Differential Costing

Topics: Marginal cost, Cost, Variable cost Pages: 6 (1779 words) Published: March 8, 2014
Differential Costing

Costs are an important feature of many business decisions. In making decisions, it is essential to have a firm grasp of the concepts differential cost. Decisions involve choosing between alternatives. In business decisions, each alternative will have costs and benefits that must be compared to the costs and benefits of the other available alternatives. A difference in costs between any two alternatives is known as a differential cost. A difference in revenues between any two alternatives is known as differential revenue. Differential cost is the difference between the cost of two alternative decisions, or of a change in output levels. This is a costing method that shows the difference in costs that result from different levels of activity such as making one thousand or ten thousand extra units of a product. The concept is used to reach decisions about which alternatives to pursue, and which to drop. The concept can be particularly useful in step-costing situations, where producing one additional unit of output may require a substantial additional cost. (Bragg, 2013). A differential cost is also known as an incremental cost, although technically an incremental cost should refer only to an increase in cost from one alternative to another; decreases in cost should be referred to as decremental costs. Differential cost is a broader term, encompassing both cost increases (incremental costs) and cost decreases (decremental costs) between alternatives. The accountant’s differential cost concept can be compared to the economist’s marginal cost concept. In speaking of changes in cost and revenue, the economist uses the terms marginal cost and marginal revenue. The revenue that can be obtained from selling one more unit of product is called marginal revenue, and the cost involved in producing one more unit of product is called marginal cost. The economist’s marginal concept is basically the same as the accountant’s differential concept applied to a single unit of output. Differential costs are often confused with marginal costs. The main reason behind such confusion is due to the fact that both (marginal costing as well as differential cost analysis) the techniques are based on the same concept of costs—variable and fixed. But differential cost analysis is a broader and more fundamental concept than the marginal cost. Illustration

Differential costs can be either fixed, variable or a mix of the two- there is no differentiation between these types of costs, since the emphasis is on the gross difference between the costs of the alternatives or change in output. Since a differential cost is only used for management decision making, there is no accounting entry for it. (Coiness,2012). To illustrate this, assume that a company is thinking about changing its marketing method from distribution through retailers to distribution by a network of neighborhood sales representatives. Present costs and revenues are compared to projected costs and revenues in the following table:

Retailer Sales Differential
Distribution Representatives Costs and
(present) (proposed) Revenues
Revenues (Variable) . . . . . . . . . . . . . . . . 700,000 800,000 100,000 Cost of goods sold (Variable) . . . . . . . . . 350,000 400,000 50,000 Advertising (Fixed) . . . . . . . . . . . . . . . . .80,000 45,000 (35,000) Commissions (Variable) . . . . . . . . . . . . . 0 40,00040,000 Warehouse depreciation (Fixed) . . . . . . 50,000 80,00030,000 Other expenses (Fixed) . . . . . . . . . . . . . 60,000 60,000 0 Total expenses . . . . . . . . . . . . . . . . . . . . 540,000 625,000 85,000 Net operating income . . . . . . . . . . . . . . .160,000 175,00015,000

According to the above analysis, the differential revenue is N100,000 and the differential costs total N85,000, leaving a positive differential net operating income of N15,000...

References: Bragg, S (January 26,2013) What is differential cost? Accounting Tools. Retrieved February 10, 2014 from http://www.accountingtools.com/questions-and-answers/what-is-a-differential-cost.html
Caplan D. (2008) Management Accounting: Concepts and Techniques. Oregon State University College of Business. Retrieved February 10, 2014 from http://www.classes.bus.oregonstate. edu
Coiness, O. (January 12, 2012).Differential Cost Analysis chapter7. Retrieved February 10, 2014 http://www.slideshare.net/coiness/differential-cost-analysis-chap
Martinelli, M. (September 2013) “Principles of Managerial Accounting”
Retrieved February 10, 2014 http://faculty.deanza.fhda.edu/martinellimark
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