Assume a company’s production cost rises from $20,000 to $25,000 due to an increase in the number of hours required to finish the project. 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. 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.
- Opportunity costs can also be included in the differential analysis format.
- As a result, determining the costs is an important role in management decision making.
- The differential cost and/or the incremental cost of operating its equipment for the additional 10,000 machine hours was $200,000.
- Therefore, the cost to produce the special order is $200 per item ($125 + $50 + $25) and the profit per item is $25 ($225 – $200).
An opportunity cost is the benefit foregone when one alternative is selected over another. For example, if a product line is eliminated, these costs are simply allocated to the remaining product lines. Moving to television commercials and social media marketing exposes ABC Company to a larger customer base. If the company generated $10,000 utilizing its present marketing platforms, switching to more advanced advertising platforms may result in a 40% increase in income to $14,000. In the case of ABC Company, moving to television ads and social media marketing exposes the company to a broader customer base. 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.
The variable cost of manufacture between these levels is 15 paise per unit and fixed cost Rs. 40,000. When assessing customer profitability, costs can be assigned to customers based on each customer’s use of activities. Fixed costs that cannot be traced directly to customers are allocated to customers. The format is similar to the differential analysis format used for making product line decisions. Managers use differential analysis to determine whether to keep or drop a customer.
Types of Differential Costs
A new plant machinery known as Double TT which is using new technology is now in use to do the same 1000 kilometers at $215. With the help of activity-based costing, costs can be assigned to activities within each category. However, management may want a more concise explanation of why profit is $10,000 higher when all three product lines are maintained.
The cost occurs when a business faces several similar options, and a choice must be made by picking one option and dropping the other. When business executives face such situations, they must select the most viable option by comparing the costs and profits of each option. You calculate your incremental revenue by multiplying the number of smartphone units how to lock cells in excel to protect them by the selling price per smartphone unit. The alternative which shows the highest difference between the incremental revenue and the differential cost is the one considered to be the best choice. A significant advantage of using activity-based costing is having accurate data for decision-making purposes, particularly in the area of differential analysis.
Marginal costing also provides insights into the concept of breakeven analysis. Breakeven analysis helps determine the level of sales or production at which the company neither makes a profit nor incurs a loss. By understanding the breakeven point, managers can make informed decisions regarding pricing, cost control, and sales volume required to achieve desired profit levels.
- In the case of ABC Company, moving to television ads and social media marketing exposes the company to a broader customer base.
- The company controller looks up the standard cost for a green widget and finds that it costs the company $14.
- Notice that in Figure 7.1 the columns labeled Alternative 1 and Alternative 2 show revenues, costs, and profit for each alternative.
- 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.
In this case, differential analysis is used to evaluate whether Phillips Accounting should keep all customers or drop unprofitable customers. The information in Figure 7.1 confirms that Phillips Accountancy would be better off dropping the unprofitable customers (Alternative 2), because company profits would increase by $20,000. The general rule is to select the alternative with the highest differential profit. Take a close look at Figure 7.1 before reading the description of this information that follows.
Definition of Differential Cost and Incremental Cost
This information is particularly useful when considering decisions such as pricing, product mix, or outsourcing. Differential revenues and costs1 (also called relevant revenues and costs or incremental revenues and costs) represent the difference in revenues and costs among alternative courses of action. Analyzing this difference is called differential analysis2 (or incremental analysis). We begin with a relatively simple example to establish the format used to perform differential analysis and present more complicated examples later in the chapter.
The company pays $125 for labor, $50 for materials, and $25 for variable overhead selling expenses. Incremental analysis helps companies decide whether or not to accept a special order. Incremental analysis also assists with allocating limited resources to several product lines to ensure a scarce asset is used to maximum benefit. When the two are compared, it is evident that the incremental revenue exceeds the incremental cost. So, you get a profit of $4,000,000 by deducting the incremental cost from the incremental revenue. You calculate your incremental cost by multiplying the number of smartphone units by the production cost per smartphone unit.
However, incremental cost refers to the additional cost related to the decision to increase output. The overall cost incurred as a result of producing an additional unit of product is referred to as incremental cost. The incremental cost is computed by examining the additional expenses incurred during the manufacturing process, such as raw materials, for each additional unit of output. Understanding incremental costs can assist businesses in increasing production efficiency and profitability. Another important aspect of marginal costing is its relevance in decision-making processes. By focusing on variable costs, marginal costing helps managers evaluate the impact of changes in production or sales volume on the overall profitability of the business.
Which costs are taken into account in the differential cost analysis?
These expenses are directly related to the increasing output or activity by one unit. A variable cost is a corporate expense that varies in relation to the amount of product or service produced or sold. Variable costs rise or fall in relation to a company’s production or sales volume, rising as production increases and falling as production drops. Since the fixed cost is being incurred regardless of the proposed sale, it is classified as a sunk cost and ignored.
Incremental costs are relevant in making short-term decisions or choosing between two alternatives, such as whether to accept a special order. If a reduced price is established for a special order, then it’s critical that the revenue received from the special order at least covers the incremental costs. Incremental cost is important because it affects product pricing decisions. 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.
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.
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. The concept of sunk costs describes a cost that’s already been incurred and does not impact any decision made by management or between alternatives. Other terms that refer to sunk costs are sunk capital, embedded cost, or prior year cost. 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. For example, the differential amount of $1,000,000 for revenue indicates Alternative 1 produces $1,000,000 more in revenue than Alternative 2. The differential amount of $750,000 for variable costs indicates variable costs are $750,000 higher for Alternative 1 than for Alternative 2.
Characteristics Of Differential Cost
The differential cost of outsourcing vs. in-house production is now $1,000 ($12,000 – $11,000). The company may choose to continue producing in-house to avoid this additional cost. However, let’s say the third-party manufacturer increases its price from $10,000 to $11,000 for 1,000 units. The total cost to outsource production would then increase to $12,000 ($11,000 outsourcing cost + $1,000 fixed overhead).
As you work through this example, notice that we also use the contribution margin income statement format presented in Chapter 5 and Chapter 6. Another important aspect of differential costing is its consideration of both variable and fixed costs. Variable costs change in direct proportion to the level of activity, while fixed costs remain constant within a certain range of activity. By analyzing the differential costs, managers can assess the impact of changes in activity levels on the overall cost structure of the business.
Differential Cost: Meaning, Features and Applications
Therefore, for these 2,000 additional units, the incremental manufacturing cost per unit of product will be an average of $20 ($40,000 divided by 2,000 units). The reason for the relatively small incremental cost per unit is due to the cost behavior of certain costs. For example, when the 2,000 additional units are manufactured most fixed costs will not change in total although a few fixed costs could increase. Understanding incremental costs can help a company improve its efficiency and save money.