Differential Cost Accounting for Managers

Allocated fixed costs—fixed costs that cannot be traced directly to a product—are typically not differential costs. For example, if a product line is eliminated, these costs are simply allocated to the remaining product lines. The raw material price and the direct labor cost both make a difference, so both of these costs would be relevant as you looked at your options. What if there was no change in the direct labor needed, regardless of the cost of the raw material? If that was the case, we could disregard that option to save us time in our decision making process. While the differential cost analysis does not directly deal with interactions between business and their customers, it can lead to stronger relationships between the two.

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. 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. And panel C presents the differential analysis for the two alternatives. The differential analysis in panel C shows that overall profit will decrease by $10,000 if the charcoal barbecue product line is dropped.

There are also the additional advertising expenses and overhead that need to be paid as well. 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. They eric block on responsible branding assist businesses in determining which financial option is the best one among various alternatives. 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.

A particular subset of incremental costs, called marginal cost, may concentrate just on the price of the last unit produced. The move places the opportunity cost of choosing to stick to the old advertising method at $4,000 ($14,000 – $10,000). The $4,000 is the income that ABC would forego for remaining with the old marketing techniques and failing to adopt the more sophisticated marketing models. In the case of ABC Company, moving to television ads and social media marketing exposes the company to a broader customer base.

The data used for differential cost analysis are cost, revenue and investments involved in the decision-making problem. Which product to make, how much to sell it for, to make or buy raw materials and components, how and where to distribute the product and so forth. Differential costs take an in-depth look at all of the things that change when comparing two possible choices. However most times, many different things are affected and the decision becomes less clear until a full analysis is made.

  1. 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.
  2. By accepting the special order, net income increases by $6,000 ($18,000 net income with special order – $12,000 net income without special order).
  3. It is a potential benefit or income which is given up due to selecting an option over another.
  4. The costs she would incur at the horse stable
    are $100 for transportation and $50 for supplies.
  5. For example, suppose you are deciding between taking the bus to work or driving your car on a particular day.

Although fixed and variable costs are not forms of differential costs in and of themselves, it is crucial to distinguish between the two when performing differential cost analysis. Differential revenues and costs (also called relevant revenues and costs or incremental revenues and costs) represent the difference in revenues and costs among alternative courses of action. In make-or-buy decisions, management also should consider the opportunity cost of not utilizing the space for some other purpose. Sometimes management has an opportunity to sell its product in two or more markets at two or more different prices. Movie theaters, for example, sell tickets at discount prices to particular groups of people—children, students, and senior citizens.

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Many times both future costs and revenues differ between alternatives. In these situations, the management should select the alternative that results in the greatest positive difference between future revenues and expenses (costs). (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.

Differential costing

The company then calculates the estimated revenue by multiplying the expected output at a specific level by the selling price. Instead of tracing revenues, variable costs, and fixed costs directly to product lines, we track this information by customer. In some manufacturing situations, firms avoid a portion of fixed costs by buying from an outside source. For example, suppose eliminating a part would reduce production so that a supervisor’s salary could be saved. In such a situation, firms should treat these fixed costs the same as variable costs in the analysis because they would be relevant costs.

One example is, You have a position in a company that pays people $25, 000 per year. For a superior future, you have to get a Master’s degree but cannot continue your job while studying. If you decide to give up your job and return for you to school to acquire a Master’s degree, you would not receive $25, 000.

For example, now that Make Money, Inc. has a solid online sales presence, it can better connect with customers and establish a two-way dialogue. This can help them hear suggestions on improving their services and products. https://simple-accounting.org/ 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.

Accounting for a Differential Cost

Depending on the business, it may have a relatively large base of fixed costs. Differential cost analysis aids businesses in determining the long-term financial effects of strategic decisions like market development, the introduction of new products, or capital expenditures. It assists in determining how profitable these choices will be in the long run.

There is also no accounting standard that mandates how the cost is to be calculated. Companies frequently experience resource limitations due to a lack of funds, labor, or materials. Resource allocation can be optimized with the use of differential cost analysis.

The price originally paid to order the machine can not be recovered by any action and it is therefore a sunk cost. Before studying the applications of differential
analysis, you must realize that opportunity costs are also relevant
in choosing between alternatives. An opportunity cost is the
potential benefit that is forgone by not following the next best
alternative course of action.

The differential cost can be quite a fixed cost or perhaps variable cost. In many situations, total variable costs differ between alternatives while total fixed costs do not. For example, suppose you are deciding between taking the bus to work or driving your car on a particular day. The differential costs of driving a car to work or taking the bus would involve only the variable costs of driving the car versus the variable costs of taking the bus. The differential cost can be a fixed cost, variable cost or a combination of both. The company’s management uses a variety of costs to choose between options to make real decisions that have a positive impact on the company.

Using Differential Analysis to Make Decisions

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. Before studying the applications of differential analysis, you must realize that opportunity costs are also relevant in choosing between alternatives. An opportunity cost is the potential benefit that is forgone by not following the next best alternative course of action. For example, assume that the two best uses of a plot of land are as a mobile home park (annual income of $100,000) and as a golf driving range (annual income of $60,000).