What it means
Incremental cost answers a narrow question precisely: if activity moves from here to there, how much more will we spend. Because it measures a change rather than an average, it is usually far lower than the full cost per unit shown in a costing system.
That difference is the whole point, and it is why average cost is a poor guide to decisions about extra volume. The term is close to marginal cost, which strictly means the cost of one more unit, while incremental cost is usually applied to a block of extra activity such as 2,000 units or a new customer contract.
In everyday business use the two are treated as near-synonyms. Both exclude costs that do not move.
Incremental cost is not always smooth, and step costs are where the concept earns its keep. Up to a capacity limit the extra cost per unit may be purely materials and energy, but crossing that limit can require a second shift supervisor, another vehicle or a larger machine.
The incremental cost of the units just past a step is much higher than of those just before it. The main business use is pricing and capacity decisions.
Knowing that an extra unit costs $15 rather than the $26 average tells a sales manager how far a price can be discounted on marginal business before it destroys value. It also shows where the true capacity constraint sits, which is often not where the costing system implies.
The important caution is that incremental cost is a short-run measure. Over time, capacity is added, overheads grow with the business and every cost becomes variable, so a business that prices everything at incremental cost will fail to cover its fixed base.
Use it for decisions at the edge, not for the core price list.
In practice
Real-world examples
Example 1
A hosting company works out that each additional user account costs about $0.90 a month in storage and compute. Because the subscription is $29 a month, incremental cost is almost irrelevant to pricing, and the real constraint is the cost of acquiring the customer. Management shifts its attention to marketing efficiency instead.
Example 2
A bakery calculates that an extra tray of 50 sourdough loaves costs $45 in flour, energy and packaging, or $45 / 50 = $0.90 a loaf, since the oven and the baker are already paid for. At a retail price of $3.20 the tray adds 50 x $3.20 = $160 of revenue and $160 - $45 = $115 of contribution. The bakery adds a second tray on Saturdays.
Example 3
A consultancy considers hiring a junior analyst at a fully loaded cost of $68,000 a year. She is expected to bill 900 hours at $110, or 900 x $110 = $99,000, giving an incremental gain of $99,000 - $68,000 = $31,000. The partners hire, on the condition that pipeline supports the billing assumption.
Think of it
Imagine you are driving a car on a road trip and deciding whether to take a scenic detour. The fuel you already burned to get this far is history. The incremental cost is just the extra petrol and time needed for the detour itself.
Formula
Calculation
Incremental cost = Total cost at the higher activity level - Total cost at the current activity level, and the per-unit figure is that amount divided by the extra units.
A components factory currently produces 10,000 units at a total cost of $260,000, an average of $260,000 / 10,000 = $26.00 per unit. A costed plan for 12,000 units shows a total cost of $290,000. The incremental cost of the extra 2,000 units is $290,000 - $260,000 = $30,000, or $30,000 / 2,000 = $15.00 per additional unit. An export enquiry for those 2,000 units at $22.00 each therefore adds revenue of 2,000 x $22.00 = $44,000 against $30,000 of extra cost, an incremental gain of $44,000 - $30,000 = $14,000. Judged on the $26.00 average the same order would have looked like a loss of 2,000 x ($26.00 - $22.00) = $8,000 and would have been refused. Beyond 12,000 units a step cost appears: a second shift supervisor at $4,000, so a further 1,000 units would cost 1,000 x $15.00 + $4,000 = $19,000, or $19.00 per unit rather than $15.00.Case study
Seen in the real world
Pennyworth Laundry Services is a fictional commercial laundry, presented here as an illustrative example of incremental thinking. A hotel offered a contract for 1,800 kg of linen a week at $1.85 per kg, giving weekly revenue of 1,800 x $1.85 = $3,330. The company's costing system showed a full cost of $2.05 per kg, which implied a loss of $0.20 per kg, or 1,800 x $0.20 = $360 a week, and the operations manager was ready to decline.
The incremental picture was different because the machines already ran below capacity. Detergent, water and energy came to $0.62 per kg, or 1,800 x $0.62 = $1,116, extra part-time labour cost $640 a week and an additional delivery run cost $240, so total incremental cost was $1,116 + $640 + $240 = $1,996. Weekly incremental profit was $3,330 - $1,996 = $1,334, or roughly $69,000 over a full year.
The company accepted, but wrote a note into its planning file that the next contract would push volume past the capacity of its existing washer and van, adding about $1,100 a week of step cost. Any further work would have to clear that hurdle before it was worth taking, and utilisation was reviewed monthly from then on.
Watch out
Common mistakes
- Using the average cost per unit to judge extra volume, which usually overstates the cost of the additional work.
- Ignoring step costs, so an order that looks profitable at $15 a unit actually triggers a new supervisor, vehicle or machine.
- Applying incremental cost to all pricing, which leaves fixed overheads unrecovered and the business unprofitable overall.
Questions
People also ask
Is incremental cost the same as variable cost?
Not quite, because incremental cost includes any newly incurred fixed or step costs specific to the decision, while variable cost only moves with volume.
How do I find the incremental cost in my own business?
Cost the whole operation at the current level and again at the proposed level, then take the difference rather than trying to build it up line by line.
Does incremental cost include depreciation?
Only if the decision causes new equipment to be bought or existing equipment to wear out faster, otherwise existing depreciation is unaffected and irrelevant.