Incremental Costs in Managerial Accounting
When you need to choose between two alternatives, incremental costs change depending on which alternative you choose. Managerial accountants sometimes refer to incremental costs as relevant costs. Other costs don’t change — you can just treat these expenses as irrelevant.
For example, suppose you’re deciding whether to travel to Cancun, Mexico, for vacation. Some incremental costs of making the trip include the following:
Ground transportation to and from the airport
A new swimsuit
A souvenir T-shirt that says My sister went to Cancun, and all I got was this lousy T-shirt
You have to pay these incremental costs if you go to Cancun but not if you stay home. On the other hand, some costs remain the same, and you ignore them for the purposes of making your vacation decision:
Rent on your apartment
Auto insurance premiums
Interest on student loans
Additionally, if you go to Cancun, certain everyday costs may change. For example, you normally pay $100 a week for food and drink at home, but in Cancun, your food and drink may cost you $175 for the week.
These incremental costs of your vacation — the amount that varies because you decide to make the trip — come to $75. On the other hand, if you decide to stay home, you incur the incremental cost of running your air conditioner during the time you would’ve been away.
As a manager, incremental costs come up as you encounter some of these decisions:
Accepting special orders: You own a hotel with empty rooms for tonight. At 11 p.m., a mysterious stranger approaches the counter, offering to pay just $20 for a room. Your rooms normally go for $100 a night and up. Should you take the money?
Consider some of the incremental costs:
Electricity to power the air conditioning, TV, and any light bulbs
Gas to heat water for the shower and to power the laundry to clean the linens
Chocolate mints for the pillows
Forget housekeeping expenses because you pay your housekeepers the same wage every day, regardless of how many rooms they clean. Because the electricity, gas, and chocolate mints certainly cost less than $20 for the night, you should take the money and direct your guest to his room.
Choosing whether to make a product or buy it from another manufacturer: You run a restaurant and must decide whether to grow your own tomatoes or buy them from a local market. Carefully think about the additional costs necessary to grow your own tomatoes — such as seeds, fertilizer, soil, growing space, and the labor required to tend the plants — to determine whether these incremental costs outweigh the cost of buying the tomatoes from the market.
Considering whether to repair or replace old or broken equipment: Your old delivery truck is on its last leg. You paid $20,000 for it, but now it’s worth only about $2,000. You’re thinking about selling it and using the $2,000 to buy something more reliable. Incremental costs of changing vehicles include
Difference in gas mileage
Difference in cost of auto insurance
Difference in cost of repairs and maintenance
Don’t even think about the original cost of your current truck because you’ll never see that money again. It’s irrelevant.
Eliminating an unprofitable product or segment of your business: You run a martial arts studio with three different divisions: kids (in the afternoon), adults (in the evenings), and senior citizens (in the morning). You’re considering closing down the senior citizen division that meets each morning because it’s the least profitable of the three divisions.
Consider some of the incremental costs:
Paying instructors to lead classes
Heat and other utilities needed to keep the studio open during the day
Additional insurance (charges are based on number of lessons given)
Don’t get confused by the costs that won’t change. For example, even if you cancel the senior citizen division, your rent will stay the same. So, too, will the salary you pay the studio manager.
As you analyze decisions, take special care to consider only incremental costs and to ignore all other costs.