Differential cost is the additional cost that comes with a financial decision. Put another way, it is the difference in costs between two available options.
Differential costs arise due to a change in production volume, sale or purchase of assets, pursuit of new products, and similar other business situations.
What is Differential Cost?
Differential cost also known as marginal or incremental cost is the difference of costs between two alternatives.
The decision demands careful consideration before choosing one option over the other one. Most commonly such situations arise when businesses have mutually exclusive projects.
Business managers often have to pursue one option in investing, production, or sale/purchase situations due to limited financial resources.
Thus, they need to be sure of making the best possible decision for the business and shareholders.
Differential cost is a concept that helps business managers achieve the goal of maximizing shareholders’ wealth.
In production, it is the cost of an additional unit after a certain production limit. It means it is the additional cost required to acquire more resources if the business needs to increase production.
Differential cost analysis is a managerial practice. Therefore, there is no accounting entry for recording a differential cost in the financial statements.
How Differential Cost is Calculated?
Since there are no specific situations or scenarios where a business can face multiple choices, there are no set rules to calculate differential costs.
For simplicity, we assume that there are only choices a business has, then, the differential cost can be calculated by:
Differential cost = Total Cost of Option 1 – Total Cost of Option 2
Again, there are no hard and fast rules to set options 1 and 2. However, it’s a common practice to use the existing scenario as option 1.
The purpose of the calculation is to assess the total costs associated with all choices on offer and then make the best decision for a business.
Differential costs can be fixed, variable, both, or a combination of both types of costs. However, businesses must use similar types of costs for all available options for consistency.
Where Do Businesses Use Differential Cost Analysis?
Differential cost analysis is used to help managers make better decisions. The aim is to improve the profitability or liquidity of a business by comparing different options.
Help in Production Volume and Profitability
Businesses operate with fixed installed production facilities. When they want to increase production levels beyond available capacity, they must install more production resources.
Therefore, the decision to increase production level comes with a choice to install new equipment or continue under existing facilities.
The differential cost analysis will help businesses understand the difference between two choices and make the right call after evaluation of total costs and profitability levels.
Optimization of Sale Prices
It is a common practice to reduce prices to increase sales. However, the decision is not a straightforward one.
Lowering selling prices affects the gross profits of a business and hence the net profitability. Therefore, there is a choice to pursue one option over the other.
Differential cost analysis in this situation will help businesses understand the outcome of the lower prices by comparing the selling prices, sales volume, and profitability levels for both scenarios.
Examples
Suppose a company ABC produces packaging boxes and sells 1,000 units monthly at $5 per piece.
The company aims to increase monthly revenue; either by increasing the production level or by increasing the sale price per unit.
Option 1:
The maximum competitive sale price for ABC company is $6 after careful market analysis.
This situation allows the company to generate a monthly revenue of $6,000 (1,000 × $6). The additional revenue is $1,000.
Option 2:
Increasing the production volume to 1,200 units per month requires an additional expense of $ 700 per month.
In this situation, the new monthly revenue will be:
Total Sales = 1,200 × $5 = $,6000
Less additional expenses = $700
New Monthly Revenue = $5,300
Thus, the company is better off increasing the sale price to $6 instead of increasing the production volume to 1,200 units.
Business Scenarios Where Differential Cost Analyses are Used
Our example above shows a simple scenario where a business can analyze two different options for a business.
However, there are several situations where a business can use differential cost analysis.
Buy or Lease
Buy v lease is a common scenario where a business must assess the total cost of using an asset over a defined period.
The differential cost comparison can help businesses make the right decision when considering inbound or outbound buy or lease decisions.
Continue or Discontinue Operations
Discontinuing operations or disposing of an asset is not a simple decision. Differential cost analysis is a useful tool for assessing the feasibility of the continuation of operations.
It can be applied to a product, a manufacturing line, or any other asset nearing its useful life.
In-House or Purchase Products
Large asset acquisition comes with significant upfront costs. Therefore, businesses consider in-house purchases, leasing, or full purchase options.
Again, carefully analyzing all options where internal manufacturing or external purchase options can be compared can help save additional costs.
Increase or Decrease Production Volume
As shown in our example above, increasing output volume does not always make sense.
Therefore, differential cost analysis can be useful in determining the optimal production level and help in deciding to increase or decrease production volume.
Repair or New Purchase Decisions
Old assets can be disposed of or repaired depending on the situation. In some situations, it is viable to purchase new equipment and increase revenue.
In other scenarios, it often makes sense to delay the new investments and continue with the old equipment at lower production levels.
Related Terms to Differential Costs
There are some closely linked terms to differential costs.
Opportunity Cost
Opportunity cost refers to the profit or revenue forgone by choosing one option over the other.
It is similar to differential cost, however, the difference is that opportunity cost analyzes the forgone opportunity in terms of profitability.
Differential Revenue
Differential or incremental revenue is the additional revenue that a business can generate by opting for one choice over another.
Differential Analysis
It is the process of analyzing several available options and comparing the costs associated with each one.
Relevant Costs
These costs refer to the costs that can increase or decrease by undertaking a decision under differential cost analysis.
Avoidable Costs
These are the costs that do not change with the decision taken under differential cost analysis.