THE INCREMENTAL CONCEPT OF BUSINESS DECISION
Incremental reasoning involves estimating the impact of decision alternatives. The two basic concepts in the incremental analysis are:
- Incremental Cost (IC) Or Marginal Cost
- Incremental Revenue (IR) Or Marginal Revenue
Incremental cost is defined as the change in total cost as a result of change in the level of output, investment etc. Incremental revenue is defined as the change in total revenue resulting from a change in the level of output, prices etc. A manager always determines the worth of a decision on the basis of the criterion that IR>IC. A decision is profitable if
- it increases revenue more than it increases cost
- it reduces some costs more than it increases others
- it increases some resources more than it decreases others
- it decreases costs more than it decreases revenues.
To illustrate the above points, let us take a case where a firm gets an order that can get it additional revenue of Rs. 2,000. The normal cost of production of this order is
Comparing the additional revenue with the above cost suggests that the order is unprofitable. But, if some existing facilities and underutilised capacity of the firm were utilised, it would add much less to cost than Rs. 2,400. For example, let us assume that the addition to cost due to this new order is, say, the following:
In the above case the firm would earn a net profit of Rs. 2000 – Rs. 1400 = Rs. 600, while at first it appeared that the firm would make a loss of Rs. 400 by accepting the order.
The worth of such a decision can be judged on the basis of the following theorem.
Theorem I: A course of action should be pursued up to the point where its In cremental benefits equal its increment costs.
According to the theorem, the firm represented in Table 2.1 will produce only seven units of output as its Marginal Revenue (MR)= Marginal Cost (MC) at that level of output. As can be calculated from the Table, the MC of 8th unit is more than its MR. Hence the firm gets negative profit from 8th unit and thus is advised not to produce it.
*Marginal Revenue is the additional revenue from selling one more unit, while Marginal Cost is the additional cost of producing one more unit.
The acceptance or rejection of an order by a firm for its product depends on whether the resultant costs are greater or less than the resultant revenue. If these principles are not followed, the equilibrium position would be disturbed. But the problem with the concept of marginalism is that the independent variable may be subject to “bulk changes” instead of “unit changes”. For example, a builder may not change one labourer at a time, but many of them together. Similarly, the output may change because of a change in process, pattern or a combination of factors, which may not always be measured in unit terms. In such cases, the concept of marginalism is changed to incrementalism. Or, in other words, incrementalism is more general, whereas marginalism is more specific. All marginal concepts are incremental concepts, but all incremental concepts need not be marginal concepts.