Incremental Analysis

What it is

Incremental analysis (also called marginal analysis, differential analysis, or the relevant cost approach) is a decision-making tool that compares the additional costs and benefits of alternative business actions. It focuses only on costs and revenues that change as a result of the decision and ignores sunk (past) costs.

Core principles

• Consider only relevant (incremental) costs and incremental revenues — those that will change because of the decision.
• Exclude sunk costs — expenses already incurred and unaffected by the choice.
• Include opportunity costs — the value of the best alternative forgone when selecting one option.
• Break relevant costs into variable and incremental fixed costs (e.g., new equipment, overtime).

Common uses

Incremental analysis guides many tactical and operational decisions, such as:
* Accepting or rejecting special orders
* Make-or-buy (produce in-house vs outsource)
* Continue, modify, or discontinue a product line or service
* Sell a product as-is or process it further
* Allocate scarce resources among product lines
* Repair, replace, or scrap assets

Example

A company sells an item normally for $300. Per-unit costs:
* Direct labor: $125
Materials: $50
Variable overhead/selling expenses: $25
* Allocated fixed overhead: $50 (sunk for this decision)

A special order requests 15 units at $225 each. The firm has excess capacity, so no additional fixed costs are required.

Relevant cost per unit = 125 + 50 + 25 = $200
Profit per unit on the special order = 225 − 200 = $25
Total profit on the order = 15 × $25 = $375

If the firm lacked excess capacity, additional incremental costs (new equipment, overtime) and opportunity costs (lost regular sales) must be included before accepting the order.

Benefits

• Highlights true incremental financial impact of choices
• Helps allocate limited resources to maximize profit
• Strips irrelevant information, simplifying decisions
• Supports faster, more focused analysis for tactical choices

Limitations

• Relies on accurate estimates of incremental costs and revenues
• May overlook nonfinancial factors (brand reputation, customer relationships)
• Short-term focus can miss long-term strategic consequences
• Capacity constraints and interdependencies can complicate simple comparisons

Key takeaways

Incremental analysis is a practical method for comparing alternatives by looking only at costs and benefits that change with the decision. When applied carefully — including opportunity costs and excluding sunk costs — it helps managers make better short-term operational choices.