Incremental cost is the cost associated with increasing production by one unit. Because some costs are fixed and other variable, the incremental cost will not be the same as the overall average cost per unit. The cost figure can be used for a variety of economic calculations, most notably the point at which increasing production ceases to be efficient.
A very simple example would be a factory making widgets where it takes one employee an hour to make a widget. As a simple figure, the incremental cost of a widget would be the wages for the employee for an hour plus the cost of the materials needed to produce a widget. A more accurate figure could include added costs, such as shipping the additional widget to a customer, or the electricity used if the factory has to stay open longer.
The incremental total is always made up of purely variable costs. It represents the added costs that would not exist if the extra unit was not made. That means that many fixed costs such as rent on a factory or buying a machine are not usually represented. However, if an economist wanted to be extremely precise, they might include some element of these fixed costs where they could specifically link them to the production of the extra unit. For example, producing even one extra widget would cause a tiny bit extra wear and tear on the machine.
In many cases, the average cost of a unit will be higher than the incremental cost. This is because the average cost takes account of fixed costs. For example, if a company spends a set sum on machines each year, this cost will be represented in the average cost of each unit produced on those machines. It will not be included in the cost because producing one extra unit does not require any more spending on buying machines. Where this happens, the incremental expense is lower than the existing average cost and thus increasing production by one unit slightly lowers the average cost: this is known as economy of scale.
This is not always the situation, however. In most situations there will eventually come a point where increasing production gives an incremental cost which is higher than existing average cost. Perhaps the most common example would be where a factory’s workforce is working to full capacity. Adding just one more unit to output would either require paying overtime or spending money on recruiting new staff. In this situation, the incremental cost is higher than the existing average cost and thus drives the average cost upwards.