Understanding Incremental Cost
Incremental cost is the additional expense a company incurs to produce one more unit of a product. It focuses on costs that change with production volume—primarily variable costs like raw materials, direct labor, and incremental utilities—rather than fixed costs such as rent or core equipment.
Key Takeaways
- Incremental cost (also called marginal cost) equals the extra cost of producing additional units.
- It comprises variable costs that change with output; fixed costs are generally excluded.
- Comparing incremental cost to incremental revenue helps determine whether expanding production or accepting special orders is profitable.
- Incremental-cost analysis supports pricing, make-or-buy decisions, capacity planning, and short-term operational choices.
What Incremental Cost Includes
Common components of incremental cost:
Raw materials and components
Direct labor specifically tied to the extra output
Incremental utilities and fuel for additional production
Shipping, packaging, and other per-unit handling costs
Fixed costs—rent, long-term salaries, depreciation—typically don’t change with small production increases and are excluded from incremental-cost calculations.
Why It Matters
Analyzing incremental costs helps businesses:
Decide whether to produce an additional unit or buy from a supplier (make-or-buy).
Evaluate special-order opportunities—accepting a lower price can be acceptable if it covers incremental costs.
Identify opportunities for economies of scale, where average cost per unit falls as production rises.
Determine the profit-maximizing output where incremental revenue equals incremental cost (MR = MC).
Comparing Incremental Cost and Incremental Revenue
Profitability for an extra unit depends on the relationship between incremental revenue and incremental cost:
If incremental revenue > incremental cost → producing the additional unit increases profit.
If incremental revenue < incremental cost → producing the additional unit reduces profit.
This comparison guides decisions about expanding production, setting discounted prices for bulk or special orders, and allocating resources across segments.
Example Calculation
A company has:
Total cost for 10,000 units = $300,000 ($30 per unit)
Total cost for 12,000 units = $330,000 ($27.50 per unit)
The incremental cost to produce the extra 2,000 units:
Total incremental cost = $330,000 − $300,000 = $30,000
Incremental cost per unit = $30,000 / 2,000 = $15
The per-unit incremental cost is lower than the previous average because fixed costs are spread over more units.
When to Use Incremental-Cost Analysis
Incremental-cost analysis is most useful for:
Short-term operational choices (e.g., accepting a one-time special order)
Pricing decisions where variable costs determine acceptable discount levels
Evaluating the profitability of adding production volume or a product line
Comparing alternatives where only some costs differ between options
Conclusion
Incremental cost provides a focused view of the costs that change with production. By isolating these variable expenses and comparing them to incremental revenue, managers can make better-informed decisions about production levels, pricing, and resource allocation to maximize profitability.