Differential Cost: Meaning, Features and Applications

As output rises, cost per unit decreases, and profitability increases. Costs are determined differently by each organization according to its overhead cost structure. The separation of fixed costs and variable costs and determination of raw material and labor costs also differs from organization to organization. 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. Conversely, if incremental cost leads to a decrease in product cost per unit, a company can choose to reduce product price and increase profit by selling more units.

Since the fixed cost is being incurred regardless of the proposed sale, it is classified as a sunk cost and ignored. The company should accept the order since it will earn $1 ($12-$11) per unit sold, or $1,000 in total. While the company is still able to make a profit on this special order, the company must consider the ramifications of operating at full capacity. If no excess capacity is present, additional expenses to consider include investment in new fixed assets, overtime labor costs, and the opportunity cost of lost sales. Differential cost may be referred to as either incremental cost or decremental cost.

INCOME SUMMARY ACCOUNT: Definition and How to Close

Also called the relevant cost approach, marginal analysis, or differential analysis, incremental analysis disregards any sunk cost or past cost. Incremental analysis is useful for business strategy including the decision to self-produce or outsource a function. Incremental costs help to determine the profit maximization point for a company or when marginal costs equal marginal revenues. If a business is earning more incremental revenue (or marginal revenue) per product than the incremental cost of manufacturing or buying that product, the business earns a profit.

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 concept of relevant cost describes the costs and revenues that vary among respective alternatives and do not include revenues and costs that are common between alternatives. The revenues that are generated between different alternatives are referred to as relevant benefits in some studies or texts.

Terms Similar to Differential Cost

In other words, incremental costs are solely dependent on production volume. Conversely, fixed costs, such as rent and overhead, are omitted from incremental cost analysis because these costs typically don’t change with production volumes. Also, fixed costs can be difficult to attribute to any one business segment.

The fixed costs don’t usually change when incremental costs are added, meaning the cost of the equipment doesn’t fluctuate with production volumes. (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

It is the net effect of a course of action on a company’s bottom line. 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.

• The marketing director estimates that it will spend approximately $1,000 on television ads every month.
• The corporation lowers the selling price to the point where it can still make a profit and cover its production costs.
• The separation of fixed costs and variable costs and determination of raw material and labor costs also differs from organization to organization.
• The incremental revenue of Rs. 10,000 is much more than the differential cost of Rs. 3,000, it will increase the profit by Rs. 7,000.
• Financial managers conduct a comparative analysis to ascertain the difference in the cost due to the change in operations.

Incremental cost is choice-based; hence, it only includes forward-looking costs. The cost of building a factory and set-up costs for the plant are regarded as sunk costs and are not included in the incremental cost calculation. Fixed costs are often not included in calculating incremental costs. To increase production by one more unit, it may be required to incur capital expenditure, such as plant, machinery, and fixtures and fittings. A restaurant with a capacity of twenty-five people, as per local regulations, needs to incur construction costs to increase capacity for one additional person. The concept of opportunity cost describes the reward or loss resulting from a decision made between respective alternatives.

Benefits to Incremental Cost Analysis

A company receives an order from a customer for 1,000 units of a green widget for $12 each. The company controller looks up the standard cost for a green widget and finds that it costs the company $14. The differential cost fiscal year definition and/or the incremental cost of operating its equipment for the additional 10,000 machine hours was $200,000. Sunk costs are costs that a company has already incurred but cannot be reduced by any managerial decision.

But first, let’s look at the definition and the many forms of costs. 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. Incremental https://online-accounting.net/ cost is usually computed by manufacturing entities as a process in short-term decision-making. It is calculated to assist in sales promotion and product pricing decisions and deciding on alternative production methods. Incremental cost determines the change in costs if a manufacturer decides to expand production.

What is Incremental Cost?

Marginal cost is the change in total cost as a result of producing one additional unit of output. It is usually calculated when the company produces enough output to cover fixed costs, and production is past the breakeven point where all costs going forward are variable. However, incremental cost refers to the additional cost related to the decision to increase output. Analysis models include only relevant costs, and these costs are typically broken into variable costs and fixed costs. Incremental analysis considers opportunity costs—the missed opportunity when choosing one alternative over another—to make sure the company pursues the most favorable option. Alternatively, once incremental costs exceed incremental revenue for a unit, the company takes a loss for each item produced.

Only the relevant incremental costs that can be directly tied to the business segment are considered when evaluating the profitability of a business segment. Incremental cost is the total cost incurred due to an additional unit of product being produced. Incremental cost is calculated by analyzing the additional expenses involved in the production process, such as raw materials, for one additional unit of production. Understanding incremental costs can help companies boost production efficiency and profitability.

• This is an investment that a company has already made and will not be able to recover.
• The primary purpose of conducting a differential analysis is decision-making.
• Companies look to analyze the incremental costs of production to maximize production levels and profitability.
• Analyzing production volumes and the incremental costs can help companies achieve economies of scale to optimize production.

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. 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. The differential revenue is calculated by subtracting sales at one activity level from sales at the preceding level.

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.