How Do I Do an Incremental Analysis?

An incremental analysis is done to determine the financial differences between choices businesses can make. Revenue, costs and savings are calculated and taken into account as a whole for each option, and the options are compared. The amounts must be relevant, or directly linked to one of the decisions, in order to be included in an incremental analysis. Analyzing the different options in terms of revenue, costs or savings alone often yields an incomplete picture as compared to looking at the effects of choices across all three areas.

When business managers conduct an incremental analysis, they will typically separate irrelevant and relevant costs. Fixed costs are often considered to be irrelevant since the company will incur them regardless of which choice is selected. For example, the choice may be to use an existing production facility to produce "Product A" versus "Product B." The rent of the production facility is irrelevant, while the projected revenue for each product is relevant.

Changes in the amount of revenue that different alternatives will generate are what should be considered in an incremental analysis. If manufacturing "Product A" results in $30,000 US Dollars (USD) of gross revenue versus $40,000 USD of gross revenue when the product is purchased, the incremental change would be $10,000 USD. Purchasing the product versus manufacturing it in-house provides the company with $10,000 USD additional gross revenue. An incremental analysis, however, does not usually look at just one variable, but rather several that will directly affect the bottom line.

For instance, if purchasing "Product A" results in an increase in variable costs that exceed the costs of producing it in-house, this may affect a manager's decision. Assuming the variable costs for the company to make the product itself are $10,000 USD and the costs to purchase it are $30,000 USD, the incremental net revenue is now in favor of in-house production as the higher variable costs of purchasing the product outweigh the higher gross revenue. Subtracting the costs for production versus manufacture from the gross revenue for each, shows that the company would reap $10,000 USD more in profit if it continues to manufacture its own product.

In addition to changes in costs that may occur as a result of a decision, a manger should also consider any cost savings. This includes any costs that a decision eliminates. For example, if a manager's decision is to choose between raw material suppliers, some of those costs may include volume discounts. One supplier may offer a certain percentage discount for a particular volume level, while the other may not.

Assuming that the company will consistently order from the supplier at the volume that qualifies for the discount, this savings amount would be factored into the incremental cost analysis. In addition to cost savings, any opportunity costs should be figured into an incremental analysis. An opportunity cost is the amount that is lost from choosing one option over the other. Examples of opportunity costs include revenue from accepting a new line of business and revenue from producing raw materials.