Differential Cost Definition
Differential Cost is a technique of decision making in which the cost between various alternatives is compared and contrasted for the purpose of choosing between the most competing alternative. It is useful when you want to understand a) Whether to process the product further or not b) Whether to accept an additional order at a lower existing price or not
It differs from the marginal cost in the sense that marginal cost includes labor, direct expenses, and variable overheads, whereas differential cost includes both fixed and variable costs.
Examples of Differential Cost
The following are examples to understand this concept in a better manner.
ABC Ltd is a company that produces card boxes. ABC Limited’s monthly cost statistics are as follows:
- Units made and sold: 800 units per month
- Maximum production and sales capacity: 1200 units per month
- Selling price: $ 30
The bifurcation of cost is as given below:
They are having an alternative to increasing the production of up to 900 by reducing the selling price at 28.
Please evaluate the feasibility of the option.
Option 1: Present situation: selling price 30
Hence, presently entity is earning a profit of $ 5600 per month.
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Option 2: Alternative to increase the production
Based on the two options, the cost of both the options can be evaluated as given below:
From the above analysis, we can observe that with the change in the alternative, an entity will have to incur an additional cost of $ 1000. Hence an increase in production is not advisable.
Continuing the above example, ABC Ltd has an opportunity for a one-time-only special order to sell 100 units at $25 each. Should they accept the special order?
Option 1: Present Situation
Option 2: Accepting one-time order
The differential analysis of both the options are as given below:
Thus, we can observe that there is an increase in profit after accepting the order. Hence, ABC ltd should accept the order and should enhance their profit.
Usage of Differential Cost Analysis
- Getting Prices of Products: What can be the optimum price quoted through which tended can be won.
- Accepting or Rejecting Special Orders: Whether to work out in any additional specific order that comes in business or not.
- Adding or Eliminating Products, Segments, or Customers: Whether to continue or to diversify from any specific business segment or not.
- Processing or Selling Joint Products: Whether to co-produce or co-sell the products or to jointly market the products;
- Deciding whether to Make Products or Buy them: Whether to manufacture the product or to leverage the production facility of others.
Accounting Treatment of Differential Costing
The differential costs can be in the nature of fixed cost, the variable cost, or semi-variable costs. Users leverage the costs to evaluate options to make strategic decisions that can positively impact 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 are there presently that can guide treatment of differential costing
Thus, Differential Cost includes fixed and semi-variable expenses. It is the difference between the total cost of two alternatives. Therefore, it’s analysis focuses on cash flows, whether it is getting enhanced or not. All variable costs are not part of the differential cost, and it is to be considered only on the case to case basis.
This has been a guide to Differential Cost and its definition. Here we discuss accounting treatment of differential cost analysis along with its examples and applications. You can learn more from the following articles –