Differential Cost Accounting for Managers

According to the above analysis, the differential revenue is $100,000 and the differential cost is $85,000,leaving a positive differential net operating income of $15,000 under the proposed marketing plan. The net operating income under the present distribution is $160,000, whereas the net operating income under door to door direct selling is estimated to be $175,000. Therefore the door to door direct distribution method is preferred, since it would result in $15,000 higher net operating income. If it were removed from the calculation, the door to door selling method would still be preferred by $15,000.

For Make Money, Inc., they would deduct the $150 they spend a week from the $4,650 they will spend. They now know they will spend an extra $4,500 a month on marketing online sales, but they hope the payout will be worth it. Differential cost is the variation in costs (increase/decrease) between two available opportunities. It is calculated based on the relevant costs in the alternatives. E.g. GNL is a shoe manufacturer who produces 60 pair of shoes at a cost of $55,700. Sales price of a pair of shoes is $ 1,500, thus the total revenue is $90,000.

Increased Revenues

Consider a company engaged in plastic bag manufacturing that acquires an advanced machine to double its current production of plastic bags. 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. Opportunity cost refers to potential benefits or incomes that are foregone by choosing one option over another.

Suppose that Neiman Marcus is considering investing a large sum of money in land that may be a site for future store. Rather than invest the funds in land, the company could invest the funds in high-grade securities. If the land is acquired, the opportunity cost will be the investment income that could have been realized if the securities had been purchased instead. A significant advantage of using activity-based costing is having accurate data for decision-making purposes, particularly in the area of differential analysis. A sunk cost is a cost incurred in the past that cannot be changed by future decisions.

Differential Cost Analysis

Opportunity cost is not usually entered in the accounting records of an organization, but it is a cost that must be explicitly considered in every decision a manager makes. Virtually every alternative has some opportunity cost attached to it. Activity-based costing first assigns costs to activities and then to products or customers based on their use of the activities.

All businesses invest money to streamline their production and related operations. Your investment, also known as the capital, requires careful planning and preparation. You also spend a certain amount on transportation and other avenues of expenditure. Differential costs do not find a place in the accounting records. These can be determined from the analysis of routine accounting records. All in all, managers often get into situations, where they have to choose from alternatives.

Differential cost definition

To determine the highest profitable level of price and production, decisions based on capital investments can be made only through differential cost analysis. Differential cost is the change in cost between two alternative decisions. Normally, this cost arises when there is a change in output or sales or in any level of activity that can be found in a different set of alternatives. A company chooses a favorable alternative that can generate profit. 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.

The company may choose to continue producing in-house to avoid this additional cost. For example, difference in costs may arise because of replacement of labour by machinery and difference in costs of two alternative courses of action will be the differential cost. The primary purpose of conducting a differential analysis is decision-making. So, we consider only relevant costs affecting the decision variables.

Differential Cost vs. Opportunity Cost

If GNL produces an additional pair of shoes, the revenue will be $91,500 and the total cost will be $ 57,000. These costs are then allocated to customers based on each customer’s use of activities. When assessing customer profitability, costs can be assigned to customers based on each customer’s use of activities. The format is similar to the differential analysis format used for making product line decisions. Use differential analysis to decide whether to keep or drop customers. Opportunity costs can also be included in the differential analysis format.

Allocated fixed costs (also called common fixed costs) are fixed costs that cannot be traced directly to a product line, and therefore are assigned to product lines using an allocation process. That is, all variable costs are differential costs for the two alternatives facing the Company. Because you set different prices for different customers, you give an opportunity for people of different economic classes to try out your product. That’s the beauty of differential pricing because you set different prices for different customers or segments of your target audience.

5 Review of Cost Terms Used in Differential Analysis

That way, you can sell your product for different prices and generate more revenue. When you have more profits, you can streamline your production or related operations by investing more money in them. Remember, your company’s products are not restricted to a specific community or high-paying customers. You have to reach out to a broad audience to increase your revenues. Business managers are faced every day with crucial decisions that can have significant effects on the well-being of their firms or companies.

• The work involving managers includes contrast of costs and also revenues of unique alternatives.
• However, given the risks inherent in compulsory licensing, it seems best to first try the approach of strengthening market separation, to enable originator firms to maintain differential pricing.
• If your products remain on shelves for a long time, you will have reduced revenue generation rates because they don’t sell out.
• In cost accounting, the way the differential cost is calculated varies depending on the needs of the company.
• Daniel thought, «Why would I not go with the cheaper website?» Without even understanding what he was doing, Daniel had completed a differential cost analysis.
• A manufacturing concern sells one of its products under the brand name ‘utility’ at Rs. 3.50 each, the cost of which is Rs. 3.00 each.

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​. On the other hand, keeping the store open until the lease expires will result in a monthly net loss of ​$2,000​. The differential cost here is ​$3,000​ which is computed by subtracting ​$2,000​ from ​$5,000​.

Cost

The changes in costs are measured from a common base point which may be a present course of action or present level of production. Make Money, Inc. would then determine the increase in business due to the help of the new employee and the upgrade to the website, which in their case is estimated to be about $2,000 more per week. After they have answered the questions, the business can begin to build their formula to compare each choice’s results.