The incremental concept is closely related to the marginal costs and marginal revenues of economic theory. Incremental concept in managerial economics involves two important activities which are as follows:
- Estimating the impact of decision alternatives on costs and revenues.
- Emphasizing the changes in total cost and total cost and total revenue resulting from changes in prices, products, procedures, investments or whatever may be at stake in the decision.
The two basic components of incremental reasoning are as follows:
- Incremental cost: Incremental cost may be defined as the change in total cost resulting from a particular decision.
- Incremental revenue: Incremental revenue means the change in total revenue resulting from a particular decision.
The incremental principle may be stated as under:
A decision is obviously a profitable one if;
- It increases revenue more than costs
- It reduces costs more that revenues.
- It decreases some costs to a greater extent than it increases other costs
- It increases some revenues more than it decreases other revenues
Some businessmen hold the view that to make an overall profit, they must make a profit on every job. Consequently, they refuse orders that do not cover full cost (labor, materials and overhead) plus a provision for profit. Incremental reasoning indicates that this rule may be inconsistent with profit maximization in the short run. A refusal to accept business below full cost may mean rejection of a possibility of adding more to revenue than cost. The relevant cost is not the full cost but rather the incremental cost.
A simple problem will illustrate this point.
Suppose a new order is estimated to bring in additional revenue of 5,000 $. The costs are estimated as under:
|Overhead (Allocated at 120% of labor cost)|
|Selling administrative expenses|
|(Allocated at 20% of labor and material cost)|
The order at first appears to be unprofitable. However, suppose, if there is idle capacity, which can be, utilised to execute this order then the order can be accepted. If the order adds only 500$ of overhead (that is, the added use of heat, power and light, the added wear and tear on machinery, the added costs of supervision, and so on), 1,000$ by way of labour cost because some of the idle workers already on the payroll will be deployed without added pay and no extra selling and administrative cost then the incremental cost of accepting the order will be as follows.
|Total Incremental Cost|
While it appeared in the first instance that the order will result in a loss of Rs. 1,000, it now appears that it will lead to an addition of 1,500$ (5,000$- 3,500$) to profit. Incremental reasoning does not mean that the firm should accept all orders at prices, which cover merely their incremental costs. The acceptance of the 5,000$ order depends upon the existence of idle capacity and labor that would go underutilized in the absence of more profitable opportunities. Earley’s study of “excellently managed” large firms suggests that progressive corporations do make formal use of incremental analysis. It is, however, impossible to generalize on the use of incremental principle, since the observed behavior is variable.
Credit: Managerial Economics-MGU