Definition of Incremental Cost
An incremental cost is the difference in total costs as the result of a change in some activity. Incremental costs are also referred to as the differential costs and they may be the relevant costs for certain short run decisions involving two alternatives.
Note: Incremental costs may include more than the change in variable costs.
Example of Incremental Cost
Let's assume that a company has the following experience:
- Total cost of manufacturing 8,000 units of Product X is $320,000, or $40 per unit
- Total cost of manufacturing 10,000 units of Product X is $360,000, or $36 per unit
From the above information, we see that the incremental cost of manufacturing the additional 2,000 units (10,000 vs. 8,000) is $40,000 ($360,000 vs. $320,000). Therefore, for these 2,000 additional units, the incremental manufacturing cost per unit of product will be an average of $20 ($40,000 divided by 2,000 units). The reason for the relatively small incremental cost per unit is due to the cost behavior of certain costs. For example, when the 2,000 additional units are manufactured most fixed costs will not change in total although a few fixed costs could increase.