Companies are frequently forced to choose between different business solutions at varying costs. Because the special order does not increase the fixed costs, the special order’s revenues need only cover its variable costs. Assume the company receives an order from a foreign distributor for 3,000 units at $10 per unit. This $10 price is not only half of the regular selling price per unit, but also less than the $17.60 average cost per unit ($88,000/5,000 units).
- When applying differential analysis to pricing decisions, each possible price for a given product represents an alternative course of action.
- Differential cost and incremental cost are two different concepts, though at times they are interchangeably used.
- Organizations can better invest resources where they will provide the greatest value by being aware of the incremental costs of each alternative.
- One aspect that companies must be aware of is the potential for cost assumptions to be wrong.
Thus 75 percent of all allocated fixed costs are assigned to that product line. Figure 7.1 presents the format used by management to perform differential analysis. 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.
Differential Costing
Assume the fictitious corporation stated above decides not to purchase equipment and instead invests in the stock market. Alternatively, if the stocks perform well, the corporation could benefit greatly. The term “opportunity cost” refers to the possible benefits or money lost by selecting one alternative over another. Company leaders must pick between possibilities, but they must do so after weighing the opportunity cost of not gaining the benefits supplied by the option not chosen. This is a cost incurred as a result of internal transactions that do not occur.
These fixed costs would continue to be incurred and would not be saved by closing the art supplies department. An incremental cost is the difference in total costs as the result of a change in some activity. Incremental costs are also referred to as the differential costs and they may be the relevant costs for certain short run decisions involving two alternatives. The difference in total costs between two or more alternative courses of action is known as differential costs, often called incremental costs. They are the extra expenses encountered by choosing one course of action over another.
Understanding Incremental Cost
A particular subset of incremental costs, called marginal cost, may concentrate just on the price of the last unit produced. Regardless of the choice chosen, sunken costs are expenses that have already been incurred and cannot be recovered. Because these costs are constant regardless of the choice made, they are irrelevant in differential cost analysis.
What Is Incremental Cost?
It is a useful tool for making strategic decisions in various business contexts. Its numerous uses are essential for maximizing revenue, allocating resources efficiently, and attaining strategic objectives. It enables businesses to streamline operations, eliminate waste, and concentrate on areas where cost savings can make a big difference. Controlling needless expenses is crucial for maintaining financial stability. The analysis makes it easier to identify which expenses are avoidable and which are directly tied to particular choices. For instance, avoidable costs are costs that can be eliminated by choosing one option over another, such as closing a department.
Treatment of Differential Cost
Incremental cost, also known as the marginal or differential cost, refers to the additional cost a business incurs when producing or selling an additional unit of a product or service. It is a crucial concept for decision-makers, allowing them to evaluate the profitability of specific actions and make informed choices that contribute to the financial success of their business. The differential revenue is obtained by deducting the sales at one activity level from the sales of the previous level. The differential cost is compared to the differential revenue to determine the most profitable level of production and the best selling price. Management will decide to increase the level of production when the differential revenue is higher than the differential cost.
Uses/Applications of Differential Costing
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. The primary purpose of conducting a differential analysis is decision-making. When a corporation wishes to raise its manufacturing capacity, the management may cut the selling price to boost sales.
Why are differential costs considered in a decision making situation?
As a result, determining the costs is an important role in management decision making. Although these five decisions are not the only applications of differential analysis, they represent typical short-term business decisions using differential analysis. A significant advantage of using activity-based costing is having accurate data for decision-making bookkeeping for landscaping business 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. Allocated costs are typically not differential costs, and therefore are typically not relevant to the decision. And panel C presents the differential analysis for the two alternatives.