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The real world counterpart to marginal analysis is incremental profit analysis, which deals with the relationship between the changes in revenues and costs associated with managerial decisions. The emphasis on only the costs or revenues that are actually affected by the decision ensures proper economic reasoning in decision analysis. That is, proper use of incremental profit analysis results in accepting any action that increases net profits and in rejecting any action that reduces profits. |
The fact that incremental analysis involves only those factors which are affected by a particular decision. It does not mean that the concept is easy to apply. Proper use of incremental analysis requires a wide-ranging examination of the total effect of the decision. For example, a firm’s decision to introduce a new product. Incremental analysis requires that the decision is based on the net effect of changes in revenues and costs. An analysis of the effect on revenues involves an estimate of the net revenues to be received for the product and, additionally, a study of how sales of the new product will affect the firm’s other products. It may be that the new product will affect the firm’s other products. It may be that the new product will, in fact, compete with the firm’s existing products; if so, even though the new product has a high individual revenue potential, the net effect on revenue might not justify the added expense. At the other extreme, although a new product may not be expected to produce much profit on its own, if it is complementary to the firm’s other products; the expected gain in sales of these other products could result in a large incremental increase in total profit.
The direct incremental costs associated with the new product, the firm must consider any impact on the costs of existing products. For example, introduction of a new product might cause production bottlenecks that would raise the cost of other products.
Incremental analysis involved long-run as well as short-run effects. New products may appear to be profitable in an incremental sense in the short-run because the firm has excess capacity in its existing plant and equipment. Over the long-run, however, this commitment to produce the new item may require a substantial investment when the necessary equipment wears out and must be replaced. There may also be high opportunity costs associated with future production if either expansion of other product lines or development of future alternative products is restricted by the decision to produce the new product.
It is important to stress once again that incremental analysis is based on the changes associated with the decision. For short-run analysis, fixed cost (over-head) is irrelevant and must not be included in incremental analysis.
An Illustration of Incremental Analysis
The Business Week article on flexible pricing cited above reports on pricing practices that reflect the use of incremental logic by numerous firms. The value of this approach is also demonstrated by an example of how Buddha Airlines has used incremental analysis in its flight service decisions. Then considering adding a new flight (or dropping an existing one that appears to be doing poorly), Buddha airways engages in a very through incremental analysis along the lines of table. The corporate philosophy is clear: “If revenues exceed out-of-pocket costs, but the flight on.” In other words, continental compares the out-of-pocket, or incremental, costs associated with each proposed flight to the total revenues generated by that flight. An excess of revenues over incremental costs leads to a decision to add the flight on continental’s schedule.
Table: Incremental Analysis as Employed by Yeti Airlines
Problems: Shall Buddha run an extra daily flight from Kathmandu to Pokhara?
Facts: Fully-allocated costs of this flight Rs. 4,500
Out-of Pocket costs of this flight Rs. 2,000
Flight should gross Rs. 3,100
Decision: Run the flight. It will as Rs.1,100 to net profit by adding Rs. 3,100 to revenues and only Rs. 2,000 to costs. Overhead and other costs totaling Rs. 2,500 (Rs. 4,500 minus Rs. 2,000) would be incurred whether the flight is run or not. Therefore, fully-allocated or average costs of Rs. 4,500 are not relevant to this business decision. It is the out-of-pocket, or incremental, costs that count.
The out-of-pocket costs figure that Buddha Airways users is obtained by circulating a proposed schedule for the new flight to every operating department concerned and finding out what added expenses will be incurred by each of them. Here, an alternative costs concept is used. If a ground crew is on duty and between works on other flights, the proposed flight is not charged a penny of their salary. Some costs may even be reduced by the additional flight. For example, on a late-night round trip flight between Kathmandu and Pokhara, Yeti Airways often flies without any passengers and with only a small amount of freight. Even without passenger revenues, these flights are profitable because their net costs are less than the rent for overnight hanger space of Kathmandu.
On the revenue side, Buddha Airways considered not only the projected revenues for the flight but also the effect on revenues of competing and connecting flights on the Buddha Airways schedule. Several Buddha airways flights which fail to cover even their out-of-pocket costs directly bring in passengers for connecting long-haul service. When the excess of additional revenue over cost on the long-haul flight is considered, Buddha airways earns a positive net profit on the feeder services.
Budhha airways use of incremental analysis extends to its schedule of airport arrival and departure times. A proposed schedule for Biratnagar Airport. For example it has two planes landing at the same time. This was expensive for Buddha airlines, because it facilitates in Biratnagar at that time were not sufficient to service two planes simultaneously. Buddha airways would have been forced to lease an extra fuel truck and to hire three new employees at an additional monthly cost of Rs. 1,800. However, when Buddha airlines began shifting around proposed departure times in other cities to avoid the congestion at Biratnagar, it appeared that the company might lose as much as Rs. 10,000 in monthly revenues, if passengers switched to competing flights leaving at more convenient hours. Needless to say the two flights were schedule to be on the ground in Biratnagar at the same time.
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