Assume that managers must choose whether to keep a store open even if sales have not reached the breakeven point for several months or to close one that is not meeting its sales quota. On the one hand, closing the store will eliminate all other expenses, but the lease will still be in place for another six months at a cost of $5,000 per month.
The benefits that will be forgone if one option is selected over another are measured by opportunity cost. It is the cost of an alternative that is foregone. An opportunity cost is the loss of a potential salary of $X from working for someone else as a result of a small business owner starting their own business.
Let’s say a store owner wants to stock the empty rack in front of the counter with goods. He discovered that his expected sales for a week would be $100 if the rack were filled with apples, but $190 if the rack were filled with candies. The opportunity cost, or cost foregone, if he decided to fill the rack with apples, would be $190. If he chose candies, his opportunity cost would be $100.
Since 2009, Raul Avenir has contributed to a number of websites as a writer, specializing in business and technology. He is a businessman with technical aptitude who has experience in building and real estate development. Avenir is a business consultant in addition to being an accountant. He received a Bachelor of Science in business administration from him upon graduation.
Part 1 – Relevant Costs for Decision Making – Sunk and Differential Costs
The importance of differential cost
Differential cost analysis can be a useful tool for companies to use when making decisions that may have an impact on their revenue and profit streams. It can also provide information on the most cost-effective options a company may select. Furthermore, differential cost can be a crucial factor in determining how much a business will charge for its goods and services. This is due to the possibility that differential costs and the economic marginal costs of maintaining production operations could be closely related.
For instance, a company may decide that in order to maximize its revenue, its production must maintain an equal balance between its differential costs and its revenue. The company could then decide the best options to maximize its revenue using this analysis.
When a company is deciding which branding, advertising, and marketing strategies to keep and which to drop, differential cost can be crucial. A business can decide where it can save money or which resources it can more effectively allocate funds to by analyzing the differences in costs between each of its options. KPIs and website analytics are two additional metrics that can be used in conjunction with differential analysis to help a business determine which strategies are more expensive to implement and which strategies it might use to do so at a lower cost while still generating revenue.
Calculating differential cost can enable a business to assess which strategies are performing well and which strategies are underperforming in addition to tracking KPIs and using metrics to evaluate the best cost alternatives.
What is differential cost?
The cost difference between two or more business decisions is known as a differential cost. When a company must choose between contrasting options and develop a solution or another workable alternative to the choice in question, differential cost calculation can be helpful. Revenue, profit, and loss are frequently elements that can affect a general business decision. Making wise business decisions can be aided by differential cost, which can be used to calculate the costs and gains that a company might experience when choosing one solution over another.
Additionally, differential costs may be a combination of fixed and variable costs or both.
Variable cost
Differential costs that are variable costs are the variations in costs based on the services rendered or the volume of a product produced. When a differential cost is identified as a variable cost, it denotes that the expense amount may change based on the operations of a business. If the results of the differential cost calculation between alternatives are variable costs, a business may anticipate that all costs related to each alternative will fluctuate over time.
Fixed cost
A business can assume that, regardless of the activities of the business, the costs for each alternative will remain the same when a differential cost appears as a fixed cost. Although production may vary from month to month or more services may be sold in a single month, the fixed cost of the differential will allow the company to plan for consistent expenses over time.
Differential cost example
The analysis of the differential cost of each alternative can be useful for many business decisions and applications. Differential cost analysis can be useful in a variety of situations, including these:
The application of differential cost calculation is demonstrated in the example below:
Assuming Dynamix is a software development company, let’s assume that its business-to-business marketing channels primarily consist of content strategy, emails, and white papers. To attract more business clients, a new marketing director advises the company to use social media marketing and a landing page for a free software trial.
Currently, the marketing team works on a monthly schedule and invests $1,000 in its website and content marketing campaign, $250 in email marketing techniques, and $350 in creating and disseminating white papers. The marketing manager expects to spend an additional $1,000 per month on the expanded social media strategy, $250 per month to keep the landing pages up to date, and $1,200 per month to hire a social media specialist to oversee the marketing efforts of the expanded social media strategy.
If the company adopts the new social media strategy, Dynamix’s monthly marketing expenses will rise from $2,100 to $4,550 if the marketing team adopts all plans. The director determines that if they fully replace the team’s current marketing expenses ($1,600) with the new marketing strategies ($2,450), the differential cost will be $850.
Dynamix must decide whether to keep using their current marketing channels or switch to new social media tactics. The marketing team can also decide to continue using a combination of new and old marketing techniques, but the marketing director wants to avoid incurring additional costs. The marketing team must now choose which marketing channels to continue using and which to stop. The team can estimate spending more on social media marketing and landing pages because they calculated the differential cost, but they must weigh the benefits and drawbacks of using the new strategies versus the company’s current strategies.
If the business’s current marketing initiatives are bringing in traffic and customers, it may decide to stick with these tactics. However, if the marketing team believes that implementing the new techniques will attract more customers, they may decide to abandon one or more of their lowest-performing tactics.
FAQ
What is an example of a differential cost?
The price difference between two options is known as differential cost (also known as incremental cost). As an illustration, suppose that Alternative A costs $10,000 per year and Alternative B costs $8,000 per year. The difference of $2,000 would be differential cost.
What is differential cost and opportunity cost?
In accounting, a differential contrasts the prices of two or more items or the results of one option versus another. The differential cost is the price difference between the options. On the other hand, opportunity cost refers to the advantages you might forgo by selecting one course of action over another.
How do you find the differential cost?
By dividing the change in costs by the change in quantity, it is determined. includes labor, direct costs, and overheads that are variable, whereas differential cost includes both fixed and variable costs.
What is differential cost accounting?
The cost differential between two potential decisions or a change in output level is known as the differential cost. The idea is applied when there are several viable options to consider and a decision needs to be made regarding which option to choose and which to forgo.
