Incremental Cost

incremental cost

Change in cost caused by a given managerial decision profit contribution

Profit before fixed charges

Incremental cost is the change in cost caused by a given managerial decision. Whereas marginal cost is the change in cost following a one-unit change in output, incremental costs typically involve multiple units of output. For example, incremental costs are the relevant consideration when an air carrier considers the cost of adding an additional departure from New York's La Guardia Airport to upstate New York. When all current departures are full, it is impractical to consider adding a single passenger-mile unit of output. Similarly, the incremental cost concept comes into play when judging the costs of adding a new product line, advertising campaign, production shift, or organization structure.

Inappropriate managerial decisions can result when the incremental concept is ignored or applied incorrectly. Consider, for example, a commercial real estate firm that refuses to rent excess office space for $750 per month because it figures cost as $1,000 per month—or incremental operating costs of $150 plus interest and overhead charges of $850. If the relevant incremental cost is indeed only $150 per month, turning away the prospective renter causes a $600 (= $750 - $150) per month loss in profit contribution, or profit before fixed charges. Interest and overhead charges will be incurred irrespective of whether the excess space is rented. By adding the prospective renter, the landlord has the same interest and overhead expenses as before, plus $600 in added revenues after incremental operating expenses. The net effect of rejecting such a renter would be to reduce profit contribution and net profits by $600.

Care must be exercised to ensure against incorrectly assigning a lower than appropriate incremental cost. If excess capacity results from a temporary reduction in demand, this must be taken into account. Accepting the $750 per month renter in the previous example is a mistake if doing so causes more profitable renters to be turned away. When excess capacity is caused by a temporary drop in demand, only short-term or month-to-month leases should be offered at the bargain price of $750 per month. In this way, pricing flexibility can be maintained while the net cost of temporary excess capacity is minimized. In any event, all incremental costs, including those that might be incurred in the future, must be considered.

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