11 9: Differential Cost Business LibreTexts

Differential cost refers to the difference between the cost of two alternative decisions. The cost occurs when a business faces several similar options, and a choice must be made by picking one option and dropping the other. When business executives face such situations, they must select the most viable option by comparing the costs and profits of each option. A bed & breakfast inn owner uses differential analysis to decide whether to renovate a first-floor guest bedroom or to convert that space to a gift shop. A summary of the year’s revenues and costs for the two alternatives follows.

1. They assist businesses in assessing the financial effects of different options and in making wise choices that maximize profitability and efficiency.
2. The notion is especially relevant in step costing scenarios, where generating one more unit of output may incur a significant additional cost.
3. (i) Prepare a schedule showing the total differential costs and increments in revenue.
4. Companies may make sure that their pricing covers all costs while remaining competitive in the market by understanding the incremental costs linked to producing extra units.

As a result, businesses must reclassify costs as those that would change as a result of the action and those that would not. Differential cost may be a fixed cost, variable cost, or a combination of both. Company executives use differential cost analysis to choose between options to make viable decisions to impact the company positively. The differential cost method is a managerial accounting process done on spreadsheets and requires no accounting entries. 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.

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. Differential revenue is the difference in revenue that results from two decisions. As the name implies, incremental cost is the rise in the cost of production caused by an increase in the number of operations.

What is the difference between a sunk cost and a differential cost?

Particularly in sectors with fluctuating production costs, these expenses are frequently considered’ while making short-term decisions. Regardless of the choice chosen, sunken costs are expenses that have already been incurred and cannot be recovered. Because these costs are constant regardless of the choice made, they are irrelevant in differential cost analysis. 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. Differential costs are the increase or decrease in total costs that result from producing additional or fewer units or from the adoption of an alternative course of action.

Definition of Differential Cost and Incremental Cost

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. Fixed costs are displayed in the income statement and have an impact on the business’s profitability. Companies may make sure that their pricing covers all costs while remaining competitive differential costs in the market by understanding the incremental costs linked to producing extra units. 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. Instead, it is simply an analysis concept used to optimize decisions.

#4. Imputed Cost:

A fixed cost is one that stays relatively fixed, irrespective of the activity level of a business. For example, a firm will incur rent expense for its premises, no matter what level of sales it generates. Depending on the business, it may have a relatively large base of fixed costs. ABC Company is a telecom operator that primarily relies on newspaper ads and the company website for marketing. However, a recently hired marketing director suggests that the company should focus on television ads and social media marketing to reach a broader client base. The differential cost and/or the incremental cost of operating its equipment for the additional 10,000 machine hours was $200,000.

They assist businesses in assessing the financial effects of different options and in making wise choices that maximize profitability and efficiency. Differential cost is the same as incremental cost and marginal cost. The difference in revenues resulting from two decisions is called differential revenue. 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 move places the opportunity cost of choosing to stick to the old advertising method at $4,000 ($14,000 – $10,000).