Differential cost

From CEOpedia | Management online

Differential cost is the difference between a change in output levels or cost of two optional decisions. When faced with situations that require choosing a solutions, business managers must choose the most viable alternative and calculate the cost of picking one option over another in order to make a sound decision. The main influencing factors when making decisions are costs and profits for each option. Businesses use differential cost to make critical decisions on long-term and short-term financial issues. Differential cost gives managers tangible numbers that act as the basis for developing company strategies.

Example of Differential Cost

There are two examples (S.Bragg 2017):

"If you have a decision to run a fully automated operation that produces 100,000 widgets per year at a cost of $1,200,000, or of using direct labor to manually produce the same number of widgets for $1,400,000, then the differential cost between the two alternatives is $200,000. A work center can produce 10,000 widgets for $29,000 or 15,000 widgets for $40,000. The differential cost of the additional 5,000 widgets is $11,000."

It can line up the expenses and revenues from one decision next to similar information for the alternative decision. The difference between all line items in the two columns is the differential cost.

Treatment of Differential Cost

A differential cost may be a fixed cost or a variable cost or a combination of both. Steven Bragg wrote that: between these types of cost haven't differentiation, he emphasis is on the gross difference between the costs of the alternatives or change in output.

There isn't accounting standard that mandates how the cost to be calculated. So, is only used for management decisions making, there isn't accounting entry for it.

Opportunity cost

Opportunity cost refers to potential benefits or incomes that is foregone by choosing one option over another. The cost doesn't require any payments of cash or it is 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.

Example of opportunity cost

Example given by Raul Avenir (R.Avenir 2018):

"Assume that a store owner has a vacant rack in front of the counter that he wants to fill with merchandise. He found out that If he filled the rack with apples, his estimated sales for one week would be $100, but if he filled the rack with candies, he would expect to sell $190. If he chose to fill the rack with apples, the opportunity cost, or cost foregone, would be $190. If he chose candies, his opportunity cost would be $100."

Examples of Differential cost

  • The cost of producing a product with one set of materials versus another. For example, if a company is deciding which material to use to produce a chair, they may compare the cost of using wood versus metal. The differential cost would be the difference in cost between using wood and metal.
  • The cost of hiring one employee with different qualifications than another. For example, a company may compare the cost of hiring a web developer with 3 years of experience versus 5 years of experience. The differential cost would be the difference in cost between the two applicants.
  • The cost of utilizing one technology versus another. For example, a company may compare the cost of using a cloud computing solution versus a physical server. The differential cost would be the difference in cost between the two technologies.

Advantages of Differential cost

Differential cost analysis is a useful tool for business decision-making as it allows for comparison of two or more alternatives in order to determine the most cost-effective option. The advantages of differential cost analysis include:

  • Greater insight into cost structure: Differential cost analysis provides a detailed analysis of the costs associated with each option, allowing for greater insight into cost structure and potential savings.
  • Increased accuracy: Differential cost analysis allows for greater accuracy in identifying costs associated with different decisions, as it takes into account all the relevant factors.
  • Improved decision-making: Differential cost analysis helps to improve decision-making by providing a clear comparison of costs and potential savings associated with each option.
  • Enhanced financial planning: Differential cost analysis can help to enhance financial planning by providing a basis for estimating potential future costs and savings associated with different decisions.

Limitations of Differential cost

Differential cost analysis can be a useful tool for decision makers, but it has certain limitations. These include:

  • It does not take into account external costs and benefits that are not directly related to the decision at hand, such as environmental or social impacts.
  • It assumes that all costs and benefits are accurately known and can be accurately predicted, but this is not always the case.
  • It does not consider non-quantifiable factors, such as the impact on staff morale or customer loyalty.
  • It can be difficult to compare options when the costs and benefits are not comparable, such as when considering different types of investments.
  • It assumes that the value of money is constant over time, when in fact it changes due to inflation and other factors.

Other approaches related to Differential cost

  • Cost-benefit analysis: This approach compares the costs of an action with the revenue generated by it. It helps to determine if an action is worth taking, by weighing the potential gains against the potential losses.
  • Marginal cost analysis: This approach considers the additional cost associated with producing one more unit of output. It helps to determine the cost of producing each additional unit and how much a company should produce.
  • Opportunity cost: This approach considers the cost of not taking an action. It helps to determine the cost of not taking a certain action and the cost of pursuing a different action instead.
  • Break-even analysis: This approach considers the point at which total cost and total revenue are equal. It helps to identify the level of output at which a company will make a profit or a loss.

In conclusion, Differential cost is a method of calculating the difference between the cost of two optional decisions. Other approaches related to Differential cost include cost-benefit analysis, marginal cost analysis, opportunity cost and break-even analysis. Each of these approaches can be used to help business managers make sound decisions when faced with situations that require choosing a solution.

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Author: Angelika Bogdanik