Incremental and marginal concepts are often used in business
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Incremental Cost Vs. Marginal Cost
Small Business
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Managing Employees
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Performance Evaluations
By
Jill Carpenter
Production efficiency studies drove the first efforts to standardize how costs are measured.
Accurate cost measurement is critical to properly pricing goods or services. Businesses with accurate cost measurement know whether they are making a profit on current goods and know how to judge potential investments, new products or other opportunities. Using the correct costing method for the opportunity is a primary focus of effective cost accounting and financial control. Incremental and marginal costs are two of the primary tools to evaluate future investment or production opportunities.
Fixed vs Variable Costs
Fixed vs variable, fully allocated, average, marginal and incremental, each of these cost definitions address the need to understand a different facet of production. Fixed costs do not vary with the number of units produced. Variable costs change with production. For example, the rent paid on a factory would be a fixed cost. The amount of oil used to maintain the machinery would be a variable cost, because it depends on how much the machinery is being used. These two costs are generally used to evaluate past performance or project expenses in the future. By contrast, marginal and Incremental costs are used to help management evaluate different potential future courses of action.
Incremental Costs
Incremental costs are associated with a choice and therefore only ever include forward-looking costs. Previously made purchases or investments, such as the cost to build a factory, are called “sunk” costs and are not included. The Incremental cost can include many different direct and indirect cost inputs depending upon the situation. However, only costs that will change as a result of the decision are to be included. When a factory production line is at full capacity, the incremental cost of adding another production line might include cost of the equipment, the people to staff the line, electricity to run the line and additional human resources and benefits.
Marginal Costs
Marginal cost is a more specific term, referring to the cost to produce one more unit of product or service. Originally used to optimize production, products with high marginal costs tend to be unique, labor intensive or at the beginning of a product life cycle. Low marginal cost items are often very price competitive. The classic example is the cost to print encyclopedias. It costs a lot to print the first encyclopedia. Research must be done, entries written, copy typeset. But it requires very little additional cost to print the 10,000th encyclopedia. Marginal cost may equal incremental cost when only one additional unit is being considered.