Businesses use the concept of incremental analysis to determine the cost difference between alternatives. In other words, incremental analysis—also known as marginal analysis and differential analysis—is a decision-making technique backed by accounting information that assists with the allocation of limited resources for product lines.
Incremental analysis does not include past and sunk costs but covers variable costs— articles, resources, units, items, assets, etc. The previous purchase costs of products, projects, or personnel are irrelevant in marginal analysis.
What are the Different Types of Incremental Analysis?
The different types of incremental analysis are determined on the basis of analysis accounting or business situations involved. Companies use this tool for decision making categories such as:
- Decisions related to outsourcing jobs or accepted/rejecting new employees.
- Selling price or process-related decisions.
- Make or buy decisions as to either manufacturing products in-house or outsourcing them.
- Decisions concerning either repairing or replacing company assets, equipment, or machinery.
- The asset-based decision, whether to keep or drop (sell) the asset.
- Funds allocation decision in the case of multiple options.
- Special order business decisions.
How to Perform an Incremental Analysis?
Incremental analysis roughly involves addition and subtraction. Depending on the alternatives being compared, the variables and figures will change. The level of complexity of the calculations also varies and are based on the alternatives.
Step 1: Determining the Relevant Costs
The primary step is to determine the options, after which you must establish both variable and non-variable relevant costs. Make sure that you do not include previous expenditures. Nevertheless, include only those costs in the calculations, which are either related or would impact your decisions.
Step 2: Identifying Opportunity Costs
Opportunity costs are nothing but the potential profits the company might lose—this loss could be anything.
Step 3: Adding the Relevant Costs and Opportunity Costs
Add all the relevant costs; you may either add or subtract the opportunity costs—this is based on how it would influence the calculations. Repeat it for all the options separately. It is advised to assign a separate table for each option. Readers are advised to note that sunk cost, previous cost, etc., are not included.
Step 4: Comparing the Options
This step involves comparing the results allotted in the table mentioned in the previous step to either one another or against certain elements like the sales price of a product or the cost involved to hire a new employee. The objective is to determine a better outcome in terms of finance.
Step 5: Decision-making Process
The above steps account for making business decisions, which is the final step.
Incremental analysis is a useful business strategy. It is simple to use and is based on adding and subtracting the various amounts or costs of the company.
Examples of incremental analysis
1. Determining the fixed costs of a company in terms of net income
Comparing the constants of every alternative that does not impact the revenues earned by the business. Such standards or fixed costs are necessary expenses that have already been incurred by the firm.
2. Changing the production
Whether to opt for an in-house manufacturing process or to outsource production. This technique is also used to make any decision related to the product line where it impacts the company’s income statement.
3. Decision related to buying new materials or goods
Differential analysis simplifies choices to be made, such as whether to buy a new piece of equipment or any other item or company’s asset. Most often, management has the rights reserved to make choices.
4. Changing the distribution channels
Another example includes any decision to be made in retaining or changing the firm’s distribution partners. Determining new options or retaining the existing alternative to increase revenues is one of the benefits.
5. Aspects used for information
While the marginal analysis includes both relevant and non-relevant costs like sunk cost and expenses already incurred, the non-relevant expenditure does not impact the results. Needless to say, it offers valuable insight into the non-relevant costs, and it is yet another example of a relevant cost approach.
The main objective is to determine improvements that could be made to the facilities in a cost-effective capacity. Some parts of the study involve expanding the company with better alternatives or ensuring the sale of products and revenue by increasing the purchase value of the product.
Usually, this study opens new arenas for investment: To earn more money by reducing expenses or increasing the number of products with limited resources. The differences obtained by comparing the book value of every alternative will help businesses make better decisions. The study also aids the management to decide on changes to be made or action to be taken to positively impact the income statements.
For instance, the main function of this problem-solving technique is to determine the means of producing one unit of product at a reduced cost. While many compare it to the CVP study, both are completely different concepts. Incremental study is helpful in increasing orders or determines the best courses to sell products for more value. Whether to hire new employees or buy new assets, or make special order decisions are examples of such courses or requirements.
Firms use an incremental analysis approach to determine the expenses incurred by the company to reduce maintenance costs and other expenditures. Typically, the additional costs reflect in the company’s balance sheet and income statement. By comparing the information on various alternatives, decisions could be made to increase production or to expand the business.
1. Is incremental analysis the same as CVP analysis?
Incremental analysis is not the same as CVP or Cost Volume Profit analysis as the former is a decision-making technique. On the other hand, company managers use CVP analysis as a cost accounting method in managerial accounting.
2. How does incremental analysis work?
Analysis incremental determines the cost implication of one alternative to alternative. It identifies costs and revenues to make analysis decisions. It will help in eliminating the necessity of producing comparative data specifically for non relevant costs and, thus, faster decision making for the company. As mentioned earlier, incremental analysis aids in determining the cost implications of one alternative from another. One of the basic models used for the same is as follows:
IC = ∑RCia – ∑RCib
where i = one or n; RCia and RCib are relevant costs (costs and revenues) of alternative A and alternative B, respectively. And, n represents the number of relevant cost articles.
3. Why is incremental analysis important?
Incremental analysis has a variety of uses as follows: It helps the company’s management to make decisions like whether to opt for in-house production or to outsource a product. It also helps with decisions such as to go for in-house personnel or to outsource services. Simply put, incremental or differential analysis helps to increase revenues or net income and to decrease costs or expenses. It helps management make special order decisions. It also will help to reduce the overhead costs or operations costs by comparing the revenue components of every alternative.