DIFFERENTIAL COST – DEFINITION, EXAMPLES AND APPLICATIONS

What is Differential Cost?

Differential cost is the difference in total cost between two alternatives. Differential costs can be used to make decisions about which option to choose. Differential cost is the expenses incurred when two alternative actions or changes in production levels are compared. The idea is employed when there are several viable options to consider and a choice must be made to pick one rather than the others.

The principle may be particularly beneficial in step costing situations, where generating one extra unit of output might necessitate a significant additional expenditure. Differential cost analysis would be used to ascertain whether the revenue generated by selling this extra unit would justify the increased costs.

Differential cost is relevant when there are two or more alternatives that have different costs.

When a firm has many comparable alternatives, the cost occurs when a choice must be made between them. When business leaders are confronted with this situation, they should choose the most viable option by evaluating the costs and benefits of each alternative.

Meaning of Differential Costs

Differential cost refers to the financial difference between two or more business decisions. It takes into account both fixed costs and future costs and is a key concept in managerial accounting. Differential cost managers must be aware of both fixed and future costs when making decisions.

Differential analysis is the process of evaluating two or more alternatives and choosing the option that will create the most value for the company. It is a key tool that managers use to make decisions about what course of action to take. Differential revenue is the increase in total revenue that a company would experience by selling one more unit of product.

Relevant costs are those costs that will change as a result of the decision that is being made. They are the only costs that should be considered when making a decision. Incremental revenue is the additional revenue that will be generated by taking a particular course of action.

Examples of Differential Cost

Example 1

A company that manufactures table lamps has two production lines, each of which can make either type A or type B lamp. The firm’s marketing department has forecasted that there will be an increase in demand for type B lamps over the next month.

The company must decide whether to use production line 1 to make all type B lamps or stop production of type A lamps on this line and use it exclusively for type B. Differential cost analysis would be used to help make this decision.

If the company decides to stop the production of type A lamps on line 1, there will be a differential cost of $5 per unit due to the need to purchase new parts for line 2. However, if the company continues to produce both types of lamps on line 1, there will be a differential cost of $2 per unit as line 2 will need to be reconfigured to produce type B lamps.

In this example, the company would decide to stop the production of type A lamps on line 1 as the differential cost is lower.

Example 2

Differential cost analysis can also be used when considering whether to outsource a particular function or activity. For example, a company might be considering outsourcing its customer service function.

The company would need to compare the costs of running its own customer service department with the costs of outsourcing the function. Differential cost analysis would be used to help make this decision.

If the company decides to outsource its customer service function, there will be a differential cost of $10 per call. However, if the company decides to keep the customer service function in-house, there will be a differential cost of $15 per call.

In this example, the company would decide to outsource its customer service function as the differential cost is lower.

Example 3

Differential cost analysis can also be used when making decisions about how to price products or services. For example, a company might be considering whether to price a product at $10 or $20.

The company would need to compare the costs of producing and selling the product at each price. Differential cost analysis would be used to help make this decision.

If the company decides to price the product at $10, there will be a differential cost of $5 per unit sold. However, if the company decides to price the product at $20, there will be a differential cost of $10 per unit sold.

In this example, the company would decide to price the product at $10 as the differential cost is lower.

Importance of Differential Cost Analysis

Differential cost analysis is an important tool that can be used to help make decisions about which of several alternative actions or changes to choose. The principle can be particularly useful in step costing situations, where generating one extra unit of output might necessitate a significant additional expenditure.

Differential cost analysis would be used to ascertain whether the revenue generated by selling this extra unit would justify the increased costs. Differential cost analysis can also be used when considering whether to outsource a particular function or activity or when making decisions about how to price products or services.

Some of the usages of differential cost analysis are

1. Getting prices of products

Differential cost analysis can be used to find out the prices of products. The company would need to compare the costs of producing and selling the product at each price. Differential cost analysis would be used to help make this decision.

