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What is Incremental Analysis?

Incremental analysis is a financial decision-making tool that evaluates the costs and benefits of alternative choices, focusing on the changes in revenue and expenses. By comparing the financial impact of these options, businesses can make informed decisions that maximize profits. Wondering how this approach can optimize your business strategy? Let's explore the potential of incremental analysis together.
James Corey
James Corey

Incremental analysis is a technique used to assist decision making by assessing the impact of small or marginal changes. Its origins are linked to the principles of marginal analysis derived by economists such as Alfred Marshall during the nineteenth century. Given this heritage, incremental analysis is also described as a procedure to assist decisions at the margin.

The most important principle of incremental analysis is that the only items relevant to a decision are those that will be different as a result of the decision. A second and related tenet is that if a past cost or negative is not recoverable or removable, it is irrelevant to a future decision. Those two principles have universal application. This style of analysis guides many decisions in nearly every discipline including engineering, architecture, management, epidemiology, medicine, demography, sociology, consumer behavior, and investment management.

A manufacturing firm deciding to accept new revenue in the form of a small order typically needs to identify which costs will change if the order is accepted.
A manufacturing firm deciding to accept new revenue in the form of a small order typically needs to identify which costs will change if the order is accepted.

Incremental analysis is applicable to both short- and long-run issues, but is particularly suited to short-run decisions. In the short run, production capacity remains unchanged so, by definition, fixed costs do not vary due to capacity shifts. In the long run, production capacity is changeable; more elements will thus generally be required to be incorporated into an incremental analysis.

A simple situation in everyday life provides an example of incremental analysis. Consider a worker leaving work to travel home. Groceries are required and can be purchased at slightly higher prices at a store on the way from the work place to the home, or at lower prices by driving to a store 3 miles (4.82 km) from home. The worker decides to purchase the groceries on the way home since no incremental travel costs are involved, and the incremental difference in grocery prices will be less than the value the worker places on the time and other costs required to drive to the more distant store.

In business, firms routinely use incremental analysis to assist a large range of decisions, including leasing versus purchasing of new assets, acquisitions and divestments, capacity expansions and additional raw material processing decisions. A key issue usually is determining the incremental impact on capital outlays, costs, and revenues. This is not always clear cut before the event and judgments are often required.

For example, a manufacturing firm deciding whether or not to accept new revenue in the form of a small order typically needs to identify which costs will change if the order is accepted. A large number of costs will remain fixed including lease payments, insurances, local government rates, cleaning costs, and telecommunication rental costs. Raw material costs will increase. The impact on factory labor costs, however, is not clear. They may remain the same if there is sufficient slack in the system; if not, new hires may need to be factored-in to the analysis.

Incremental analysis is sometimes referred to as incremental cost analysis, relevant cost analysis, or differential cost analysis. These terms may be confusing, since they suggest the technique is focused exclusively on costs, but this is incorrect.

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    • A manufacturing firm deciding to accept new revenue in the form of a small order typically needs to identify which costs will change if the order is accepted.
      By: onizu3d
      A manufacturing firm deciding to accept new revenue in the form of a small order typically needs to identify which costs will change if the order is accepted.