Incremental Cost
Incremental cost, also known as differential cost or marginal cost, refers to the change in total costs that results from producing additional units of a product or service. It’s the cost associated with one additional unit of production.
Incremental costs can take into account both variable and fixed costs. Variable costs change with the level of output (like raw materials and direct labor), while fixed costs stay the same regardless of output levels (like rent or salaries). However, in the short term, incremental costs often mainly consist of variable costs as many fixed costs (like rent or machinery) cannot be quickly adjusted.
Let’s take an example:
Assume that a bakery produces 100 loaves of bread per day at a total cost of $200. If it decides to produce one additional loaf, bringing the total to 101 loaves, and the total cost increases to $202, the incremental cost of the additional loaf is $2 ($202 – $200).
Understanding incremental costs can help a business make decisions about scaling production, pricing, or whether or not to accept special orders. It’s important to keep in mind that only those costs which change should be included in incremental cost analysis.
Example of an Incremental Cost
Let’s consider a more detailed example to illustrate incremental cost:
Suppose a T-shirt manufacturing company, “Tees & More,” currently produces 1,000 T-shirts per month. The costs involved are as follows:
- Fixed Costs (like rent, salaries): $10,000 per month
- Variable Costs (like raw materials, direct labor): $5 per T-shirt
So, the total cost for producing 1,000 T-shirts would be:
$10,000 (Fixed Costs) + $5,000 (Variable Costs for 1,000 shirts) = $15,000
Now, Tees & More is considering an order for an additional 200 shirts. The incremental cost associated with this order would be the extra costs that Tees & More incurs to produce these additional shirts.
The Fixed Costs would not change, as these are costs that the company has to pay regardless of the level of output.
The Variable Costs would increase, as these are costs directly associated with the production of each shirt. The additional variable cost for 200 shirts would be:
200 shirts x $5/shirt = $1,000
So, the incremental cost of producing an additional 200 shirts is $1,000. This is the cost that Tees & More would need to consider when deciding whether to accept the order.
It’s important to note that this is a simplified example. In reality, a company might also consider whether producing the extra shirts would require additional overtime, whether it would lead to extra wear and tear on machines, whether it would delay production for other orders, and other factors. All these would be included in a comprehensive incremental cost analysis.
