What is Differential Cost?
Differential cost refers to the difference between the cost of two alternative decisions or a change in output levels. The cost occurs when a business faces several decisions to make, and a choice must be made by picking one decision and dropping the other. When business executives are faced with such situations, they must select the most viable option that increases revenues. They must determine the cost of both options and calculate the cost of picking one option over another in order to make a sound decision. In most cases, the main influencing factors when making such decisions are costs and profits for each option.
Effective business executives can predict how things would go depending on the direction the company takes. If it takes the right direction, then there is potential for growth and an increase in revenues. However, if the business takes the wrong direction, the company is likely to incur a loss, demotivate employees, or see a decline in revenues, depending on the circumstances involved. Businesses use differential cost to make critical decisions on long-term and short-term financial issues. Differential cost also gives managers tangible numbers that act as 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 now 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. Also, the company will 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 as advertisement expenses. The differential cost, in this case, is $1,500 ($2,000 – $500).
ABC Company must decide between remaining with their current advertisement platforms or adopting the suggested advertisement platforms, which translate to additional costs. They must calculate the benefits and gains of choosing one option and leaving the other. If the business faces a tight budget and is getting a few clients via the old advertising platforms, the company may prefer to stay put in its current state. However, if the business goes ahead and implements the new option, it means it gains access to a wider market for its products and services by choosing to spend more money. Another advantage is that social media advertising will give the company an opportunity to interact with its customers directly to know their concerns and suggestions on the company’s current products.
Treatment of Differential Cost
Differential cost may be a fixed cost, variable cost, or a combination of both. Company executives use differential cost to choose between options to make viable decisions to positively impact the company. Therefore, no accounting entry is required for this cost because it is not an actual transaction. Also, there are no accounting standards that guide how differential costs are treated.
Opportunity cost refers to potential benefits or incomes that is foregone by choosing one option over another. The cost does not require any payments of cash or its equivalent. The company executives must choose between options that are attractive, but the decision should be made after taking into account the opportunity cost of other alternative options. Choosing either of the options must be based on analytical calculations rather than instincts.
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 increment 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 changed by any decision of the executive. They may occur 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.
As an extreme hypothetical example, consider a company engaged in plastic bag manufacturing that may acquire a more advanced machine to double its current production of plastic bags. As soon as the company puts the 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.
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. When the differential revenue is higher than the differential cost, the level of production is increased.
2. Offer a quotation at a lower selling price to increase capacity
When the company wants to expand its production capacity, the management may decide to lower the selling price to increase the number of 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 determines 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 profit for the company.
However, the company management must also consider the total profits and profit margin available at different selling prices. For example, assume a company is currently selling 1,000 products per month at a price of $10 each. It determines that it could sell 1,500 products per month if it lowered the sales price for each product to $8.50. The per unit production cost is $7. Therefore:
1,000 sales per month x $3.00 profit per sale = $3,000 monthly profit
1,500 sales per month x $1.50 profit per sale = $2,250 monthly profit
This shows that a 50% increase in products sold would, in fact, result in substantially lower profits for the company. But if manufacturing 1.500 products per month lowered the per unit production cost to $6, then selling 1,500 products with a sales price of $8.50 and a per unit profit of $2.50 would produce a greater total profit (1,500 x $2.50 = $3,750) than selling 1,000 products per month with a sales price of $10 and a per unit profit of $3.
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