Then the direct labor cost would be come in irrelevant cost. If that was the case, we could disregard that option to save us time in our decision making process. We now have to look at the differential cost between the two what is capex choices.
What is Differential Cost?
- Determination of the most profitable level of production and price.
- The components of an item are manufactured by another unit under the same management.
- 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.
- (ii) It is profitable for the company to increase the level of production so long as the incremental revenue is more than the differential costs.
(i) Prepare a schedule showing the total differential costs and increments in revenue. The alternative which shows the highest difference between the incremental revenue and the differential cost is the one considered to be the best choice. Differential cost is the change in cost that results from adoption of an alternative course of action. It can be determined simply by subtracting cost of one alternative from cost of another alternative or from the cost at one level of activity, the cost at another level of activity. A mixed cost is one that contains both a fixed and variable element.
The difference in revenues resulting from two decisions is called differential revenue. Since a differential cost is only used for management decision making, there is no accounting entry for it. There is also no accounting standard that mandates how the cost is to be calculated.
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9: Differential Cost
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. In the case of ABC Company, moving to television ads and social media marketing exposes the company to a broader customer base.
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. 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. The telecom operator currently spends $400 on newspaper ads and $100 on maintaining the company’s website every month.
“Differential cost” also found in:
The differential costs can be fixed, variable, or semi-variable costs. Users leverage the costs to evaluate options to make strategic decisions positively impacting 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 can guide the treatment of differential costing. (ii) It is profitable for the company to increase the level of production so long as the incremental revenue is more than the differential costs.
It is not advisable to increase the level of production to such a level where the differential costs are more than the incremental revenue. In the given problem, the company should set the level of production at 1,50,000 units because after this level differential costs exceed the incremental revenue. 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. The differential revenue is obtained by deducting the sales at one activity level from the sales of the previous level.
Accounting Treatment of Differential Costing
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. Differential cost refers to the difference between the cost notes payable definition 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.
Applications of Differential Cost
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. Differential cost is the difference in total cost that arises from selecting one alternative over another. It is a key concept in decision-making processes where managers compare costs to make informed choices.
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.
Therefore, its analysis focuses on cash flows, whether it is getting enhanced or not. Therefore, all variable costs are not part of the differential cost and are considered only on a case-to-case basis. 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. 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.