One of the 4P’s of your marketing mix is pricing or price management. Price is a crucial element that helps you make an informed decision about your marketing strategy. The components Differential cost 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.

The total cost to outsource production would then increase to $12,000 ($11,000 outsourcing cost + $1,000 fixed overhead). It may be remembered that differential cost may be increase or decrease in costs. Suppose, present cost is Rs. 2,50,000 when the work is done by labour and the expected cost Rs. 2,25,000 when the work is done by machinery. A sunk cost is a cost that has already been incurred and that cannot be changed by any decision made now or in future.

Summary – Marginal Costing vs Differential Cost

Good accounting (vs. simple bookkeeping) lets small-business owners see why they are making or losing money. For making a choice among the various alternatives, the alternative which gives the maximum difference between the incremental revenue and incremental cost is recommended to be adopted. The ascertainment of differential cost becomes easy if a flexible budget is prepared by the concern because it shows cost at various levels of activity. Prepare differential cost analysis to ascertain acceptance or rejection of the order.

A manufacturing concern sells one of its products under the brand name ‘utility’ at Rs. 3.50 each, the cost of which is Rs. 3.00 each. After further processing, which entails additional material and labour costs of Rs. 2,50 and Rs. 2.00 per number respectively, ‘utility’ is converted into another product ‘Ace’ which is sold at Rs. 8.00 each. Determination of the most profitable level of production and price. Differential cost analysis is related to the future course of action or future level of output, so it deals with future costs. Historical costs or standard costs may be used but they should be suitably adjusted to future conditions.

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Present cost and revenues are compared to projected costs and revenues in the following table. In the above example, total differential revenue is $200,000 (1,600,000 – 1,400,000), differential cost is $130,000 (1,240,000 – 1,110,000) and differential net operating income is $70,000 ($360,000 – $290,000). Differential costing is the difference between the cost of two alternative decisions, or of a change in output levels. The concept is used when there are multiple possible options to pursue, and a choice must be made to select one option and drop the others. An effective differential pricing strategy is directly proportional to streamlined production.

• Historical costs or standard costs may be used but they should be suitably adjusted to future conditions.
• But if the alternate course of action does not involve any extra fixed costs change in variable costs will become differential costs and there will be no difference between marginal costs and differential costs.
• Direct fixed costs—fixed costs that can be traced directly to a product line or customer—are differential costs and therefore pertinent to making decisions.
• A company chooses a favorable alternative that can generate profit.
• These are not differential costs and should be ignored in decision making.

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. Sunk costs are already incurred and cannot be recovered, thus are irrelevant in making a new decision.

4.1 Case of Change in variable cost

Those items that are the same under all alternatives can be ignored. Differential costs are typically variable costs, meaning they can change based on the volume of output or other activity levels. When the cost differences of business decisions are analyzed in accounting, this is called differential cost.

The work involving managers includes contrast of costs and also revenues of unique alternatives. Differential cost (also often known as incremental cost) would be the difference in price of two solutions. For example, if the cost of alternative A can be $10,000 per year and the cost of alternative B can be $8, 000 per year. The differential cost can be quite a fixed cost or perhaps variable cost. For the purpose of decision making, costs are usually classified as differential cost, opportunity cost, and sunk cost. It is essential to have a firm grasp of the concepts differential cost & differential revenue, opportunity cost, and sunk cost.

This comparison would help the company determine the more cost-effective option. Managers may have to choose between options that look appealing, but choosing which one is better is a decision should be made after considering the opportunity cost of other alternative options. Opportunity cost measures the benefits that will be lost if one option is chosen over another. The simple fact that a small-business owner starts a company means that he or she will lose a potential salary of ?$X? working for someone else, which is an example of an opportunity cost. Differential cost refers to the difference in cost between two or more possible business decisions, explains AccountingTools.com.

When this was first reported to the CEO, she balked at the idea. However, the accountant doing the differential cost analysis showed the possible benefits of additional online sales, which would make the change beyond worth it. Differential cost may be a fixed cost, variable cost, or a combination of both. 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.