Differential Cost Definition, Examples, Applications
The difference in revenues resulting from two decisions is called differential revenue. 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.
What is Differential Cost?
Sunk costs refer to costs that a business has already incurred, but that cannot be eliminated by any management decision. An example is when a company purchases a machine that becomes obsolete within a short period of time, and the products produced by the machine can no longer be sold to customers. In the case of ABC Company, moving to television ads and social media marketing exposes the company to a broader customer base.
(ii) To continue the present level of output of ‘utility’ but double the production of ‘Ace’. You are required to work out the incremental profit/loss involved in each of the two proposals and to offer your suggestions. A company has a capacity of producing 1,00,000 units of a certain product in a month. Differential cost can then be defined as the difference in cost between any two alternative choices. Differential costing involves the study of difference in costs between two alternatives and hence it is the study of these differences, and not the absolute items of cost, which is important. Moreover, elements of cost which remain the same or identical for the alternatives are not taken into consideration.
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. 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. When a company wants to determine the ideal level of production that yields the highest revenues or highest net profit, it must conduct market research to determine the selling prices for its products at various activity levels. The company then calculates the estimated revenue by multiplying the expected output at a specific level by the selling price.
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. 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.
Examples of Differential Cost
Then the direct labor cost would be come in irrelevant cost. bookkeeping sacramento If that was the case, we could disregard that option to save us time in our decision making process. We now have to look at the differential cost between the two choices.
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. (ii) It is profitable for the company to increase the level of production so long as the incremental revenue is more than the differential costs.
Raw Material 2
It is not advisable to increase the level of production to such a level where the differential costs are more than the incremental revenue. In the given problem, the company should set the level of production at 1,50,000 units because after this level differential costs exceed the incremental revenue. For the company to know if the new selling price is viable, it calculates the differential cost by deducting the cost of the current capacity from the cost of the proposed new capacity. The differential cost is then divided by the increased units of production to determine the minimum selling price. Any price above this minimum selling price represents incremental profit for the company. The differential revenue is obtained by deducting the sales at one activity level from the sales of the previous level.
When business executives face such situations, they must select the most viable option by comparing the costs and profits of each option. 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. 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.
- A company has a capacity of producing 1,00,000 units of a certain product in a month.
- Moreover, elements of cost which remain the same or identical for the alternatives are not taken into consideration.
- A fixed cost is one that stays relatively fixed, irrespective of the activity level of a business.
- The first proposal results into a loss and hence is not acceptable.
As soon as the company puts the new machine into use, the government bans the manufacturing of plastic bags in the country and makes it a crime for any person to manufacture or sell plastic bags. The new regulation renders the machine and the produced plastic bags obsolete, and the company cannot change the government’s decision. It is an expense that cannot be reversed or is a sunk cost.
Opportunity Cost
It has a higher cost per unit, but it saves production time. Thus, differential cost includes fixed and semi-variable expenses. It is the difference between the total cost of the two alternatives.
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. Differential cost is the difference in total cost that arises from selecting one alternative over another. It is a key concept in decision-making processes where managers compare costs to make informed choices.
The differential cost is compared to the differential revenue to determine the most profitable level of production and the best selling price. Management will decide to increase the level of production when the differential revenue is higher than the differential cost. 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. The telecom operator currently spends $400 on newspaper ads and $100 on maintaining the company’s website every month.
(i) Prepare a schedule showing the total differential costs and increments in revenue. The alternative which shows the highest difference between the incremental revenue and the differential cost is the one considered to be the best choice. Differential cost is the change in cost that results from adoption of an alternative course of action. It can be determined simply types of inventory 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. A mixed cost is one that contains both a fixed and variable element.
