Differential Cost Analysis

Differential cost is the difference in the total cost that will arise from the selection of one alternative instead of another. The alternate choice may arise on account of change in the method of production, sales volume, product mix, price, selection of an additional sales channel, make or buy decisions etc.

Characteristics of Differential costing

1. In order to ascertain the differential costs, only total cost is needed and not cost per unit.
2. Existing level is taken to be the base for comparison with some future or forecasted level.
3. Differential cost is the economist’s concept of marginal cost.

4. It may be referred to as incremental cost when the difference in cost is due to increase in the level of production and decremental costs when difference in cost is due to decrease in the level of production. 5. It does not form part of the accounting records, but may be incorporated in budgets.
6. It is not necessary to adopt marginal cost technique for differential cost analysis because it can be worked out on the method of absorption costing or standing costing.
7. What is said of the differential cost above, applies to differential revenue also.

Uses of Differential Costing in policy decisions like:

1. The introduction of a new plant.
2. Make or buy decisions.
3. Lease or buy decisions.
4. Discontinuing a product, suspending or closing down a segment of the business.
5. The profitability of a change in product mix.
6. Acceptance of an offer at a lower selling price.
7. Change in the methods of production.
8. The determination of the most profitable levels of production and price.
9. Submitting tenders.
10. The determination of price at which raw materials can be purchased.
11. Equipment replacement decisions.
12. The profitability or otherwise of further processing.
13. The opening of a new sales area or territory.

Example: Make or Buy Decision

Suppose a manufacturing company incurs the following costs with respect to producing a product “A” (5000 units)

Materials                           $500,000

Labor                               $250,000

Overheads                        $200,000

Indirect expenses               $150,000

          Total expenses  $1,100,000

Suppose the same product “A” is available from an outsider at $200 per unit, the company will decide to buy rather than to make because buying will cost the company only $1,000,000, which is lower than the cost of production.

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