, then it also can be ignored.
Incremental costing is frequently used for the following types of analyses:
- Whether to retain production in-house or outsource it.
- Whether to maintain personnel in-house or outsource their services.
- Whether to accept a one-time order from a customer (usually for a low price).
- Whether to rebuild an existing asset or replace it with a new one.
- Whether to sell a product in its current condition or keep processing it and sell it later.
- How to allocate scarce resources among a number of possible uses, such as the choices for allocating limited funds among several proposed capital projects.
For example, a company receives an order from a customer for 1,000 units of a green widget for $12.00 each. The company controller looks up the standard cost for a green widget and finds that it costs the company $14.00. Of this $14.00, $11.00 is variable cost and $3.00 is fixed cost. Since the fixed cost is being incurred irrespective of the proposed sale, it is classified as a sunk cost and ignored. This means that the incremental cost of the widget is $11.00. The company should accept the order, since it will earn $1.00 per unit sold, or $1,000 in total.
Incremental analysis is also known as differential analysis or marginal analysis.