7 2: Using Differential Analysis to Make Decisions Business LibreTexts

The opportunity cost of sticking with the old advertising technique is now $4,000 ($14,000 – $10,000). The $4,000 represents the income that ABC would lose if it continued to use conventional marketing approaches rather than adopting more advanced marketing models. Every month, the telecom operator spends $400 on newspaper ads and $100 on website maintenance. The marketing director anticipates that the company will spend about $1,000 each month on television advertisements.

• Since the fixed cost is being incurred regardless of the proposed sale, it is classified as a sunk cost and ignored.
• As you work through this example, notice that we also use the contribution margin income statement format presented in Chapter 5 and Chapter 6.
• For instance, avoidable costs are costs that can be eliminated by choosing one option over another, such as closing a department.
• When a corporation wishes to raise its manufacturing capacity, the management may cut the selling price to boost sales.

(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. In the given problem, the company should set the level of production at 1,50,000 units because after this level differential costs exceed the incremental revenue. From the above information, we see that the incremental cost of manufacturing the additional 2,000 units (10,000 vs. 8,000) is $40,000 ($360,000 vs. $320,000). 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.

Understanding Differential Cost

Differential cost also provides managers quantitative analysis that forms the basis for developing company strategies. Differential revenue is the difference in revenue that results from two decisions. Fixed costs are displayed in the income statement and have an impact on the business’s profitability. In make-or-buy decisions, management also should consider the opportunity cost of not utilizing the space for some other purpose. Allocated fixed costs—fixed costs that cannot be traced directly to a product—are typically not differential costs. Sunk costs—costs incurred in the past that cannot be changed by future decisions—are not differential costs because they cannot be changed by future decisions.

• Costs that can be avoided or eliminated by choosing one option over another are known as avoidable costs.
• Thus 75 percent of all allocated fixed costs are assigned to that product line.
• Instead of tracing revenues, variable costs, and fixed costs directly to product lines, we track this information by customer.
• The differential cost and/or the incremental cost of operating its equipment for the additional 10,000 machine hours was $200,000.
• The marketing director anticipates that the company will spend about $1,000 each month on television advertisements.

However, the decision to accept or reject the alternative depends on the net gain/loss. The differential cost analysis is used by businesses to make key decisions on long-term and short-term projects. It also gives managers quantitative analysis that serves as the foundation for formulating firm strategies.

Differential cost definition

The additional requirement may be purchased from the market at Rs. 8.50 per unit. The components of an item are manufactured by another unit under the same management. Get instant access to lessons taught by experienced private equity pros and bulge bracket investment bankers including financial statement modeling, DCF, M&A, LBO, Comps and Excel Modeling.

Differential Analysis (Accounting) – Explained

Although a by-product, companies convert this bark into fuel or landscaping material. When the differential revenue of further processing exceeds the differential cost, firms should do further processing. As concerns increase about the effects of waste on the environment, companies find more and more waste materials that can be converted into by-products.

Incremental Cost: Definition, How to Calculate, and Examples

All in all, managers often get into situations, where they have to choose from alternatives. Differential Costing is helpful in a comparative evaluation of the substitutes available. ABC Firm is a telecommunications company that primarily markets itself through newspaper advertisements and the company website. However, a newly appointed marketing director free accounting tutorial proposes that the corporation focuses on television commercials and social media marketing to reach a larger client base. Although using quantitative factors for decision making is important, management must also consider qualitative factors. Using these quantitative factors to make decisions allows managers to support decisions with measurable data.

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. The estimated revenue is then calculated by multiplying the predicted output at a certain level by the selling price. 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.

The components required by the main factory are to be increased by 20 per cent. The components factory can increase production upto 25 per cent without any additional labour force. Overheads are variable to the extent of 25 per cent of the present amount. (ii) To continue the present level of output of ‘utility’ but double the production of ‘Ace’. You are required to work out the incremental profit/loss involved in each of the two proposals and to offer your suggestions.