Differential Cost Learn How to Calculate Differential Cost

Differential cost is known as a relevant cost because it helps to account for expenses in the future by comparing two alternatives. For instance, it may cost $1000 to manufacture an item and $1500 https://turbo-tax.org/turbotax-launches-free-tool-to-help-americans-get/ to purchase the item from somewhere. Fixed costs are not relevant costs because they have already been spent. The most notable financial cost comes from increased direct material costs.

• This includes both fixed costs, or costs incurred regardless of output, and variable costs, or those costs that can change depending on output.
• Differential cost may be a fixed cost, variable cost, or a combination of both.
• After the analysis, the business will choose the option that has the best financial outcomes.
• The company sells chess boards sets in the national market at Rs. 150 per unit.
• (b) Acceptance of special orders – offer at a lower price or offering a quotation at lower selling price in order to increase the capacity.

Fixed costs are not relevant because they are costs that have already been incurred. Since the money must be spent or is already spent, they are not able to be relevant. Relevant costs always occur in the future as far as planning is concerned. Sunk costs are also not relevant costs because they have already been spent even if their use is no longer viable with a company.

Differential Cost Formula

Then, the differential cost is divided by the number of new units of production or multiplied by the expected profits. Differential cost is the difference between two alternatives for a company. If the auto manufacturer is making a decision about whether to import or manufacture a certain piece, they may calculate the difference between the two alternatives. The cost to import their engines from a manufacturer is $4,000 per unit. The components required by the main factory are to be increased by 20 per cent.

For example, when shopping online, Daniel saw two of the same pair of jeans on two different websites. One website listed them for $80, while the other listed them for $65. Daniel thought, «Why would I not go with the cheaper website?» Without even understanding what he was doing, Daniel had completed a differential cost analysis.

Terms Similar to Differential Cost

One has to find net gain/loss by differential cost and revenue. However, the decision to accept or reject the alternative depends on the net gain/loss. (b) Assume the resources now used for this component’s manufacture are to be used to produce another new product for which the selling price is Rs. 485. 90,000 units of this product can be produced at the same cost basis as above for labour and expenses. The decision to accept or reject special offer is based entirely on differential cost and the contribution margin approach.

Differential cost is the change in cost that results from adoption of an alternative course of action. It can be determined simply by subtracting cost of one alternative from cost of another alternative or from the cost at one level of activity, the cost at another level of activity. Direct material and labour will be constant for the special order. But, there is a need for special tools costing ₹ 600/- to meet additional orders’ production. In these problems also, change from the present course is recommended only if the differential revenue exceeds the differential cost. These are committed or such costs which will be spent irrespective of the alternative chosen.

Differential Cost in Accounting: Definition, Analysis & Formula

As long as the differential revenue is more than the differential cost, level of production is increased. But when differential cost is more than the differential revenue, that level is not beneficial to the concern and level prior to this will be the optimum level of production. In cost accounting, the way the differential cost is calculated varies depending on the needs of the company. However, it generally begins by deducting the cost of the present capacity from the cost of the proposed new capacity.

There are also mixed costs, which are a combination of fixed and variable. Utilities tend to be a mixed cost because there is a base charge that will be incurred regardless of use. An electric company will charge a base fee to carry energy to a customer. The added variable comes from how much electricity is used in that period.

How to Find the Differential Cost

The estimated revenue is calculated by multiplying the expected output at that level with the estimated price. Plus, they would need to hire someone to track the online sales and market the products to the public, resulting in an additional $1,000 a week to hire a new employee. Rather than paying $150 a month for website and sales, the company would now be paying $4,650 a month. When this was first reported to the CEO, she balked at the idea.

Differential costs help a manager understand the real cost of a particular course of action. An additional per-unit cost may not reflect the additional costs that come along with pursuing a different plan. For example, many companies may have to add increased capacity if they choose to create more units beyond a certain point. Differential cost allows us to see the cost of that added capacity. Before looking into what online sales would entail, the CEOs of Make Money, Inc. first needed to check with their accountant for a differential cost analysis. For the past five years, the company spent $50 a month on its online website and about $100 a month packing and shipping products.