All businesses have many different types of casts and accountants and economists categorise these costs by different characteristics. An “incremental cost” is not the cost of an increment and the “marginal cost” is not the cost of a margin. They are expressions of the nature of certain costs and their behaviour. Analysis of these two types of costs helps companies fix their product prices and track changes in cost models.
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Incremental cost expresses an increase in total costs as a result of a specific decision. For example, a company may decide to switch its mail delivery from a cheaper to a more expressive courier service because of quality of service. Although the new contract may bring operational benefits, the total costs of the company will increase.
The marginal cost is the increase in total costs as a result of producing one more unit. Therefore the marginal cost. Excludes any fixed costs like cost of premises or payments for plant hire. The production of one more unit would require more power, but it would not alter any standing connection charges from the power company. The main element of marginal cost is the cost of raw materials.
Many accountants and financial analysts use the terms “marginal cost” and “incremental cost” interchangeably. Margin cost could be seen to be a subset of incremental cost as the increased cost from producing one more item is the result of a decision. Both cost models examine the effect of a business decision on the total costs of the business.
Incremental costs are not tied to output volumes like marginal costs. Tthe incremental cost does not aim to improve competitive pricing, which is one of the purposes of marginal costing. Instead, incremental costs express the increases in expenditure when a non-price driven decision is made.
Use of marginal costing
Marginal costing is also a method of pricing a product. For example, a company may be selling into a specific regional or national market, but have spare capacity. It wishes to break into a new market and realises that a low price will get them market share against established competition. In this case they could choose to price their goods in the new market, using marginal costs only. It uses the sales in its home market to cover all its fixed costs and makes the same profit on the discounted price in the new market, transport costs excluded. This is a common strategy for breaking into an export market. However, national governments, like the US, recognise the threat this practice poses to their domestic manufacturers. They label the practice “dumping” and impose import tariffs and fines to discourage it.
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