Marginal Analysis and Incremental Analysis: Making Better DecisionsEconomics is all about making decisions with limited resources. A fundamental principle in microeconomics is that individuals and businesses make decisions at the margin.
Marginal analysis and incremental analysis are two economic tools that can help decision-makers make better choices.
Marginal Analysis
Definition and Application
Marginal analysis is the study of the additional or marginal effects of a decision. It is based on the premise that economic variables such as scarce resources, marginal product, marginal cost, marginal revenue, and marginal utility should influence decision-making.
For example, a company can produce more widgets by hiring more workers. However, the marginal product of each additional worker will likely decrease due to diminishing returns.
The marginal cost of hiring an additional worker includes not only the salary but also training costs and other expenses. The marginal revenue generated by the additional widgets produced will depend on the current market price and demand.
Therefore, the company needs to consider all these factors to determine the optimal level of production.
Example
To illustrate marginal analysis, let’s consider a scenario in which a company sells cookies. Suppose the company’s production capacity is 1,000 cookies per day, and they currently produce 800 cookies per day.
The company can increase the production to 1,000 cookies per day by adding more ingredients, baking more cookies, and hiring more workers. However, the company needs to consider whether the additional costs are worth the extra revenue generated.
Assuming that the marginal cost of producing one cookie is $0.50, and the current selling price is $1.00 per cookie, the company’s profit margin is $0.50 per cookie. If they increase the production to 1,000 cookies per day, the marginal cost will increase to $0.60 per cookie due to the economies of scale being exhausted.
However, the company expects to sell all the cookies at $1.00 each, and the marginal revenue for each additional cookie will be $0.40.
Therefore, the company’s profit margin decreases to $0.40 per cookie produced.
Based on the marginal analysis, the company should not increase production to 1,000 cookies per day since it will result in a lower profit margin.
Incremental Analysis
Definition and Application
Incremental analysis is a type of decision-making that compares the benefits and costs of a specific action against an alternative action or a base case. This approach is essential for short-term decision making and investment decisions.
For example, a company is considering investing in a new machine that costs $100,000 and can increase production capacity by 25%. The company’s current production is 10,000 units a year, and the current selling price is $10 per unit.
The variable cost of producing one unit is $6 per unit. The investment has a lifespan of five years and a salvage value of $10,000.
The incremental revenue generated by the new machine is $25,000 (25% of 10,000 units x $10 per unit). The incremental cost is $22,500 [$100,000 (cost of the machine) – $10,000 (salvage value) / 5 (lifespan) + $6 (variable cost) x 2,500 units (additional production)].
The incremental profit is $2,500 ($25,000 – $22,500).
However, the company needs to compare the incremental profit against the alternative option, such as continuing with the current production or investing in other options.
The company can also consider relevant costs, opportunity costs, and sunk costs to make better decisions.
Example
To illustrate incremental analysis, let’s say the company presented with two alternative options – investing in the new machine at $100,000 or outsourcing the extra production to a third party at $1 per unit. The outsourcing has no salvage value, and the lifespan is only one year.
The incremental revenue from outsourcing is $2,500 (2,500 units x $1 per unit). The incremental cost is $2,500 ($1 per unit x 2,500 units).
The incremental profit is $0.
Based on the incremental analysis, the company should invest in the new machine, as it generates a higher incremental profit than outsourcing.
However, the company should also consider other relevant factors, such as the long-term impact of the investment, the reliability of the third party, and the impact on employee morale.
Conclusion
In conclusion, marginal analysis and incremental analysis are two useful economic tools that can help decision-makers make better choices. By considering the marginal effects of a decision and comparing it to alternative options or base case, companies can make informed decisions that maximize profits or benefits.
The key takeaway is that incremental analysis and marginal analysis are essential for decision-making, especially when the costs and benefits of the decision are not immediately evident. Expanding on Marginal Analysis and Incremental Analysis: Similarities and DifferencesMarginal analysis and incremental analysis are two economic tools that can assist business financial decision-makers in making informed decisions.
Although they have distinct features, they share some similarities. This article will explore the similarities between marginal analysis and incremental analysis and discuss their differences.
Similarities Between Marginal Analysis and Incremental Analysis
Application
Marginal analysis and incremental analysis are economic concepts used primarily in the field of business financial decision-making. Both methods help decision-makers make informed decisions by considering a range of economic factors and comparing them to alternative actions.
For instance, by comparing the additional benefits of an investment with the incremental cost of the investment, a company can determine if it’s ultimately worthwhile.
Features
Both marginal analysis and incremental analysis utilize three fundamental features in their evaluation of business decisions: cost, revenue, and utility. Both tools focus on maximizing the benefits of a decision while minimizing the accompanying costs.
Differences Between Marginal Analysis and Incremental Analysis
Use
Marginal analysis and incremental analysis differ in their use. Marginal analysis is a tool whereby business decision-makers assess the cost and benefit of a single additional unit, while incremental analysis compares the cost and benefit of an entire project to the same figure in its previous state.
For instance, if a business wishes to enhance its production output, it would evaluate the cost and benefit of producing one more unit using marginal analysis. However, if the company wants to expand its entire production plant or implement a new strategy, it would assess the costs and benefits of the whole new production plan in comparison to the current model using incremental analysis.
Function
The function of marginal analysis is to evaluate decisions that entail adding one additional unit of a particular action. In contrast, incremental analysis is more useful in determining the best decision among a range of alternative actions.
Marginal analysis helps decision-makers determine whether they should continue a previously profitable decision or not, while incremental analysis evaluates several decisions and selects the best option among them.
Decision Making
The biggest distinction between marginal analysis and incremental analysis is their method of decision-making. While both involve considering costs and benefits, marginal analysis focuses on measuring the potential benefits of adding one extra unit of a particular action while comparing it to the additional cost.
An incremental analysis, on the other hand, evaluates the benefits compared to the original model of production to effectively analyze the additional costs and benefits that come with the proposed decision.
Information Considered
Marginal analysis often considers specific economic variables, such as marginal cost, marginal revenue, and marginal utility, while incremental analysis also considers accounting information such as investment figures, revenue figures, and other relevant cost factors. Both use information to help with the decision-making process, but their specific concerns and focuses are quite different.
Types of Costs Considered
When engaging in marginal analysis, decision-makers factor in variable costs and revenues. In contrast, incremental analysis considers costs like opportunity costs, relevant costs, and sunk costs that become relevant when assessing the feasibility of a particular course of action over an extended period.
Conclusion:
While there seem to be similarities between marginal analysis and incremental analysis, their differences are significant. The purpose of both tools is to help businesses make data-driven decisions with a more nuanced understanding of their options that better inform their choices.
Effective use of either depends on knowing which method to apply given the nature of a specific business decision. In conclusion, marginal analysis and incremental analysis are essential tools for business financial decision-making.
Both approaches allow decision-makers to evaluate costs and benefits, with the former focusing on adding one additional unit of a particular action while the latter considers entire projects or alternative options. These tools have similarities in their application of cost, revenue, and utility, among other features.
However, their uses, functions, decision-making methods, information considered, and types of costs assessed differ significantly. Therefore, businesses need to use these tools appropriately to make informed decisions that maximize benefits and minimize costs.
The takeaway is that understanding the differences between marginal analysis and incremental analysis is crucial for businesses, especially when making investment decisions that can impact their long-term success.