Differential Cost Meaning, Features and Difference

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Differential cost refers to the additional or extra cost incurred when opting for a specific decision or choosing one option over another. It helps to understand the specific cost difference between different alternatives and it is also a helpful tool for making decisions in business or financial planning.

Differential Cost

Differential cost (which may be incremental or decremental cost) is the difference in total costs between any two acceptable alternatives. Incremental cost is an increase in cost from one alternative to another alternative. Whereas If we analyze the reduction in output, we refer to the difference in costs between the two output levels as decremental costs.

The term differential costing comprises both the terms incremental cost and decremental cost.

“Incremental cost measures the addition to unit cost which results from an addition to output.” It is the standard practice to state it as a cost per unit.

Thus, differential costs are the net increase or decrease in total costs due to an increase or decrease in the volume of production or level of activity. Differentiation among costs at various levels helps determine these costs. When the unit variable cost and the fixed costs remain stable, the differential cost would be the same as the marginal cost. But sometimes additional output involves an increase in fixed cost. Absorption costing is the usual method for presenting costs in differential cost analysis i.e., total costing (fixed costs + variable costs).

What is Differential Cost?

According to John G. Blocker and W. Keith Weltmore, “Differential cost is the increase or decrease in total costs that result from producing and distributing additional or fewer units of a product or from a change in method of production or distribution such as the use of improved machinery, addition of a product or territory or selection of an additional channel”. People typically express it in an aggregated form.

In the words of Blocker and Weltmer, “Differential costs, also frequently described as marginal cost and Incremental costs, are the increase or decrease in total costs that result from producing and distributing additional or fewer units of a product or from a change in method of production or distribution”.

According to CIMA Official Terminology, Incremental cost is defined as, “A technique used in the preparation of ad-hoc information where consideration is given to a range of graduated or stepped changes in the level or nature of the activity, and the additional costs and revenues likely to result from each degree of change are presented”.

Differential costing is defined as, “A technique used in the preparation of ad-hoc information in which only costs and income differences between alternative courses of action are taken into consideration”.

According to the Institute of Cost and Management Accounting (ICMA), London, Differential Cost may be defined as “An increase or decrease in total cost or the change in specific elements of cost that result from any variation in operations”.

Features of Differential Cost

Features of differential costing are as follows:

1) Accounting records usually do not include the recording of differential costs. However, routine accounting records offer a means to identify them.

2) It analysis utilizes data about costs, revenues, and investments associated with the decision making process. 

3) Differential cost analysis determines the choice for the optimal course of action for the future. It focuses on evaluating the financial implications of different alternatives. While the major focus is on fixed costs, it is worth noting that historical or standard costs, adjusted to meet future requirements, can also be utilized in the process of differential costing.

4) Differential costing involves the study of differences in costs between two alternatives. Hence, it is the study of these differences, rather than the absolute cost figures. Additionally, we exclude cost elements that show no variation between the alternatives.

5) The alternative, which shows the highest difference between the incremental revenue and the differential cost is the optimal choice.

6) Differential costing places greater importance on total cost figures, as opposed to cost per unit.

7) The measurement of differences begins at a common base point.

Uses and Applications of Differential Costing in Decision-Making

The uses and applications of differential costing in management decisions are as follows:

1) Sales Policies

Differential cost analysis assists in deciding the following:

2) Make or Buy Decisions

The other problem that frequently daunts the management is whether it is more profitable to make or buy the parts. The application of differential cost analysis is the solution to this.

3) Acceptance of Order

At times, management is confronted with the problem – of whether or not to accept special orders at a price below the existing price of the product. Differential cost analysis assists in deciding such actions as whether to accept or reject the order.

4) Replacement Decisions

While deciding about the replacement of capital equipment/assets, the firm should take into consideration the resultant savings in operating costs and the cost of incremental investment in the new equipment. If the savings exceed the expenses associated with acquiring additional funds for the new assets, the proposal may be accepted. Besides, the book value of the asset is the sunk cost and therefore, is irrelevant to the current decision-making.

5) Operation or Shut-down Decisions

At times of economic recession, many managers may be in a dilemma whether to run the production continuously or shut down temporarily till the economic scenario improves. Proper differential cost analysis will provide an apt decision on whether to operate or shut down the plant.

6) Further Process Decision

Some of the products specifically semi-finished goods, have the potential to reach a stage where they become consumable. At this stage, the management may not be able to decide on the issue of whether the product can be sold in that semi-finished stage itself or processed further. Differential cost analysis will provide a suitable solution for this.

7) Volume of Production

Differential cost analysis helps decide the volume of production upon which a maximum profit can be earned.

8) Pricing Decisions

Proper product pricing is an important factor. This technique is the best for analyzing the interplay of factors and revenue.

Dissimilarities of Differential Costing and Marginal Costing

Both the techniques of differential cost analysis and marginal costing are similar but often confused. The following points highlight both the similarities and differences.

1. Differential costs apply to the fixed additional quantity of production while marginal costs apply to any additional unit.

2. Marginal costs do not include fixed costs, while differential costs may include.

3. Unlike marginal costing, differential cost analysis statements do not find their place in accounting records.

Similarities between Differential Costing and Marginal Costing

1) Both techniques serve the purpose of cost analysis and cost presentation.

2) Management makes use of both in the decision-making and policy formulation processes.

3) When fixed costs remain constant at two levels of output, the differential cost would be the same as the marginal cost.

4) Both techniques mainly arise out of the difference in the behaviour of fixed and variable costs.

Differences between Differential Costing and Marginal Costing

Differential CostingMarginal Costing
It makes use of incremental costs, incremental revenues and incremental profit as tools for decision making.It is a technique of ascertainment of marginal costs and of the effect on profit of changes in volume of output by differentiation of fixed and variable costs.
Differential costing has a wider scope. It can be successfully used for a large number of alternative proposals.Marginal costing has a limited scope.
It is difficult to ascertain differential costs in a precise manner.It can be ascertained with ease by adding prime costs to variable overheads.
Differential costing can be used for short-term and medium-term decision-making.Marginal costing can be used for short-term and medium-term decision-making.
It case of differential costing, accounting information is used.It can be incorporated into the accounting system.
Differential costing makes use of incremental costs, incremental revenues and incremental profit as tools for decision-making.Marginal costing makes use of incremental costs, incremental revenues and incremental profit as tools for decision-making.
It can be used both under a marginal cost system and an absorption costing system.It is a method of analysis using the marginal costs.

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