Companies are frequently forced to choose between different business solutions at varying costs. Differential cost refers to a comparison of those various prices, which assists a corporation in determining which option will make the most commercial sense.
In this post, we will define differential cost, explain the relevance of using it in business choices, and present an example of how differential cost analysis is used. But first, let’s look at the definition and the many forms of costs.
Cost
In management accounting, the idea of cost refers to the amount paid or surrendered to get something. The monetary value of all costs will have to be determined. In cost accounting, there are several categories of costs. As a result, determining the costs is an important role in management decision making.
Types of Cost
The loss or gain incurred by a firm when one alternative is chosen at the expense of the other possibilities is referred to as the opportunity cost. For example, A was offered a $50,000-a-year job, but he chose to complete his education in order to have a better future. The opportunity cost in this case is $50,000.
#1. Sunk Costs
Sunk costs are costs that a company has already incurred but cannot be reduced by any managerial decision. For example, suppose a corporation buys a machine that quickly becomes obsolete, and the products created by the equipment can no longer be sold to clients.
Consider a corporation that manufactures plastic bags and purchases innovative equipment to double its present production of plastic bags. As soon as the company starts using the new equipment, the government outlaws the production of plastic bags in the country and makes it a crime for anybody to manufacture or sell plastic bags. The new legislation renders the machine and the plastic bags created outdated, and the corporation is powerless to overturn the government’s decision. It is a sunk cost or an expense that cannot be reversed.
#2. Fixed Cost:
A fixed cost is one that does not change with production. Rent, depreciation, and salaries are all included in this cost. Fixed costs are displayed in the income statement and have an impact on the business’s profitability.
#3. Variable cost:
Variable cost varies in response to variations in output. It consists of labour and material costs that vary with production; for example, as production increases, labour and material costs rise, and vice versa. It is computed by dividing the variable cost per unit of output by the number of units.
#4. Imputed Cost:
This is a cost incurred as a result of internal transactions that do not occur. Such costs are not accounted for. It occurs as a result of using an asset rather than renting or selling it. However, these costs are a vital element of running a firm.
#5. Incremental Cost:
As the name implies, incremental cost is the rise in the cost of production caused by an increase in the number of operations. Assume a company’s production cost rises from $20,000 to $25,000 due to an increase in the number of hours required to finish the project. The additional cost is $5,000.
What is Differential Cost?
The difference in cost between two alternative decisions or a change in output levels is referred to as differential cost. When there are several possibilities to explore, and a decision must be made to select one option and discard the rest, the notion is applied. The notion is especially relevant in step costing scenarios, where generating one more unit of output may incur a significant additional cost.
Differential cost is the same as incremental cost and marginal cost. Differential revenue is the difference in revenue that results from two decisions.
The differential cost analysis is used by businesses to make key decisions on long-term and short-term projects. It also gives managers quantitative analysis that serves as the foundation for formulating firm strategies.
Differential Cost Characteristics:
The essential properties of differential costs are as follows:
- Differential cost analysis is performed outside of the accounting records; nonetheless, differential costs may be incorporated in flexible budgets because they budget costs at various levels of activity.
- In differential cost analysis, total differential costs are taken into account. The cost per unit is not taken into account.
- Before recommending an alternative course of action, total differential revenues are compared to total differential costs. A change in strategy is only advised if differential revenues surpass differential costs.
- The cost items that do not change for the alternatives under evaluation are omitted; only the difference in cost items is evaluated since differential cost analysis is concerned with cost changes.
- Cost changes are measured from a common starting point, which could be a current course of action or current level of production.
- Differential cost analysis is concerned with future costs since it is tied to a future course of action or level of production. Historical costs or standard costs may be used, but they must be appropriately modified for future conditions.
- When deciding amongst the numerous alternatives, it is recommended that the option with the greatest difference between incremental income and incremental cost be chosen.
Differential Cost Example
ABC Firm is a telecommunications company that primarily markets itself through newspaper advertisements and the company website. However, a newly appointed marketing director proposes that the corporation focuses on television commercials and social media marketing to reach a larger client base.
