Marginal and Incremental Principle

MARGINAL AND INCREMENTAL PRINCIPLE

A manager has to use resources of production carefully as they are scarce. Marginal analysis helps to assess the impact of a unit change in one variable on the other. For example, a firms’ decision to change prices would depend on the resulting change in marginal revenue and marginal cost. Changes in these variables would, in turn,depend on the units sold as a result of a change in price. Change in the price is desirable if the additional revenue earned is more than the additional cost. Similarly,decision on additional investment is taken on the basis of the additional return from that investment, that is, the marginal changes.

The word ‘marginal’ is used for such small changes. In contrast, incremental concept applies to changes in revenue and cost due to a policy change. For example, additional cost of installing computer facilities will be incremental cost and the additional revenue earned due to access to Internet will be incremental revenue. Thus, a change in output because of a change in process, product or investment is regarded as an incremental change. Incremental reasoning highlights the fact that incremental cost,rather than full cost, should be taken in consideration to assess the profitability of a decision. The incremental principle states that a decision is profitable when:

• it increases revenue more than costs;

• it decreases some costs to a greater extent than it increases others;

• it increases some revenues more than it decreases others; and

• it reduces costs more than revenues.

Suppose a firm gets an order that brings additional revenue of Rs 3,000. The cost of

production from this order is:

Rs

Labour 800

Materials 1,300

Overheads 1,000

Selling and administration expenses 700

Full cost 3,800

At a glance, the order appears to be unprofitable. But suppose the firm has some idle capacity that can be utilised to produce output for new order. There may be more efficient use of...