What is Differential Cost?
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. When business executives face such situations, they must select the most viable option by comparing the costs and profits of each option.
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.
Example of Differential Cost
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.
The telecom operator currently spends $400 on newspaper ads and $100 on maintaining the company’s website every month. The marketing director estimates that it will spend approximately $1,000 on television ads every month. The company will also need to hire a millennial at $250 per week to oversee its social media marketing efforts. If the telecom operator adopts the new advertisement techniques, they will spend $2,000 per month in advertising expenses. The differential cost, in this case, is $1,500 ($2,000 – $500).
ABC Company must decide between continuing with their current advertising platforms or spending additional amounts on the new advertising channels. They must assess whether the potential incremental benefits are worth the additional costs. Will it access a wider audience and increase the opportunity to capture new customers? Is the additional spending within the budget? Will social media marketing improve interactions with its existing customers and increase sales?
Treatment of 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.
Opportunity cost refers to potential benefits or incomes that are foregone by choosing one option over another. 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.
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.
The move places the opportunity cost of choosing to stick to the old advertising method at $4,000 ($14,000 – $10,000). The $4,000 is the income that ABC would forego for remaining with the old marketing techniques and failing to adopt the more sophisticated marketing models.
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.
Consider a company engaged in plastic bag manufacturing that acquires an advanced machine to double its current production of plastic bags. 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.
Applications of Differential Cost
Managers use differential cost in the following ways:
1. Determine the most profitable level of production and price
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.
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. Management will decide to increase the level of production when the differential revenue is higher than the differential cost.
2. Offer a quotation at a lower selling price to increase capacity
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.
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.
CFI is the official global provider of the Financial Modeling and Valuation Analyst (FMVA)® designation, a leading financial analyst certification program. To continue learning and advancing your career, these additional CFI resources will be helpful: