Incremental Analysis
Incremental Analysis and Relevant Costing are terms describing the same concept. They both focus on identifying and analyzing the costs that are relevant to a specific decision or alternative, and disregard irrelevant costs like sunk costs. In essence, they both aim to determine the true cost difference between options.
Here's a more detailed explanation:
- Incremental analysis: (also known as marginal analysis, differential analysis, or the relevant cost approach) is a decision-making tool that focuses on the difference in costs (and revenues) between alternative courses of action.
- Relevant costs: are costs that will change or be affected by the decision being made. They are also known as differential costs.
- Incremental analysis: uses relevant costs to compare different options and determine the best course of action.
- Both terms emphasize the importance of focusing on future, cash flow-related costs that will be affected by the decision, and ignoring past costs or irrelevant overhead allocations.
Discounted Cash Flow (DCF) analysis is commonly used in conjunction with Incremental Analysis.
Incremental cash flow analysis focuses on the additional cash flows generated by a specific investment, while DCF uses those incremental cash flows to determine the present value of future earnings.
Here's how they work together:
Incremental Analysis:Identify the project or investment's incremental cash flows. This includes the additional revenues, costs, and capital expenditures associated with the investment.
Discounted Cash Flow Analysis:
- Forecast Future Incremental Cash Flows: Project the expected incremental cash flows over the project's lifespan.
- Determine Discount Rate: Select an appropriate discount rate, often the company's cost of capital, which reflects the time value of money and the risk of the investment
- Calculate Present Value: Discount the future incremental cash flows back to its present value using the discount rate.
- Evaluate the Project: Calculate the Net Present Value by comparing the total present value of the incremental cash flows with the initial investment cost to determine if the project is financially viable.
Steps Involved in Incremental Analysis
Note: Incremental analysis uses only the relevant costs and ignores the non-relevant costs. The costs and revenues that remain same are non-relevant whereas the costs and revenues that change across alternatives are relevant and must be considered.
Step 1 – Compare the revenues that are possible under both the alternatives, eliminate the revenues that are non-relevant and list the revenues that are relevant. Determine the incremental revenue here.
Step 2 – Now repeat the above exercise for the costs that you will incur under both the alternatives. Keep the relevant costs (like opportunity cost) and do away with the non-relevant costs (like sunk costs). Determine the incremental cost here.
Step 3 – Differentiate the relevant costs into fixed and variable costs and arrive at the difference amount (you will find that this is actually the incremental cost savings)
Step 4 – Finally tabulate the incremental revenue, incremental cost and incremental cost savings, sum up all the amounts and find out the most profitable choice among the alternatives available. If the incremental revenues are more than the incremental costs, then the profits would increase whereas if the revenues are lower than the costs, the profits would decrease.
Based on the above mentioned steps, you can make faster, smarter and effective decisions. It’s as simple as that !
Incremental Analysis with Multiple Alternatives
Incremental analysis, also known as differential analysis, is a decision-making tool that focuses on the changes in costs and revenues that will occur as a result of choosing one alternative over another. When you have multiple alternatives, the process becomes slightly more involved but follows the same core principles.
Here's how to approach incremental analysis with multiple alternatives:
1. Identify Alternatives:
Clearly list all the possible courses of action you are considering.
For example: If deciding between three potential projects, label them Project A, Project B, and Project C.
2. Determine Relevant Costs and Revenues:
For each alternative, identify the costs and revenues that are relevant to the decision.
Relevant costs are those that differ among the alternatives and are expected to occur in the future.
Irrelevant costs (e.g., sunk costs, costs that don't change) are ignored.
Consider both quantitative (e.g., cost of materials, labor) and qualitative factors (e.g., impact on company image).
Include opportunity costs, which represent the potential benefits forgone by choosing one alternative over another.
3. Create a Comparative Framework:
Organize the relevant costs and revenues for each alternative in a table or spreadsheet.
This will allow for a clear comparison of the financial implications of each option.
4. Perform Incremental Analysis:
Compare the alternatives incrementally, meaning pairwise comparisons.
Start by comparing the two lowest-cost alternatives and determine which is better based on the incremental costs and benefits.
Eliminate the inferior alternative and then compare the winner to the next lowest-cost alternative.
Continue this process until only one alternative remains.
Example:
Compare Project A vs. Project B. If B is better, eliminate A.
Compare Project B vs. Project C. If C is better, eliminate B.
Project C would be the preferred option.
5. Make a Decision:
Choose the alternative that provides the greatest net benefit (total benefits minus total costs).
Consider the qualitative factors and any potential risks associated with each option before making a final decision.
Key Points to Remember:
- Focus on the future: Incremental analysis looks at future costs and benefits that will change due to the decision.
- Ignore sunk costs: Sunk costs are irrelevant because they have already been incurred and cannot be recovered.
- Consider opportunity costs: Include the potential benefits forgone by choosing one alternative over another.
- Qualitative factors matter: Don't solely rely on quantitative analysis; consider qualitative factors that might influence the decision.
By systematically following these steps, you can effectively use incremental analysis to make informed decisions when faced with multiple alternatives.