How to Use Incremental Analysis for Business Decisions
Updated September 30, 2022
Decision-making is a crucial aspect of management that helps determine the sustenance of any business. Businesses often use incremental or marginal analysis to decide on a viable option between two or more alternatives. Learning about marginal analysis can help you understand how a company makes decisions that help it stay operational. In this article, we define incremental analysis, explain the relationship between it and types of costs, explore the types of marginal analysis decisions, highlight the steps to calculate it, discover benefits, and give two examples.
What is incremental analysis?
Incremental analysis, relevant cost approach, marginal analysis, or differential analysis is a comparative business decision-making technique by management and executives. It involves comparing the differences between multiple alternatives to select the most cost-effective one. The technique uses a true cost approach, which means it only considers the costs that directly impact the selection of one option over the other. This analysis incorporates accounting information into the decision-making process, enabling a business to understand each alternative's potential outcomes sufficiently.
Relationship between marginal analysis and relevant, sunk, and opportunity costs
Marginal analysis uses the true cost approach to ignore all non-relevant costs to a business's decision. Below are the types of costs that this analysis considers important:
Relevant or differential costs are the expenses that vary between selected alternatives. These costs are typically for decisions the business hasn't made, so you may also refer to them as avoidable costs because they can avoid them.
For example, suppose an airline decides to sell a ticket to an individual for a plane that's about to depart. The relevant costs include the labour for their luggage and their food mid-flight. These are the only costs that change between accepting and rejecting the passenger. The business has already incurred other costs, such as fuel, salary, and airport gate fees. Relevant costs are typically incremental and result in a change in cash flow. This concept also only applies to management accounting, where it aids in decision-making and not financial accounting.
In applying the marginal analysis technique, a business considers all relevant costs while ignoring those that don't change with respect to the alternative that it chooses. For example, the business doesn't consider sunk costs because these are expenses they've already incurred. If an airline sells an additional ticket to an individual right before a plane departs, sunk costs include fuel, salary, and airport gate fees for which the airline has already paid. If a business incurs the same expenses for both alternatives, it can also ignore this to obtain a focused analysis.
Opportunity costs are the benefits that a company loses for choosing one alternative over the other. It shows the business's loss to make a gain or the loss of one gain for another. For example, a furniture manufacturing company decides to produce coffee tables in-house rather than outsourcing. The opportunity cost of this decision might be the decrease in the production capacity of dining tables, which the company also makes.
Types of marginal analysis decisions
Management uses marginal analysis for several decisions. They use it to decide whether to accept special orders, which are unusual requests from customers. These orders typically require special processing or involve a request for a lower price than the normal selling price. Other types of business decisions that a business can use marginal analysis for are:
Retaining production in-house or outsourcing it
Selling assets immediately or later
Assigning tasks to in-house personnel or outsourcing them
Selling a product in its present condition or keep processing it to sell it later
Allocating resources between multiple options
How to calculate marginal analysis
The steps below highlight how to calculate marginal analysis:
1. Determine the relevant costs and revenues
First, identify the options between which you want to make a decision. After understanding these options, determine the relevant costs and revenues. These costs can be variable or non-variable between options. Ensure you don't include any non-relevant or sunk costs in your calculation to help ensure the accuracy of your analysis. You may also determine the revenue you expect to receive for each option and identify any opportunity costs.
2. Add all costs and revenues
Consider checking your costs to confirm they're complete. Additional costs that are also important include overtime labour costs and investment in new assets. Gather these costs and add them together. You can then add or subtract the opportunity costs based on how they impact the calculation. Repeat these steps for all the chosen options individually.
3. Compare both options and decide
You can now compare the results of your calculations against a set price. For example, you may compare your results against the revenue you expect to receive for selling each item or against the cost of hiring a new employee. With this, you may understand which outcome is better financially.
Benefits of marginal analysis
Marginal analysis may provide a business with many benefits, including:
Helps determine business costs: Marginal analysis helps a business understand what costs are relevant to an important business decision.
Helps make profitable decisions: Businesses use this technique to analyze multiple profitable options. They can select the best one to improve their profit margins or reduce their operating costs.
Helps utilize resources effectively: Marginal analysis enables businesses to understand which decision encourages the maximum utilization of resources.
Examples of marginal analysis
Below are various examples to help you understand how to apply the marginal analysis concept:
Manufacturing goods in-house or assigning them to an external party
This example shows how a business decides whether to outsource production or perform it in-house:
Comfort Rest Furnishings is a company that makes home furniture for businesses and individuals. The company wants to calculate the marginal analysis to decide whether to produce a new line of sofas in-house or outsource the production. They estimate their expected revenue from each sofa to be $400. They also estimate the cost of in-house production to be $120 for material, $60 for labour, and $80 for overhead costs on each sofa. Making the sofas in-house reduces their production capacity for coffee tables, which the company also makes, by about $50 for every sofa.
Outsourcing costs about $100 for material, $60 for labour, and $100 for shipping. To obtain the costs of producing a sofa, they added all the relevant costs, $120 + $60 + $80, to obtain $260. After adding the opportunity cost to this, the resulting value became $310. They also added the outsourcing costs, $100 + $60 + $100, to obtain $260. They subtracted both costs from the expected revenue to determine the most profitable option, giving $90 for in-house production and $140 for outsourcing. The company decides to outsource the production for two reasons. The profit margins are higher, and they can use their resources for other products.
Accepting a special order request from a customer or rejecting it
This example shows how a business may accept a special order request from a customer:
Bey Horizons in Toronto, Ontario produces books to deliver to customers. A retail company recently ordered 1000 pieces of a particular type of book at $6 each. The company decides to use marginal analysis to determine whether to accept or reject the order. It checked the standard cost of producing the book and saw that it costs $8. Of this $8, $5 is a variable cost, and $3 is a fixed cost.
The business knows that the fixed cost is a sunk expense, and it incurs it irrespective of the sale, so it decides to ignore it. That means the incremental cost of the book is $5. The business decides to accept the order because it earns $1 for each sale. Multiplying the $1 by 1,000 gives a $1,000 profit.
Choosing between repairing or replacing an asset
This example clarifies how a company may choose between buying an asset new or replacing a broken one:
Future Homes Construction Company is a contractor on different construction projects around the country. One of its excavators broke, so it decided to use marginal analysis to determine whether to replace it or buy a new one. To repair the old machine, the repairer quoted them $4,000 for the parts and $500 for labour. The company added $1,000 for the opportunity cost, which is the lost business while the machine is in the repair shop. The total relevant cost for repairing the machine is $5,500.
Buying a new machine may cost the business $50,000 and an additional $2,000 of opportunity cost for a total of $52,000. The business decides to replace the machine due to the substantial difference in the costs for both options.
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