# Incremental Analysis: Definition, Types, Importance, and Example

![Incremental Analysis](https://www.investopedia.com/thmb/gJiOyYxk1nlBtBodphi-JRH61Wg=/1500x0/filters:no_upscale():max_bytes(150000):strip_icc()/IncrementalAnalysisV1-deb2566b68c246c7b53c076fd9c4032a.jpg)

*Businesses use incremental analysis to choose between different choices. — Investopedia / Jake Shi*

> **Definition**
>
> Incremental analysis is a problem-solving method to compare the cost differences between different business options.

## What Is Incremental Analysis?

Incremental analysis is a decision-making tool used in business to find the most profitable choice among alternative opportunities. Also called [marginal analysis](https://www.investopedia.com/articles/economics/08/understanding-microeconomics.asp), the relevant cost approach, or differential analysis, incremental analysis disregards any sunk cost (past cost) to focus on ongoing expenses and opportunity costs.

Incremental analysis is useful when a company works on its business strategies, including the decision to self-produce or outsource a process, job, or function.

### Key Takeaways

*   Incremental analysis helps to determine the cost implications of various business opportunities.
*   It is also known as marginal analysis, the relevant cost approach, and differential analysis.
*   Non-relevant sunk costs, or past costs, are not included in the analysis.
*   Incremental analysis also assists with allocating limited resources to product lines to ensure a scarce asset is used to maximum benefit.

## Understanding Incremental Analysis

Incremental analysis is a problem-solving method that applies accounting information—with a focus on costs—to strategic decision-making.

The use of incremental analysis can help businesses identify the potential financial outcomes of one business action or opportunity compared to another. With that information, management can make better-informed decisions that can affect profitability.

### Relevant Versus Non-Relevant Costs

Relevant costs (also called incremental costs) are incurred only when a particular activity has been initiated or increased.

Non-relevant, [sunk costs](https://www.investopedia.com/terms/s/sunkcost.asp) are expenses that already have been incurred. Because the sunk costs are present regardless of any opportunity or related decision, they are not included in incremental analysis.

Incremental analysis models include only relevant costs, and typically these costs are broken into variable costs and fixed costs.

Incremental analysis also considers [opportunity costs](https://www.investopedia.com/terms/o/opportunitycost.asp)—the financial implications of a missed opportunity when choosing one alternative over another—to ensure that a company is aware of and can pursue its most favorable option.

## Uses for Incremental Analysis

*   Incremental analysis helps companies decide whether or not to accept a special order. A special order product is typically priced lower than the item's normal selling price.
*   Incremental analysis also assists with allocating limited resources to several product lines to ensure that a scarce asset is used to maximum benefit.
*   Decisions on whether to produce or buy goods, scrap a project, or rebuild an asset call for incremental analysis of the opportunity costs.
*   Incremental analysis also provides insight into whether a good should continue to be produced or sold at a certain point in the manufacturing process.

> **Important**
>
> Companies use incremental analysis to decide whether to accept additional business, make or buy products, sell or process products further, eliminate a product or service, and decide how to allocate resources.

## Example of Incremental Analysis

The Acme company sells a particular item for $300. The company pays $125 for labor, $50 for materials, and $25 for variable overhead selling expenses. The company also allocates $50 per item for fixed [overhead costs](https://www.investopedia.com/articles/personal-finance/011216/economics-owning-bar.asp).

The company is not operating at capacity and will not be required to invest in equipment or overtime to accept any special order that it may receive. Then, a special order arrives requesting the purchase of 15 items at $225 each.

The sum of all variable costs and fixed costs per item is $250. However, the $50 of allocated fixed overhead costs are a sunk cost and are already spent. The company has excess capacity and should only consider the relevant costs. Therefore, the cost to produce the special order is $200 per item ($125 + $50 + $25). The profit per item would be $25 ($225 - $200).

While the company is able to make a profit on this special order, the company must consider the ramifications of operating at full capacity.

If no excess capacity is present, additional expenses to consider include investment in new fixed assets, overtime labor costs, and the opportunity cost of lost sales.

> **Fast Fact**
>
> Incremental analysis only focuses on the differences between particular courses of action. These differences—not the similarities—form the basis of the analysis comparison.

## What Is the Benefit of Incremental Analysis?

A primary benefit of its examination of costs is that it can help a business make the best use of available resources and maintain a focus on profitability.

## What Costs Does Incremental Analysis Involve?

It examines relevant costs and opportunity costs. It also takes into account sunk, or non-relevant costs, and excludes those from analysis.

## What's a Limitation of Incremental Analysis?

One aspect that companies must be aware of is the potential for cost assumptions to be wrong. Every effort must be made to make correct cost estimates so that the choice of an opportunity that a business ultimately makes doesn't affect the company negatively.

## The Bottom Line

Incremental analysis is a crucial decision-making tool that can help businesses better understand their costs, utilize resources efficiently, and maximize profit.

Its focus on true costs, including opportunity costs, and its stripping away of irrelevant information, can reveal in a less effort-intensive amount of time the most cost-effective options for companies to choose from to reach important financial goals.