Incremental analysis is a way of evaluating the changes that occur in the variable costs of a company in the face of the different alternatives that affect them.
In this way, these incremental models focus on the costs of the company. In fact, for their study they are separated into fixed and variable, focusing on the latter. Thus, we will see what its main use is, how to do it and an example of a purchase of machinery.
Utility of incremental analysis
Incremental analysis helps the company to make decisions when it is necessary to know various alternatives. Thus, you can decide which of them is more beneficial or less expensive. On the other hand, by focusing only on relevant costs, the variables, it allows a better analysis.
Thus, some of the utilities could be the ones shown below.
- Know whether or not they accept a special request from a client.
- Know if they are interested in carrying out an investment in fixed assets.
- Decide on the correct allocation of resources, including human resources.
- Decide whether or not to sell a product or service and even if it is convenient to eliminate another.
How to perform incremental analysis
Let’s see how to perform the incremental analysis by steps. To finally clarify all this, in the last section we will propose an example.
- In the first place, we must know the accounting aspects of the matter analyzed. If we talk about sales, we must go to the income statement. If we study an investment in assets, to the balance sheet.
- In a second step, we must calculate the new sales or the new production with the paradigm shift. For this, we have to know how they will affect the variable related costs, since the fixed ones do not influence. You have to calculate the net cash flows (FNE).
- As a third step, it is necessary to find out the difference between these FNEs in each alternative. This difference should be expressed as a percentage and will be the increase.
Incremental Analysis Example
Let us imagine that the company wants to buy new machinery. To decide if it does, it’s going to compare the expected FNEs on the one it already has (0) and on two possible new machines (1 and 2) and then the difference between each in percentage.
We can verify that the two new machines have minor depreciations, since the old one is in worse condition. In addition, the incremental analysis shows us that the most appropriate, compared to the one we have, is the two with a higher percentage of difference.