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.
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."
- Avenir, Raul (November 19, 2018) Differential Cost vs. Opportunity Cost Chron.com, 1
- Bragg, Steven (December 1, 2017) Differential cost AccountingTools, 1, 1.
- Danzon, Patricia M., Drummond, Michael F., Pauly, Mark V., Towse Adrian (2018) Objectives, Budgets, Thresholds, and Opportunity Costs—A Health Economics Approach: An ISPOR Special Task Force Report Value in health 21, 140-145
- Maher, Michael (1997). Solutions Manual for Cost Accounting Creative Value for Management, University of California, Davis, Fifth Edition, 411-413.
Author: Angelika Bogdanik