Question

What is incremental analysis? In what types of situations is incremental analysis most useful? Discu

Answer 1

Incremental analysis studies the cost and revenue differences between the various alternatives to help you arrive at the decision. This problem-solving tool mainly focuses on three of the major cost components that need to be understood thoroughly for an effective analysis:

·         Relevant Cost – The costs and revenues that are different amongst the alternatives as against those that remain same, are called relevant costs (or relevant benefits). For example, say you have to decide whether to buy a new piece of machinery or get the existing one repaired. Here, the insurance and maintenance costs would be different hence relevant; whereas the revenue earned from its operation might be the same therefore, non-relevant.

·         Sunk Cost – Costs that have already been incurred and have no impact on the decision making process are called sunk costs and these are never relevant. Some examples of sunk costs are advertising expenses, investing in an asset that fails to earn returns, product research expenses etc.

·         Opportunity Cost – This is the cost of losing a potential benefit from another alternative when you made a choice and these are necessarily relevant costs. For example, you decided to buy a vacant land in the suburbs instead of investing in a commercial complex in the city. The income that you could have earned by leasing out the commercial space becomes your opportunity cost.

The main aspect of incremental analysis is to correctly identify the relevant costs and revenues between the various options at hand and use them to arrive at the decision. Once you have identified and separated them into variable and fixed costs, you can quickly solve the problem and make an ‘informed’ decision.

Most often managers spend a lot of their precious time in studying all the data available on the different choices, relevant or not. This leads to unnecessary wastage of productive time that they could have effectively used elsewhere. Since the non-relevant costs have no play in the final outcome of a decision, it doesn’t make business sense to examine them.

By using Incremental Analysis, managers can focus on the relevant costs to arrive at short-term business/financial decisions quickly and more effectively.

You can use this simple approach to make decisions that fall under various categories such as:

• Special order decisions – While deciding whether to accept special orders with lower than normal rates in order to book short-term profits
• Limited resource decisions – On choosing a product from a range of products for allocating limited resources to its development or production
• Make or buy decisions – When you must decide whether to manufacture a product or develop software in-house or procure it from an outside supplier
• Sell, scrap or rebuild decisions – Would you sell a product with its existing features and capture the market, scrap the obsolete products with minimal loss or invest more on enhancing its features?

Steps Involved in Incremental Analysis

Note: As stated earlier, incremental analysis uses only the relevant costs and ignores the non-relevant costs. The costs and revenues that remain same are non-relevant whereas the costs and revenues that change across alternatives are relevant and must be considered.

• Step 1 – Compare the revenues that are possible under both the alternatives, eliminate the revenues that are non-relevant and list the revenues that are relevant. Determine the incremental revenue here.
• Step 2 – Now repeat the above exercise for the costs that you will incur under both the alternatives. Keep the relevant costs (like opportunity cost) and do away with the non-relevant costs (like sunk costs). Determine the incremental cost here.
• Step 3 – Differentiate the relevant costs into fixed and variable costs and arrive at the difference amount (you will find that this is actually the incremental cost savings)
• Step 4 – Finally tabulate the incremental revenue, incremental cost and incremental cost savings, sum up all the amounts and find out the most profitable choice among the alternatives available. If the incremental revenues are more than the incremental costs, then the profits would increase whereas if the revenues are lower than the costs, the profits would decrease.

Here are some examples of incremental analysis:

• Accepting additional business.
• Making or buying parts or products.
• Selling products or processing them further.
• Eliminating a segment.
• Allocating scarce resources (sales mix).