2. Accepting or rejecting special orders

Differential cost analysis can be used to decide whether to accept or reject special orders. The company would need to compare the costs of accepting and fulfilling the order with the revenue that would be generated from it. Differential cost analysis would be used to help make this decision.

3. Adding or eliminating products, segments, or customers

Differential cost analysis can be used to decide whether to add or eliminate products, segments, or customers. The company would need to compare the costs of adding or eliminating the product, segment, or customer with the revenue that would be generated from it. Differential cost analysis would be used to help make this decision.

4. Processing or selling joint products

Differential cost analysis can be used to decide whether to process or sell joint products. The company would need to compare the costs of processing and selling the joint product with the revenue that would be generated from it. Differential cost analysis would be used to help make this decision.

5. Deciding whether to make products or buy them

Differential cost analysis can be used to decide whether to make products or buy them. The company would need to compare the costs of making and buying the product. Differential cost analysis would be used to help make this decision.

Accounting Treatment of Differential Costing

Differential cost is the amount by which two alternatives differ in their costs. In accounting, differential costing is a method of allocating fixed and variable costs to products or services based on the decision to either keep or discontinue them. Differential costing is also known as marginal costing or incremental costing.

Differential costing is used to make decisions about pricing, outsourcing, and product mix. Differential costing can be applied to both manufacturing and service industries.

In manufacturing, differential costing is used to determine the best price for a product. In service industries, differential costing is used to decide whether to outsource a particular function or activity.

Applications of Differential Cost

1. Deciding the most profitable level of production and price

Differential cost is very important in deciding the most profitable level of production and price. The company needs to find the break-even point where the marginal revenue is equal to the marginal cost. Differential cost analysis can be used to help make this decision.

2. Offering a quotation at a lower selling price to increase capacity

Differential cost is also important in offering a quotation at a lower selling price to increase capacity. The company needs to find the break-even point where the marginal revenue is equal to the marginal cost. Differential cost analysis can be used to help make this decision.

3. Make or buy decisions

Differential cost is also helpful in making or buying decisions. The company has to compare the total cost of making with the total cost of buying. Differential cost analysis can be used to help make this decision.

4. Optimal production and pricing decisions

Differential cost is also helpful in optimal production and pricing decisions. The company has to find the point where marginal revenue is equal to marginal cost. Differential cost analysis can be used to help make this decision.

5. Shut down or continue decisions

Differential cost is also helpful in shut down or continuing decisions. The company has to find the point where marginal revenue is equal to marginal cost. Differential cost analysis can be used to help make this decision.”

Opportunity Cost

Opportunity cost is the cost of an opportunity foregone (not taken). It is the benefit that could have been received from the best alternative use of resources. In other words, opportunity cost is the cost of choosing one option over another. Assume that you have $100 to spend and you can either buy a new shirt or go to the movies. The opportunity cost of buying the shirt is the movie ticket. The opportunity cost of going to the movies is the new shirt.

Sunk Costs

A sunk cost is a cost that has already been incurred and cannot be recovered. A sunk cost is irrelevant to any decision about whether to continue or discontinue a project. For example, suppose that you paid $100 for a movie ticket. The $100 is a sunk cost. It does not matter whether you go to the movie or not. The cost has already been incurred and cannot be recovered.

Differential Cost vs Incremental Cost

Differential cost is the amount by which two alternatives differ in their costs. The incremental cost is the additional cost incurred by choosing one alternative over another.

Differential Cost vs Marginal Cost

While differential cost is understood as the cost of two alternatives, marginal cost is the incremental or additional cost of producing one more unit of output. Differential cost can be both fixed and variable, while marginal cost is always variable.

Differential Cost vs Total Cost

Differential cost is the cost of two alternatives, while total cost is the sum of all costs incurred in a period. Differential cost can be both fixed and variable, while total cost includes only variable costs.

Conclusion!

Now, in the end, it is clear that differential cost is a very important concept in managerial decision-making. Differential cost analysis is a powerful tool that can help managers make better decisions when it comes to pricing, production, and capacity.

What do you think? Do you have any questions about differential cost? Let us know in the comments below!

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