Differential costs are the increase or decrease in total costs that result from producing additional or fewer units or from the adoption of an alternative course of action.
The alternative course of action may arise due to change in sales volume, alternative method of production, change in product/sales mix, make or buy, refuse or accept decisions, addition of a new product, exploring a new market, decision to drop a product line, etc.
Differential cost may be referred to as either incremental cost or decremental cost. When there is an increase in the cost due to increase in the level of production, it is called incremental cost, and when there is decrease in the cost due to decrease in the level of production, it is called decremental cost. A few definitions of differential cost are given below.
According to the Institute of Cost and Management Accountant, London, differential cost may be defined as “the increase or decrease in total cost or the change in specific elements of cost that result from any variation in operations”.
In the words of Blocker and Weltmer, “differential costs, also frequently described as marginal cost and incremental costs, are the increase or decrease in total costs that result from producing and distributing additional or fewer units of a product or from a change in method of production or distribution.”
Determination of Differential Cost:
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.
Essential Features of Differential Costing:
- The data used for differential cost analysis are cost, revenue and investments involved in the decision-making problem.
- Differential costs do not find a place in the accounting records. These can be determined from the analysis of routine accounting records.
- The total cost figures are considered for differential costing and not the cost per unit.
- Differential cost analysis determines the choice for future course of action and hence it deals with the future costs but even then historical or standard costs, adjusted to the future requirements may be used in differential costing.
- Differential costing involves the study of difference in costs between two alternatives and hence it is the study of these differences, and not the absolute items of cost, which is important. Moreover, elements of cost which remain the same or identical for the alternatives are not taken into consideration.
- The differences are measured from a common base-point.
- The alternative which shows the highest difference between the incremental revenue and the differential cost is the one considered to be the best choice.
Managerial Applications of Differential Cost Analysis:
Differential cost analysis is very useful to the management in formulating policies and making decisions, such as:
- Determination of the most profitable level of production and price.
- Introduction of new products.
- Acceptance of an offer at a lower selling price.
- Changing the product mix.
- Changing the method of product.
- Discontinuing a product to avoid the losses and increase profits – decision to drop a product line.
- Make or buy decisions.
- Decision regarding the depth of processing.
- Shut -down decisions.
- Equipment replacement decisions.
- Determining a suitable price at which raw materials may be purchased.