Incremental analysis, also known as marginal or differential analysis, is a decision-making tool used in accounting and finance to determine the true cost difference between alternative choices. The focus is on the differences in revenue and costs between the options, not their absolute levels.
This analysis technique is used when making decisions about:
- Pricing and special orders: Should we reduce the price for a large, special order?
- Make or buy: Should we produce a component part in-house or buy it from an external supplier?
- Sell or process further: We have a product that can be sold as is or processed further and sold at a higher price. Which option is more profitable?
- Add or drop a product line: Should we keep a low-performing product line?
- Equipment replacement: Should we continue using current equipment or replace it?
Incremental analysis looks at the relevant costs and relevant revenues of each option. Relevant costs and revenues are those that will differ in the future among alternative actions. Costs and revenues that don’t differ between alternatives are irrelevant and are ignored.
Incremental analysis is a short-term decision-making tool and doesn’t consider the long-term strategic goals of a company. Also, it typically focuses on financial information, and non-financial information may not be considered.
Example of Incremental Analysis
Let’s consider a scenario where a company is deciding whether to make a component in-house or buy it from an external supplier.
Company ABC produces widgets and needs a specific part for its production process. They have the choice of making the part themselves or buying it from an external supplier.
Option 1: Make In-House
- Direct materials: $10 per unit
- Direct labor: $15 per unit
- Variable manufacturing overhead: $5 per unit
- Fixed manufacturing overhead (allocated): $10 per unit
Total in-house production cost: $40 per unit
Option 2: Buy from External Supplier
The supplier offers the part for $35 per unit.
At first glance, it might seem cheaper to buy the part from the supplier ($35 < $40). However, the decision should be based on the relevant costs only.
Relevant costs are costs that will change depending on the decision made. In this case, the fixed manufacturing overhead of $10 per unit will still be incurred even if the part is not produced in-house. It’s a sunk cost and, thus, not relevant for the decision-making process.
So, the relevant cost of making the part in-house is actually $30 per unit (direct materials + direct labor + variable overhead). Given this, it would be cheaper for Company ABC to produce the part in-house rather than buying it from the supplier.
This is a simplified example of how incremental analysis can be used to make business decisions. Other factors could also be relevant in a real-world scenario, such as capacity constraints, quality differences, delivery times, and strategic considerations.