Differential Cost In Accounting

In essence, you can line up the revenues and expenses from one decision next to similar information for the alternative decision, and the difference between all line items in the two columns is the differential cost. All variable costs are not part of the differential cost, and it is to be considered only on the case to case basis. Is needed for this cost as no actual transactions are undertaken, and this is the only evaluation of alternatives. Also, no accounting standards are there presently that can guide treatment of differential costing.

Differential revenues and costs represent the difference in revenues and costs among alternative courses of action. Analyzing this difference is called differential analysis. Differential analysis is useful in making managerial decisions related to making or buying products, keeping or dropping product lines, keeping or dropping customers, and accepting or rejecting special customer orders. If the offer from Middle East is accepted then 50% of the production capacity will be utilised for processing this order. The balance of 50% (i.e. 100 – 50) capacity plus 10% augmented capacity at an additional cost of Rs. 40 lacs will be available for local sales. The incremental revenue and differential costs are compared below to know whether order should be accepted or not.

Opportunity Cost:

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. Our formula begins with the proposed additional sales that would occur based on the number of new people being reached through television and social media advertising. This number is an educated guess that is completed by experts in that area. If the company is successfully driving traffic and gaining customers with its current marketing efforts, it may choose to remain with its current strategies. However, if the marketing team anticipates bringing in more clientele with adding the new methods, they might decide to drop one or more of their lowest-performing strategies. Since a differential cost is only used for management decision making, there is no accounting entry for it. There is also no accounting standard that mandates how the cost is to be calculated.

A component Wye-2010 can be made in the same equipment in four hours incurring a variable cost of Rs. 20 per unit. The factory purchases the component at a price of Rs. 50 per unit.

1 Using Differential Analysis To Make Decisions

However, the non-cost factors vital to the long-term interest of the company must be kept in view. The fixed overhead would continue to be incurred even when the component is bought from outside although there would have been reduction to the extent of Rs. 2,00,000. Advise the company as to whether any or all the export orders should be accepted or not.

From the above analysis, we can observe that with the change in the alternative, an entity will have to incur an additional cost of $ 1000. It is because we do not need to prepare complete income statements for both scenarios to arrive at a conclusion. We just need to consider only such revenues and costs which change. 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. The variable cost of manufacture between these levels is 15 paise per unit and fixed cost Rs. 40,000. Determination of the most profitable level of production and price.

differential cost formula

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. From the above, it is clear that semi-automatic machine is economical, if the annual requirement is 5,00,000 nos. If the volume is expected to increase, then automatic machine may be preferred-as it will avoid the replacement cost of semi-automatic machine by automatic machine in future and will also reduce the cost of production. 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. In the latter case, material price will be Rs. 200 per unit.

Differential Cost Vs Opportunity Cost

Sometimes, a concern may receive special offers from its regular customers to sell its regular products. Special offers may be received from the home customers for one time quantity sales or sales to foreign customers. Such offers generally are received at lesser prices than the usual customary prices. Differential cost calculations are an important part of how managers make the best decisions for their businesses. In this lesson, we’ll see how it’s used and learn how to a find differential cost. It is not entered in the accounting records but must be considered while making decisions. 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).

What is committed cost?

A committed cost is an investment that a business entity has already made and cannot recover by any means, as well as obligations already made that the business cannot get out of. One should be aware of which costs are committed costs when reviewing company expenditures for possible cutbacks or asset sales.

Some managers may want only this type of summary information, whereas others may prefer more detailed information. It is important to be flexible with the format, to best meet the needs of managers. We will build upon the differential analysis format shown in Figure 7.1 “Differential Analysis for Phillips Accountancy” throughout this chapter, and show how more detail can easily be provided using the same format. When calculating, you take into account both fixed costs, those costs not dependent on the output, and variable costs, those costs dependent on output. The resulting number doesn’t appear on a financial statement, but it’s valuable to managers trying to make decisions because it allows them to see the real cost of a course of action.

Public Vs Private College: Key Differences With Pros And Cons

Therefore, the company should accept export orders from all the three sources to earn additional profits. Differential costs take an in-depth look at all of the things that change when comparing two possible choices. However most times, many different things are affected and the decision becomes less clear until a full analysis is made. Asking the right questions about the two choices will allow you to develop a formula similar to the one discussed earlier.

Discuss whether it would be advisable to divert the resources to manufacture that new product, on the footing that the component presently being produced would, instead of being produced, be purchased from the market. The effect on current and future capacity in terms of an expansion of plant, personnel, financial requirements and other capacity constraints. Export price will have no effect on the indigenous market where the product will continue to be sold at the old price. Try it nowIt only takes a few minutes to setup and you can cancel any time. Try it now It only takes a few minutes to setup and you can cancel any time. 21 Comments on Differential, opportunity and sunk costs 1.

Differential Cost

90,000 units of this product can be produced at the same cost basis as above for labour and expenses. There will be no additional cost towards overheads by accepting the export order as there is spare capacity available.

  • When we work to make decisions, we need to look at the pros and cons of each option.
  • This includes both fixed costs, or costs incurred regardless of output, and variable costs, or those costs that can change depending on output.
  • The monthly capacity is 1,000 units and the export order is received in April 2008.
  • Includes labor, direct expenses, and variable overheads, whereas differential cost includes both fixed and variable costs.
  • We begin with a relatively simple example to establish the format used to perform differential analysis and present more complicated examples later in the chapter.

