Meaning and definition of Incremental Cost
Incremental cost can be defined as the encompassing changes experienced by a company within its balance sheet because of one additional unit of production. This is also referred as ‘marginal cost’. However, the incremental cost cannot always be the same as the average cost per unit due to different (fixed and variable) costs involved. Moreover, the incremental cost is always made up of purely variable costs. It characterizes the added costs that might not exist if an extra unit was not produced.
A very simple example of incremental cost would be a factory producing widgets where it takes one employee an hour to produce one widget. As a simple figure, the incremental cost of a widget would include the wages for an hour in addition to the cost of materials used in production of a widget. A more exact figure could comprise added costs, like electricity consumed if the factory had to stay open for a longer duration, or the cost for shipping the additional widget to a consumer.
Calculating Incremental Cost
Calculating the incremental cost is helpful for the business to determine their proper production amounts. The key steps involved in computation of the incremental cost are:
1. Review the formula for incremental cost (changing from producing one product to producing two products) – Total cost of producing two – total cost of producing one = incremental cost.
2. Determine the amount incurred as the cost of producing one good. This consists of all variable costs of production including labor, inventory, and any other expenses involved with the cost of producing one item. Let us assume the cost of producing one good be $500.
3. Determine the cost of producing two items. Due to economies of scale, it might cost less in producing two items than what was incurred in producing each one separately. Let us assume that it costs 950 for producing two items simultaneously.
4. Estimate the incremental cost by computing the difference between the two figures. The result is: total cost of producing two ($950) – total cost of producing one ($500) = $450. This is the incremental cost between production of one item and two items.