Differential cost definition

The new legislation renders the machine and the plastic bags created outdated, and the corporation is powerless to overturn the government’s decision. The loss or gain incurred by a firm when one alternative is chosen at the expense of the other possibilities is referred to as the opportunity cost. For example, A was offered a $50,000-a-year job, but he chose to complete his education in order to have a better future. 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.

When making short-term decisions or selecting between two possibilities, such as whether to accept a special order, incremental costs are important. If a lower price is set for special order, it is vital that the income generated by the special order at least covers the incremental costs. To fully comprehend the concept of incremental analysis, one has to understand its underlying concepts. The three main concepts are relevant cost, sunk cost, and opportunity cost.

The analysis makes it easier to identify which expenses are avoidable and which are directly tied to particular choices. These are expenses incurred by outside parties but are not directly the responsibility of the business. Potential gains or profits are lost when one option is selected over another.

Certain costs will be incurred whether there is an increase in production or not, which are not computed when determining incremental cost, and they include fixed costs. However, care must be exercised as allocation of fixed costs to total cost decreases as additional units are produced. Understanding incremental expenses can assist a business in improving its efficiency and saving money. Incremental costs can also help you decide whether to make a product or buy it elsewhere. Understanding the additional costs of increasing a product’s manufacturing is beneficial when deciding the retail price of the product.

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. Incremental costs are the extra expenses spent when a business produces one more unit of a product, offers an additional service, or takes a certain action. These expenses are directly related to the increasing output or activity by one unit. You calculate your incremental revenue by multiplying the number of smartphone units by the selling price per smartphone unit. Companies utilize incremental revenue as a comparative measure with their baseline revenue level to calculate their return on investment.

Avoidable and Unavoidable Costs in Differential Analysis

External costs are costs imposed on third parties or society as a whole, which are not accounted for by the business itself. These costs can include pollution, but they are not directly incurred by the business as a result of the ultimate list of small business tax deductions its decisions. Consider the scenario when a business decides to fund Project A rather than Project B using its resources. The potential profit or advantages that Project B may have provided would then be the opportunity cost.

  • These can be determined from the analysis of routine accounting records.
  • Organizations can better invest resources where they will provide the greatest value by being aware of the incremental costs of each alternative.
  • Consider a company engaged in plastic bag manufacturing that acquires an advanced machine to double its current production of plastic bags.
  • It is advisable to accept the second proposal provided facilities exist for the production of additional numbers of ‘utility’ and to convert them into ‘Ace’.

Differential cost may be referred to as either incremental cost or decremental cost. Allocated fixed costs—fixed costs that cannot be traced directly to a product—are typically not differential costs. Sunk costs—costs incurred in the past that cannot be changed by future decisions—are not differential costs because they cannot be changed by future decisions.

It includes relevant and significant costs that exert a material impact on production cost and product pricing in the long run. They can include the price of crude oil, electricity, any essential raw material, etc. Incremental revenue is compared to baseline revenue to determine a company’s return on investment. The two calculations for incremental revenue and incremental cost are thus essential to determine the company’s profitability when production output is expanded. It is usually made up of variable costs, which change in line with the volume of production.

The only future expenses that matter are those that vary between choices. The two main categories of expenses evaluated in differential cost analysis are incremental costs (more costs incurred) and avoidable costs (costs that can be minimized). These are expenses that the decision under consideration will immediately influence. The reason there’s a lower incremental cost per unit is due to certain costs, such as fixed costs remaining constant. The calculation of incremental cost shows a change in costs as production expands. Incremental cost is usually computed by manufacturing entities as a process in short-term decision-making.

Special Order Pricing Decision

Prepare differential cost analysis to ascertain acceptance or rejection of the order. The costs that do not change in the alternatives are not part of the analysis. This chapter has focused on using relevant revenue and cost information to perform differential analysis. Activity-based costing first assigns costs to activities and then to products or customers based on their use of the activities. Activity-based costing is a refined approach to allocating costs to products or customers. The format is similar to the differential analysis format used for making product line decisions.

Long-Run Incremental Cost Analysis

It covers important and significant costs that have a long-term impact on manufacturing costs and product pricing. They could include the price of crude oil, electricity, or any other key raw commodity, for example. The calculation of incremental cost shows how costs alter as production grows. The incremental revenue of Rs. 10,000 is much more than the differential cost of Rs. 3,000, it will increase the profit by Rs. 7,000. Instead of tracing revenues, variable costs, and fixed costs directly to product lines, we track this information by customer.


Businesses looking to maximize efficiency and profitability must thoroughly understand these costs and how they operate. Alternative A reports a net income amounting to $750,000, while Alternative B’s net income totals $855,000. Based purely on the available financial information, the management team should decide to take on Alternative B as a new and/or additional segment. The example below briefly illustrates the concept of incremental analysis; however, the analysis process can be more complex depending on the scenario at hand. Discontinuing a product to avoid the losses and increase profits – decision to drop a product line.

The company reduces the selling price up to a point where the company will still earn a profit and meet the production costs. They assist businesses in determining which financial option is the best one among various alternatives. If the LRIC increases, it means a company will likely raise product prices to cover the costs; the opposite is also true. Forecast LRIC is evident on the income statement where revenues, cost of goods sold, and operational expenses will be affected, which impacts the overall long-term profitability of the company. Long-run incremental cost (LRIC) is a forward-looking cost concept that predicts likely changes in relevant costs in the long run.

They may then determine how much money they can afford to spend on marketing efforts and how much sales volume is required to generate a profit for the company. It simply divides the change in costs by the change in quantity produced to determine the incremental cost. The concept of opportunity cost describes the reward or loss resulting from a decision made between respective alternatives.

What is Differential Cost?

Moreover, elements of cost which remain the same or identical for the alternatives are not taken into consideration. Among several alternatives, management opts for the most profitable one. Financial managers conduct a comparative analysis to ascertain the difference in the cost due to the change in operations. It involves estimating cost differences either by replacing the existing operation or introducing new procedures. Pablo road constructors has been using Double XX plant machinery to prepare 1000 kilometers of road at a cost of $250.

#2. Fixed Cost:

If incremental cost leads to an increase in product cost per unit, a company may choose to raise product price to maintain its return on investment (ROI) and to increase profit. Conversely, if incremental cost leads to a decrease in product cost per unit, a company can choose to reduce product price and increase profit by selling more units. Incremental cost is the additional cost incurred by a company if it produces one extra unit of output. The additional cost comprises relevant costs that only change in line with the decision to produce extra units. The primary purpose of conducting a differential analysis is decision-making. However, sales revenue, variable costs, and fixed costs are traced directly to customers rather than to product lines.

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