For example, if your factory can only make 4,000 widgets a month, you’d have to upgrade your factory to be able to produce the new order in a timely manner. The cost of upgrading your factory is factored into the differential cost. As a result, it may not be such a great contract after all. An incremental cost is the difference in total costs as the result of a change in some activity. Incremental costs are also referred to as the differential costs and they may be the relevant costs for certain short run decisions involving two alternatives. It is profitable for the company to increase the level of production so long as the incremental revenue is more than the differential costs.

If the annual requirement of the company for a year is expected to be 5,00,000 nos. and the volume is expected to increase rapidly thereafter, would you recommended the automatic or semi-automatic machine ? The annual volume required to justify selection of the automatic machine instead of the semi-automatic machine. In assembly type concerns, different components parts are assembled in order to manufacture the product. Such component parts can be manufactured in the concern or these can be purchased from external suppliers. If the concern has idle capacity and idle workers that can be used to make component parts, it is preferable to make and realise cost savings; If there is no idle capacity, the parts can be purchased from the outside.

differential cost formula

Similarly, differential profit is the combined effect of differential revenues and differential costs. It is the net effect of a course of action on a company’s bottom line. Notice that the columns labeled Alternative 1 and Alternative 2 show information in summary form (i.e., no detail is provided for revenues, variable costs, or fixed costs).

In these problems also, change from the present course is recommended only if the differential revenue exceeds the differential cost. Thus, if the building is purchased, the investment required will be Rs. 4,60,000 which otherwise would have fetched Rs. 36,800 by way of 8% interest. Hence total cost which GPC Ltd. has to incur will be Rs. 81,800 (i.e. Rs. 45,000 expenses plus Rs. 36,800 loss of income) annually as against total cost of Rs. 64,000 incurred if the building is taken op lease. In sell or process decisions incremental analysis provides the Solution. However an amount of Rs. 2,000 will have to be incurred on special packing, labelling, get up etc. No additional factory, selling or administrative overhead costs would be incurred in executing the export order since the firm is operating below normal capacity.

In the last financial year, it sold 100,000 units at $100 per unit. Its variable cost ratio is 60% and its fixed costs are $2 million.

Differential Cost In Accounting: Definition, Analysis & Formula Quiz

Differential cost in accounting refers to the cost that a company will incur from two alternative decisions. Learn more about the definition, formula, examples, and analysis. When a differential cost appears as a fixed cost, a business can assume that the expenses for each alternative remain the same, regardless of the activities of the business. The raw material price and the direct labor cost both make a difference, so both of these costs would be relevant as you looked at your options. What if there was no change in the direct labor needed, regardless of the cost of the raw material? Then the direct labor cost would be come in irrelevant cost.

Positive amounts appearing in this column indicate Alternative 1 is higher than Alternative 2. Negative amounts appearing in the Differential Amount column indicate Alternative 1 is lower than Alternative 2. The fourth column shows whether Alternative 1 is higher or lower than Alternative 2 for each line item. Differential costs are the increase or decrease in total costs that result from producing additional or fewer units or from the adoption of an alternative course of action. Your company, Profits, Inc., currently advertises through newspapers and on your rarely-updated website. One of your new marketing executives suggests that the company should instead focus its advertising on television and social media.

differential cost formula

Semi-variable CostsFixed and variable costs combine to form semi-variable costs. Because semi variable costs are influenced by both fixed and variable costs, they are also referred to as mixed costs. The difference in revenues and costs from one alternative to another . The selling price recommended for the company is Rs. 16/- per unit at an activity level of 1,50,000 units.

Using differential cost analysis method, prepare the income statement for May and June, 2008 to show whether the acceptance of the export order would be profitable to the company. Assumptions and comments, if any, may be given separately. The decision to accept or reject special offer is based entirely on differential cost and the contribution margin approach. The point to be considered is whether incremental revenue is more than the differential cost to be incurred. Sometimes, the management is interested to operate the concern at full capacity as there may be offer from the foreign country to purchase the goods but at less price than is available from the local market.

It is clear from the above statement that it is advantageous for the company only when it accepts all the export orders. If the company accepts export orders only for one or two of the three sources, it will suffer a loss.

Plus, get practice tests, quizzes, and personalized coaching to help you succeed. Cash FlowsCash Flow is the amount of cash or cash equivalent generated & consumed by a Company over a given period. It proves to be a prerequisite for analyzing the business’s strength, profitability, & scope for betterment. Hence, presently entity is earning a profit of $ 5600 per month. The following are examples to understand this concept in a better manner.

At first glance, it sounds like the newspaper and website advertising is a better financial decision. However, differential cost analysis looks at all of the potential benefits gained and costs involved with television and social media advertising. Additionally, there could also be some non-financial gains that management would take into account as well.

The possibility of selling additional units to the new customers beyond the special offer. Similarly incremental cost is calculated by deducting existing cost from the proposed cost. If the incremental revenue is more than the incremental cost, the proposal should be accepted otherwise not. You are required to determine the differential cost of producing 1,500 units by increasing capacity to 100 per cent. Opportunity cost measures the benefits that will be lost if one option is chosen over another.