MyCFO Link Blog

Thanks for stopping by our blog. If you visit often, you'll learn about our Issaquah cost accounting, business services, and other tax help solutions. We hope you find the content valuable and relevant.  Should you have a question you would like to see answered, please drop us an email and let us know what you would like to see answered!


Incremental Costs and When They Apply

by anonymous on October 17, 2016
In order to assess the profitability of any company it is important to know how various costs affect the overall operation. This also means it is necessary to evaluate the entire cost factors including production, materials and any other factors that are included. 

Defining and Calculating Incremental Costs

An incremntal cost is the increase that results because of a cost increase in the production process and any other activity relative to the product a company manufactures. In other words, if a company increases machine hours by 2,000 hours and the cost increases from $320,000 to $360,000, the incremental cost is the difference between the previous and current cost or $40,000. Another name for incremental cost is differential cost. 

Calculating incremental cost allows a business to more accurately assess the actual cost of production. The primary steps necessary for accomplishing this include:

1. Reviewing the formula for incremental cost
2. Calculate the dollar amount incurred when the company produces one product (this will include all variable production costs)
3. Calculate the dollar amount of producing two products
4. Compute the difference between producing one product and producing two in order to estimate the incremental cost.

Irrelevant vs. Incremental Costs

Irrelevant cost is an accounting term that is used to define a cost that has no relationship with a situation involving the decision of a manager. The circumstances may not always be the same; some costs may be relevant in some situations but irrelevant in other situations. Some irrevelant costs include things such as book values, fixed overhead, notional costs and sunk costs.

Incremental costs are those a company experiences that are recorded on the balance sheet because of additional production units. An incremental cost is not one that is expected and some people may refer to it as a marginal cost. For instance, a company may have predicted a particular project would cost $5,000, but for various reasons it ends up costing $7,000. The additional $2,000 of the project cost is called the incremental cost. 
Another type of cost that is closely tied to both irrevelant and incremental cost is called sunk cost. The sunk cost refers to a cost that is incurred but is impossible to return. This could include a variety of items that could include a gym membership you can never use; equipment a company purchased but is unable to return; or a computer program the company spent thousand of dollars to purchase only to find out there was a better program for a substantial lower cost. 

Importance of Understanding Various Cost Factors

The more a business understands about various associated costs, the easier it will be to plan for all possible situations. Each of these factors has an effect on the other including the sunk costs. A business can use the sunk cost to assess the increment cost. For instance, if a company has irrevelant costs that are the result of an increased cost of the parts necessary in manufacturing a specific product, this would then cause an increase in the production cost of the product and thus a decrease in the profit margin. An incremental cost factor can also cover the expense a company incurs as a result of irrevelant costs. 

The type of business determines the types of costs the company might incur. However, when a business owner knows and understands the differences between the types of costs, it will help the company see the importance of needing to include both the irrevelant and incremental cost in the financial documents. It's important to compare all the associated costs and then decide how much focus you want to place on each individual cost. This will help you determine how much of your cash flow you need to set aside in order to cover each of those costs.