The essence of incremental costing is to measure the cost incurred because a product is sold, or not incurred because it is not sold. We cannot delve into all the details of setting up a useful managerial accounting system here. For our purposes, it will suffice to caution that there are four common errors that managers frequently make when attempting to develop useful estimates of true costs.
1. Beware of averaging total variable costs to estimate the cost of a single unit. The average of variable costs is often an adequate indicator of the incremental cost per unit, but it can be dangerously misleading in those cases where the incremental cost per unit is not constant. The relevant incremental cost for pricing is the actual incremental cost of the particular units affected by a pricing decision, which is not necessarily equal to average variable cost. Consider the following example:
A company is currently producing 1,100 units per day, incurring a total materials cost of $4,400 per day and labor costs of $9,200 per day. The labor costs consist of $8,000 in regular pay and $1,200 in overtime pay per day. Labor and materials are the only two costs that change when the firm makes small changes in output. What then is the relevant cost for pricing? One might be tempted to answer that the relevant cost is the sum of the labor and materials costs ($13,600) divided by total output (1,100 units), or approximately $12.36 per unit. Such a calculation would lead to serious underpricing when demand is strong, since the real incremental cost of producing the last units is much higher than the average cost. A price increase, for example, could eliminate only sales that are now produced on overtime at a cost substantially above the average.
What is the cost of producing the last units, those that might not be sold if the product's price was raised? It may be reasonable to assume that materials costs are approximately the same for all units, so that average materials cost is a good measure of the incremental materials cost for the last units. Thus a good estimate of the relevant materials cost is $4 per unit ($4,400/1,100). We know, however, that labor costs are not the same for all units. The company must pay time-and-a-half for overtime, which are the labor hours that could be eliminated if price is increased and if less of the product is sold. Even if workers are equally productive during overtime and regular hours, producing approximately 100 units per day during overtime hours, the labor cost is $12 per unit ($1,200/100), resulting in a labor and materials cost for the last 100 units of $16 each, substantially above the $12.36 average cost.
2. Beware of accounting depreciation formulas. The relevant depreciation expense that should be used for all managerial decision making is the change in the current value of assets. Depreciation of assets is usually calculated in a number of different ways depending on the intended use of the data. For reporting to the Internal Revenue Service, depreciation is accelerated to minimize tax liability. For standard financial reporting, rates of depreciation are estimated as accurately as possible but are applied to historical costs. For pricing and any other managerial decision-making, however, depreciation expenses should be based on forecasts of the actual decline in the current market value of assets as a result of their use.
Failure to accurately measure depreciation expenses can severely distort an analysis of pricing options. For example, the author of one marketing textbook wrote that a particular airline could price low on routes where its older planes were fully depreciated, but had to price high on routes where new planes were generating large depreciation charges. Such pricing would be quite senseless. Old planes obviously have a market value regardless of their book value. The decline in that market value should either be paid for by passengers who fly on those planes, or the planes should be sold. Similarly, if the market value of new planes does not really depreciate as quickly as the financial statements indicate, excessive depreciation expenses could make revenues appear inadequate to justify what are actually profitable new investments. The relevant depreciation expense for pricing is the true decline in an asset's resale value.
3. Beware of treating a single cost as either all relevant or all irrelevant for pricing. A single cost on the firm's books may have two separate components — one incremental and the other not, or one avoidable and the other sunk — that must be distinguished. Such a cost must be divided into the portion that is relevant for pricing and the portion that is not. Even incremental labor costs are often not entirely unavoidable (see “Peak Pricing: An Application of Incremental Costing” on next page).
In past recessions, some steel producers found when they considered laying off high-seniority employees that the avoidable portion of their labor costs was only a small part of their total labor costs. Their union contracts committed them to pay senior employees much of their wages even when these employees were laid off. Consequently, those companies found that the prices they needed to cover their incremental, avoidable costs were actually quite low, justifying continued operations at some mills even though those operations produced substantial losses when all costs were considered.
4. Beware of overlooking opportunity costs. Opportunity cost is the contribution that a firm forgoes when it uses assets for one purpose rather than another. Opportunity costs are relevant costs for pricing even though they do not appear on financial statements. They should be assigned hard numbers in any managerial accounting system, and pricers should incorporate them into their analyses as they would any other cost. In the earlier example of the book publisher, the cost of capital required to maintain the firm's inventory was the cost of borrowed funds (18 percent). It, therefore, generated an explicit interest expense on the firm's income statement. A proper analysis of the publisher's problem would have been no different had we assumed that the inventory was financed entirely with internally generated funds. Those internally generated funds do not create an interest expense on the publisher's income statement, but they do have alternative uses. Internally generated funds that are used to finance inventories could have been used to purchase an interest-bearing note or could have been invested in some profitable sideline business such as printing stationery. The interest income that could have been earned from the best of these alternatives is an incremental, avoidable cost of using internally generated funds, just as the interest paid explicitly is an incremental, avoidable cost of using borrowed funds.