What Is the Significance of Incremental Cost?

Malcolm Tatum

Also known as marginal cost, incremental cost has to do with the change in cost that a company experiences when making a decision to produce one additional unit of a good or service. Identifying this marginal cost is very important, since doing so can help company officers decide if that additional production is really in the best interests of the company. Depending on the actual amount of that incremental cost, the company may be able to increase production and enjoy a lower cost per unit produced that yields more profit per unit sold. At the same time, assessing the revised total cost of production may indicate that less profit is made off each unit produced, effectively making the effort of less value.

Incremental costs matter in decisions related to production.
Incremental costs matter in decisions related to production.

Calculating incremental cost requires understanding all additional expenses that are involved in the process of creating one additional unit of a product. By properly accounting for any increased expenses, it is possible to decide if the effort will benefit the business or actually be detrimental. For example, if the incremental cost indicates that the additional production actually increases the expense associated with the manufacturing of each unit of a good, that means less profit is made off each unit that is sold at the current price. If the demand for the product would decrease due to a price increase, this means that producing that extra unit could reduce overall revenue generation as well as net profits. When this is the case, keeping production at the same level for the present time would be the best approach for that business.

Using the incremental cost as a guideline can also provide the motivation to increase production under certain circumstances. This is true when that cost is found to be so low that producing an extra unit actually decreases the average cost of production for all the units. When this is the case, the company is able to manufacture more units at a lower cost, making it possible to sell those units at the same price but generate more profit from each unit sold. When this is the case, the incremental cost paves the way for the business to take advantage of higher demand in the marketplace and make more money.

Since so many of the expenses that must be considered in order to determine incremental cost can change, taking the time to recalculate this marginal cost on a regular basis is a good idea. Shifts in the economy, increases or decreases in the cost of raw materials, and even changes in the demands of consumers will have some impact on that incremental cost. By assessing the cost from time to time, a company can adjust production to fit the most current economic situations, prepare for future changes, and increase the chances of staying in business even during adverse economic periods.

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