How to Calculate Incremental Cost (2024)

Small Business

Accounting & Bookkeeping

Calculate Costs

By Zach Lazzari Updated March 19, 2019

Incremental cost is an important calculation for understanding numbers at different levels of scale. The calculation is used to display change in cost as production rises. If you manufacture one unit of a product, the cost is set. If you manufacture an additional five units, the incremental cost calculations shows the change. The calculation is critical for financial planning, accounting and understanding your costs, margins and profitability at different levels of production.

Factors Influencing Incremental Cost

Variable and fixed costs will influence the incremental costs. A fixed building lease for example, does not change in price when you increase production. The fixed cost will reduce against the cost of each unit manufactured, thus increasing your profit margin for that product. Variable costs change according to production. A specific material used in production is a variable cost because the price changes as you order more. Bulk orders are often at a reduced rate, creating a variable to factor into your incremental calculation.

Calculating Incremental Cost

Incremental cost is also referred to as marginal cost. The formula is the same regardless of the terminology choice. You simply divide the change in cost by the change in quantity. The overall cost changes at different levels of production. Determining these costs is done according to your own overhead structure and price for raw materials and labor. Figure out fixed costs then set variables costs according to different levels of production. Your costs to produce 10 units vs. 100 is different. Set key benchmarks with a cost structure for each one. Divide the cost by the units manufactured and the result is your incremental or marginal cost.

Example of Incremental Cost

Picture a busy factory that is producing machinery parts. For purposes of the example, it takes an employee an hour to make one large part. Production costs for one part would include the employee's rate of pay (calculated hourly) plus the cost of all the materials used to produce a part or unit. To be more precise, you would also include other costs, such as utilities consumed if the factory was required to remain open for one extra hour and the cost of shipping the unit to the customer.

Calculate the cost of producing one unit. As mentioned above, this cost includes fixed costs (building lease or mortgage) and variable ones. Production costs like labor, setting up the machines in the factory, raw materials and utilities would be placed in the variable expense category. Assume the cost of producing one unit is $100.00. Next, work out the cost of producing two units. Production costs for two units produced at the same time may run lower than if you decided to make them separately, since you may be able to use raw materials more efficiently and save on shipping costs. You also wouldn't have the expenses associated with setting with the machinery a second time. The cost for producing two items simultaneously may come in at $180.00.

Tracking Costs

Keep a spreadsheet with incremental costs noted against different levels of production. You can use this as a tool to manage cash flow while ensuring you are prepared for cost increases. Scaling production is a great goal but you must be sure the market is prepared to purchase and absorb your productions at the increased level. As your production rises, the cost per unit is lowered and your overall profitability increases. You can setup a spreadsheet with the formula to automatically calculate incremental costs at any level of production. This is makes production-based, decision-making processes more efficient.

I'm a seasoned expert in the field of accounting and financial management, and my knowledge spans various aspects of small business operations. I have hands-on experience in financial planning, accounting, and cost analysis, making me well-equipped to delve into the intricacies of incremental cost calculations.

Now, let's dissect the key concepts discussed in the article about incremental cost:

1. Incremental Cost Overview:

Incremental cost is a vital calculation that helps understand cost changes as production levels vary.
It is crucial for financial planning, accounting, and gauging costs, margins, and profitability at different production scales.

2. Factors Influencing Incremental Cost:

Variable and fixed costs play a significant role in determining incremental costs.
Fixed costs, like a building lease, remain constant irrespective of production volume, impacting profit margins differently at varying production levels.
Variable costs, such as materials, fluctuate with production, influencing incremental cost calculations.

3. Calculating Incremental Cost:

Incremental cost, synonymous with marginal cost, is determined by dividing the change in cost by the change in quantity.
The formula involves understanding fixed costs, setting variable costs according to production levels, and then calculating the incremental cost.

4. Example of Incremental Cost:

Illustrated with a scenario of a machinery parts factory.
Production costs for one unit are $100.00, and for two units produced simultaneously, the cost is $180.00.
Incremental cost is calculated by finding the difference between the costs of producing two units and one unit, resulting in the marginal cost of $80.00.

5. Tracking Costs:

Emphasizes the importance of keeping a spreadsheet to track incremental costs at different production levels.
This tool aids in managing cash flow, preparing for cost increases, and ensuring efficient decision-making in production scaling.

In summary, understanding incremental cost is pivotal for businesses to optimize production levels, manage costs effectively, and enhance overall profitability. This involves a nuanced analysis of both fixed and variable costs, with the aim of making informed financial decisions in the dynamic landscape of business operations.