What Is Differential Cost? (With Formula And Examples)

By Indeed Editorial Team

Published 19 October 2022

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As part of their role, managers often choose the best option from the various available alternatives. Differential analysis is a quantitative decision-making technique that examines the costs and benefits of two options and compares the net results to help professionals make the right choice in scenarios with multiple options. Understanding differential analysis can help managers make informed decisions that yield the highest revenue or result in the least loss. In this article, we discuss the definition of differential cost, explore a few associated terms, explain it with a few examples and understand its significance in business decisions:

What Is Differential Cost?

Differential cost is the difference in cost between two alternatives. Also known as incremental or marginal cost, it helps business managers and senior executives make informed decisions about the right option to choose. For example, when a business has several similar opportunities, business executives use differential analysis to determine the most viable option by comparing each option's expenditures and potential revenues. It helps companies make critical short and long-term decisions on various projects. It provides managers and senior executives with a quantitative analysis that helps them develop profitable and sustainable company strategies.

Related: What Is Cost Accounting? (Definition And Objectives)

Key Terms Related To Differential Costing

Here are a few terms that can help you better understand the importance of differential pricing:

  • Differential analysis: It is the process of comparing two or more alternatives and choosing the best option that creates the maximum value for the company. Managers rely on differential analysis to make critical decisions about what course of action to take in crucial business processes.

  • Incremental revenue: It is the additional revenue that a company can generate by following a particular course of action.

  • Variable costs: These are expenses that vary depending on the company's production outputs or sales and they increase with sales and production output and decrease with a drop in sales. Common examples include the cost of raw materials, labour charges, utility bills and commissions.

  • Fixed costs: These are expenses that remain the same irrespective of production volumes or sales and are independent of the company's business activities. Common examples include rent, insurance, property tax and depreciation.

  • Relevant costs: These are the business expenses that change depending on the result of the decision. When making a decision, managers consider the relevant costs to help them decide the right course of action.

  • Avoidable costs: These are expenses that companies can eliminate by choosing one alternative over another.

Related: How To Calculate Variable Cost In 3 Steps (With Examples)

Formula To Calculate Differential Costing

You can calculate differential costing using the following formula:

Differential cost = Total cost of alternative 1 - Total cost of alternative 2

Start by calculating the overall costs of each alternative. Next, find the difference in revenue between the two options. You can choose the right option based on the net gain or loss.

Related: What Is Implicit Cost And Explicit Cost? (With Examples)

Examples To Illustrate The Benefits Of Differential Analysis

Here are a few examples that help you better understand

Example 1

Paper Cart is a company that manufactures paper boxes in Cochin. The company sells an average of 800 paper boxes monthly at the cost of ₹30 per unit. The company desires to increase their revenue. They have two options: increase production or increase the unit cost of each box. Differential analysis of both these options can help the company choose the better option. For example, currently, the company earns a monthly revenue of ₹24,000 by selling 800 boxes at ₹30 per unit after deducting all expenses.

By increasing the selling price to ₹32 per unit, the company can earn additional revenue of ₹1600, which brings the overall monthly income to ₹25,600. The other alternative is to increase production capacity to 900 boxes per month. This would increase the monthly revenue to ₹27,000 but would incur additional expenses of ₹5000 due to increasing production. In this scenario, the average monthly income after deducting the extra costs is ₹22,000. In this scenario, differential analysis can help the company determine that increasing production is not advisable.

Related: What Is Cost Of Production? (With Factors That Affect It)

Example 2

Beds for All is a hotel in Chennai. The hotel manager wants to decide whether to renovate unused space on the first floor into an extra guest bedroom or to turn the available space into a gift shop. Differential analysis of the expected revenues and costs can help them make an informed decision. The expected cost to convert the area into a guest bedroom is ₹30,000, whereas the cost to turn it into a gift shop is estimated to be ₹40,000.

If the unused space becomes a guest room, it can generate additional revenue of ₹60,000 per annum. After deducting all expenses, the estimated revenue from a gift shop is ₹75,000 per annum. To conduct the differential analysis, the manager can calculate the total income from both options after deducting the expenses.

Estimated income from an additional guest room = ₹60,000 - ₹30,000 = ₹30,000

Estimated income from the gift shop = ₹75,000 - ₹40,000 = ₹35,000

Since the gift shop generates higher revenue compared to an additional guest bedroom, the manager can choose to convert the additional space into a gift shop. Differential analysis helps the team make informed business decisions.

Related: What Is Opportunity Cost? (Plus How To Calculate It)

Example 3

Barter Co purchased equipment worth ₹40,000 five years ago. The equipment has a book value of ₹15,000 and the company is looking to replace it with newer machinery. The company has two options: sell it for ₹10,000 or lease it to Alden Co for ₹2400 per year for four years. At the end of the lease period, Alden Co would return the machinery to Barter Co and the company can sell it for scrap for ₹1000. Differential analysis can help the financial manager determine the better option.

In option 1, the company can sell the machinery right away and earn ₹10,000. In the second choice, the company makes total revenue of ₹10,600, including the lease income and scrap value. Since leasing the equipment helps Barter Co earn an increased return of ₹600, the company can consider leasing the machinery instead of selling it immediately.

Related: What Is Standard Costing? (With Formula And Examples)

Significance Of Differential Analysis In Making Business Decisions

Differential analysis can help managers make informed business decisions in the following scenarios:

To manufacture or buy a product part

A manufacturing company may have the resources and equipment to produce a part in-house. Alternatively, it might also have the option of purchasing the same part from an external supplier. Differential analysis can help the manufacturing manager decide which is the better option. Assuming equal availability and product quality, they can choose the lower-cost option. This helps reduce manufacturing costs and increase revenues without compromising product availability and quality.

To discontinue or continue a product

Consider the situation where a product, service or department does not perform up to expectations or generates a loss. The company might consider discontinuing the product to reduce its losses. By suspending the product, the company can eliminate the variable costs of manufacturing the product. But the fixed expenses such as rent, insurance, property taxes and depreciation remain the same. Stopping the production of a particular product may not always result in higher income for the business. The company can use differential analysis to decide whether to continue or discontinue the product line based on the financial impacts.

Related: Understanding Cost Of Goods Sold (With Formula And Methods)

To lease or sell equipment

A company might have purchased a fixed asset like equipment, building or a vehicle. The company no longer requires the item for its operations. They can decide to sell or lease the asset to another business to generate a secondary income stream. The company can use differential analysis to determine which of these two alternatives provides the bigger financial returns and make an informed choice.

To sell a product or process it further

Manufactured products go through various processes or stages. In some instances, the initial production phase yields one finished product and results in another different product on further processing. In some situations, there might be a market for partially completed products, where the buyer completes production per their specifications. Differential analysis helps manufacturers compare the profits of selling a product in the initial stage with further processing. They can then choose the right option that is more beneficial financially.

Related: What Is Cost Unit? (Definition, Calculation And Examples)

To repair or purchase an asset

When a fixed asset like machinery or equipment breaks down, the company has two options. They can fix or replace the broken equipment with a new one. Differential analysis can help managers compare the cost of repairing the original asset with replacing it with a newer one.

Related: What Is Fixed Cost Formula? (Definition And Examples)

To accept or reject sales at a reduced rate

Sometimes manufacturers may receive quotations from customers for selling products at a price lower than usual. If the company has the capacity for additional production, it might consider fulfilling the customer's order at a lower price. In such situations, the company can use differential analysis to determine whether it makes sense to accept or reject the offer based on financial considerations.

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