Differential Cost Definition, Examples, Applications

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. Businesses often face such choices and rely on comparative cost analysis to guide them. Put simply, they tally up extra costs like materials, labor or shipping that come with each option. Differential cost, simply put, is the difference in total cost when considering two different options. Since a differential cost is only used for management decision making, there is no accounting entry for it.

The new regulation renders the machine and the produced plastic bags obsolete, and the company cannot change the government’s decision. Differential cost is the variation in costs (increase/decrease) between two available opportunities. It is calculated based on the relevant costs in the alternatives. Differential cost is a technique of decision-making in which the cost between various alternatives is compared and contrasted with choosing between the most competing alternative.

Prepare differential cost analysis to ascertain acceptance or rejection of the order. The company sell similar Mugs at ₹ 10/- each to existing customers. Soniya Ltd. can produce extra units with the current capacity. Which product to make, how much to sell it for, to make or buy raw materials and components, how and where to distribute the product and so forth. A company uses differential cost to decide between options by comparing their costs. Understanding fixed costs is essential for any accounting professional.

It is a technique of decision-making based on the differences in total costs. One has to find net gain/loss by differential cost and revenue. However, the decision to accept or reject the alternative depends on the net gain/loss. Managers also consider differential cost for equipment choices. Two machines might do the same job but have different maintenance and operation costs over time – these are indirect variable and fixed expenses related to restaurant revenue per square foot running them each day. Making the right choice between two products involves a close look at differential costs.

Differential Costing

1. Diving deeper into the fundamentals, differential cost is a crucial concept in accounting.
2. This difference in cost helps managers decide which path will lead to more profit.
3. Understanding differential costs helps businesses choose the best path.
4. You compare what each option will cost you extra over the other.
5. With this tool, managerial accounting becomes more strategic and data-driven.

Company executives must choose between options, but the decision should be made after considering the opportunity cost of not obtaining the benefits offered by the option not chosen. 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. Differential cost refers to the difference between the cost of two alternative decisions.

The differential cost, in this case, is $1,500 ($2,000 – $500). Thus, differential cost includes fixed and semi-variable expenses. It is the difference between the total cost of the two alternatives. Therefore, its analysis focuses on cash flows, whether it is getting enhanced or not. Therefore, all variable costs are not part of the differential cost and are considered only on a case-to-case basis.

Accounting for Managers

The following are examples to understand this concept in a better manner. Access and download collection of free Templates to help power your productivity and performance.

With real-life examples and clear explanations on types and analysis methods, we’ll guide you through using this powerful tool for sharper decision-making. When the company wants to expand its production capacity, the management may lower the selling price to increase sales. The company reduces the selling price up to a point where the company will still earn a profit and meet the production costs. The primary purpose of conducting a differential analysis is decision-making. So, we consider only relevant costs affecting the decision variables.

Usage of Differential Cost Analysis

The differential costs can be fixed, variable, or semi-variable costs. Users leverage the costs to evaluate options to make strategic decisions positively impacting the company. Hence, no accounting entry is needed for this cost as no actual transactions are undertaken, and this is the only evaluation of alternatives. Also, no accounting standards can guide the treatment of differential costing. The differential revenue is obtained by deducting the sales at one activity level from the sales of the previous level. The differential cost is compared to the differential revenue to determine the most profitable level of production and the best selling price.

He is the sole author of all the materials on AccountingCoach.com. For the past 52 years, Harold Averkamp (CPA, MBA) has worked as an accounting california city and county sales and use tax rates supervisor, manager, consultant, university instructor, and innovator in teaching accounting online. They receive a special order for producing Mugs of 1000 units at a rate of ₹ 5/- per unit.

The difference in revenues resulting from two decisions is called differential revenue. Businesses use differential cost analysis to make critical decisions on long-term and short-term projects. Differential cost also provides managers quantitative analysis that forms the basis for developing company strategies. When we work to make decisions, we need to look at the pros and cons of each option. The key to making these decisions is called differential analysis-focusing on the pros and cons (costs and benefits) that differ between the two options.

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. A mixed cost is one that contains both a fixed and variable element. This means that there will be a baseline cost, irrespective of the activity level, plus a variable cost that changes to a degree as the activity level changes. Consider a company engaged in plastic bag manufacturing that acquires an advanced machine to double its current production of plastic bags.

Differential cost analysis helps managers choose between options. In the case of ABC Company, moving to television ads and social media marketing exposes the company to a broader customer base. If the company earned $10,000 using the current marketing platforms, moving to the more advanced advertising platforms might result in a 40% revenue increase to $14,000.

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.