Incremental analysis, also known as marginal or differential analysis, is one of the methods used by managers in decision making. It involves choosing between alternatives based on revenue differences, cost differences and cost saving differences. While undertaking incremental analysis, the three different costs to be considered are sunk costs, relevant costs and opportunity costs.
Sunk costs are those which are not relevant for decision making. They are incurred indifferent to the alternative course of action. Relevant costs are those which need to be considered for decision making. They vary between the alternatives. Opportunity costs is the cost of choosing one alternative over the other.
There are three different types of incremental analysis – present worth analysis, cash flow analysis and rate of return analysis.
Cash flow analysis:
· First step is to identify the incremental after tax cash flows for all alternatives.
· When determining the above, only relevant costs are to be taken
· Consider the cost of opportunity of not choosing the other alternative
· Overhead costs which are fixed should not be allocated
· Changes in net working capital (Current Assets – Current Liabilities) should be included
· Depreciation is a non cash expense. However, the tax effect of the same should be considered if tax rates are applicable
· Second step is to discount the cash flows using an appropriate discounting rate considering the time value of money.
· Finally, the best alternative is chosen after considering the following non-quantitative factors.
Other outside factors:
Other qualitative factors to be kept in mind by the manager are the following:
Employee morale – in case it is a “Make or buy decision”, employees may lose their morale if a “Buy” decision is taken.
Quality of supplies – In