DIFFERENTIAL COST ANALYSIS: Examples & Application to Businesses

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As a result, determining the costs is an important role in management decision making. Since a differential cost is only used for management decision making, there is no accounting entry for it. There is also no accounting standard that mandates how the cost is to be calculated. Similarly, organizations can utilize differential cost analysis to identify the most cost-effective choice when deciding whether to outsource or internalize specific operations. Companies frequently experience resource limitations due to a lack of funds, labor, or materials.

Differential costs are a key idea in the fields of business and economics. When the two are compared, it is evident that the incremental revenue exceeds the incremental cost. So, you get a profit of $4,000,000 by deducting the incremental cost from the incremental revenue. You calculate your incremental cost by multiplying the number of smartphone units by the production cost per smartphone unit. Differential cost is the change in cost that results from adoption of an alternative course of action. It can be determined simply by subtracting cost of one alternative from cost of another alternative or from the cost at one level of activity, the cost at another level of activity.

The reason for the relatively small incremental cost per unit is due to the cost behavior of certain costs. For example, when the 2,000 additional units are manufactured most fixed costs will not change in total although a few fixed costs could increase. Understanding incremental expenses can assist a business in improving its efficiency and saving money.

Net differential cost represents the extra cost of the rejected alternative; therefore, it is also referred to as incremental cost. Thus 75 percent of all allocated fixed costs are assigned to that product line. 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.

Differential Costing

Differential costs are those items of total costs of two or more alternatives which have different magnitude under each alternative. Items of differential costs may be variable cost items or fixed cost items. Following table illustrates the concept of differential costs in case of a decision to choose between two alternative methods of production. The difference in total costs between two or more alternative courses of action is known as differential costs, often called incremental costs.

  • When a corporation wishes to raise its manufacturing capacity, the management may cut the selling price to boost sales.
  • Knowing the difference between the two makes determining which expenses apply to a certain decision easier.
  • Differential cost is the change in cost that results from adoption of an alternative course of action.
  • It enables businesses to streamline operations, eliminate waste, and concentrate on areas where cost savings can make a big difference.

There is a requirement to create a spreadsheet that tracks costs and output. The incremental revenue of Rs. 10,000 is much more than the differential cost of Rs. 3,000, it will increase the profit by Rs. 7,000. Marginal costing also provides insights into the concept of breakeven analysis.

If no excess capacity is present, additional expenses to consider include investment in new fixed assets, overtime labor costs, and the opportunity cost of lost sales. A variable cost is a corporate expense that varies in relation to the amount of product or service produced or sold. Variable costs rise or fall in relation to a company’s production or sales volume, rising as production increases and falling as production drops. If the LRIC rises, it is likely that a corporation will boost product pricing to meet the costs; the inverse is also true. Forecast LRIC is visible on the income statement, where revenues, cost of goods sold, and operational expenses will be altered, affecting the company’s total long-term profitability.

Customer Decisions

Relevant costs are also called incremental costs because they are only incurred when an activity of relevance has been increased or initiated. Incremental analysis is a decision-making technique used in business to determine the true cost difference between alternatives. Also called the relevant cost approach, marginal analysis, or differential analysis, incremental analysis disregards any sunk cost or past cost. Incremental analysis is useful for business strategy including the decision to self-produce or outsource a function.

Terms Similar to Differential Cost

Analyzing production volumes and incremental costs can assist businesses in achieving economies of scale in order to optimize production. Economies of scale occur when expanding production results in cheaper costs because the costs are spread out over a greater number of commodities produced. In other words, when output increases, the average cost per unit decreases.

Benefits to Incremental Cost Analysis

Another important aspect of differential costing is its consideration of both variable and fixed costs. Variable costs change in direct proportion to the level of activity, while fixed costs remain constant within a certain range of activity. By analyzing the differential costs, managers can assess the impact of changes in activity levels on the overall cost structure of the business. Alternatively, once incremental costs exceed incremental revenue for a unit, the company takes a loss for each item produced. Therefore, knowing the incremental cost of additional units of production and comparing it to the selling price of these goods assists in meeting profit goals.

Relevant costs are those costs that differ between alternatives and have an impact on decision-making. By considering only the relevant costs, managers can make more informed choices and avoid being influenced by irrelevant expenses. However, sales revenue, variable costs, and fixed costs are traced directly to customers rather than to product lines. Direct fixed costs—fixed costs that can be traced directly to a product line or customer—are differential costs and therefore pertinent to making decisions. However, we must review these costs on a case-by-case basis because some direct fixed costs may not be considered differential in spite of being traced directly to a product line. 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.

What is the Differential Cost?

On the other hand, marginal costing provides insights into the long-term behavior of costs and aids in decisions related to pricing, product mix, and capacity planning. In the field of managerial accounting, two commonly used costing techniques are differential costing and marginal costing. Both approaches provide valuable insights into the cost behavior of a business and aid in decision-making processes. While they share some similarities, they also have distinct attributes that set them apart. In this article, we will explore the characteristics of differential costing and marginal costing, highlighting their differences and similarities. 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.

Incremental costs can also help you decide whether to make a product or buy it elsewhere. Understanding the additional costs of increasing a product’s manufacturing is beneficial when deciding the retail price of the product. Companies seek to maximize production levels and profitability by analyzing the incremental costs of manufacturing. When evaluating a business segment’s profitability, only relevant incremental costs that can be directly linked to the business segment are examined. Differential costs assist decision makers while making a choice between different alternatives.

What is the meaning of variable cost?

Differential cost and incremental cost are two different concepts, though at times they are interchangeably used. The former is defined as a future cost that differs from one alternative to another, while the latter represents an increase in cost of one alternative over the cost of another. Incremental costs are the extra expenses spent when a business produces one more unit of a product, offers an additional service, or takes a certain action. These expenses are directly related to the increasing output or activity by one unit.

One of the key attributes of marginal costing is its contribution margin analysis. Contribution margin represents the difference propeller industries company culture between sales revenue and variable costs. It indicates the amount available to cover fixed costs and contribute towards profit.