Every month, the telecom operator spends $400 on newspaper ads and $100 on website maintenance. The marketing director anticipates that the company will spend about $1,000 each month on television advertisements. In addition, the company will need to recruit a millennial at $250 a week to manage its social media marketing efforts. If the telecom operator uses the new advertising strategies, they will incur advertising costs of $2,000 per month. In this scenario, the differential in cost is $1,500 ($2,000 – $500).
ABC Company must choose between continuing to use their present advertising platforms and investing more money in new advertising channels. They must decide whether the potential incremental benefits outweigh the extra costs. Will it reach a larger audience and boost the chances of gaining new customers? Is the additional spending budgeted for? Will social media marketing improve interactions with current customers and boost sales?
Differential Cost Applications
Differential cost is used by managers in the following ways:
#1. Determine the most lucrative production and pricing level
When a corporation wants to find the optimal level of production that produces the most revenue or net profit, it must do market research to discover the selling prices for its products at various activity levels. The estimated revenue is then calculated by multiplying the predicted output at a certain level by the selling price.
The differential revenue is calculated by subtracting sales at one activity level from sales at the preceding level. To find the most profitable level of production and the best selling price, the differential cost is compared to the differential revenue. When the differential revenue exceeds the differential cost, management will opt to expand the level of output.
#2. Provide a quotation at a reduced selling price in order to improve capacity.
When a corporation wishes to raise its manufacturing capacity, the management may cut the selling price to boost sales. The corporation lowers the selling price to the point where it can still make a profit and cover its production costs.
To determine whether the new selling price is viable, the corporation computes the differential cost by subtracting the cost of the current capacity from the cost of the proposed new capacity. To estimate the minimal selling price, the differential cost is divided by the increased units of production. Any price that is more than the minimum selling price represents additional profit for the company.
Differential Cost Treatment
Differential cost can be either constant or variable, or a combination of the two. Organization executives utilize differential cost analysis to choose between possibilities in order to make viable decisions that will benefit the company. The differential cost approach is a spreadsheet-based managerial accounting process that requires no accounting inputs.
Opportunity Cost
The term “opportunity cost” refers to the possible benefits or money lost by selecting one alternative over another. Company leaders must pick between possibilities, but they must do so after weighing the opportunity cost of not gaining the benefits supplied by the option not chosen.
Moving to television commercials and social media marketing exposes ABC Company to a larger customer base. If the company generated $10,000 utilizing its present marketing platforms, switching to more advanced advertising platforms may result in a 40% increase in income to $14,000.
The opportunity cost of sticking with the old advertising technique is now $4,000 ($14,000 – $10,000). The $4,000 represents the income that ABC would lose if it continued to use conventional marketing approaches rather than adopting more advanced marketing models.
Considering the Opportunity Cost
Because neither option’s return is clear-cut, calculating the opportunity cost, which is a forward-looking computation, can be difficult. As a result, the exact rate of return for either choice is uncertain. Assume the fictitious corporation stated above decides not to purchase equipment and instead invests in the stock market. Depending on the performance of the stocks, money could be lost. Alternatively, if the stocks perform well, the corporation could benefit greatly.
Once a decision has been made between the two possibilities, the company has a defined set of costs. This is an investment that a company has already made and will not be able to recover.
Conclusion
As a result, differential cost encompasses both fixed and semi-variable costs. It is the difference in the overall cost of the two options. As a result, its analysis focuses on cash flows, regardless of whether it is improved or not. As a result, all variable costs are not included in the differential cost and are only addressed on a case-by-case basis.
Differential Costs FAQs
What is the difference between a sunk cost and a differential cost?
Sunk costs—costs incurred in the past that cannot be modified by future decisions—are not differential costs since they cannot be changed by future decisions. Direct fixed costs—fixed costs that can be connected directly to a product line or customer—are differential costs and thus relevant in decision making.
Why are differential costs considered in a decision making situation?
Because a company’s income statement does not automatically link costs with specific products, segments, or customers, differential analysis is important in this decision making. As a result, businesses must reclassify costs as those that would change as a result of the action and those that would not.
What are the uses of differential costing?
The differential cost analysis is a useful technique for management to understand the outcomes of suggested changes in the quantity or nature of the activity. This method determines the differential costs for each proposal and compares them to the projected changes in revenue associated with each proposal.
