Instead, it is simply an analysis concept used to optimize decisions. A fixed cost is one that stays relatively fixed, irrespective of the activity level of a business. For example, a firm will incur rent expense for its premises, no matter what level of sales it generates. Depending on the business, it may have a relatively large base of fixed costs. Opportunity cost refers to potential benefits or incomes that are foregone by choosing one option over another.
Accounting for a Differential Cost
Differential costs do not find a place in the accounting records. These can be determined from the analysis of routine accounting records. So we need to ignore those things that remain constant, regardless of the decision we make.
It has a higher cost per unit, but it saves production time. Thus, differential cost includes fixed and semi-variable expenses. It is the difference between the total cost of the two alternatives.
It won’t matter whether you are making widget A, B or C, you still have to pay for the building, right? aipb certification test So rent would not be relevant to the decision regarding which product to make or sell. Hence, the entity is earning a profit of $5,600 per month.
When business executives face such situations, they must select the most viable option by comparing the costs and profits of each option. When we work to make decisions, we need to look at the pros and cons of each option. The key to making these decisions is called differential analysis-focusing on the pros and cons (costs and benefits) that differ between the two options. 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.
This means that there will be a baseline cost, irrespective of the activity level, plus a variable cost that changes to a degree as the activity level changes. 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. ABC Company is a telecom operator that primarily relies on newspaper ads and the company website for marketing. However, a recently hired marketing director suggests that the company should focus on television ads and social media marketing to reach a broader client base. Determination of the most profitable level of production and price. The total cost figures are considered for differential costing and not the cost per unit.
AccountingTools
The additional requirement may be purchased from the market at Rs. 8.50 per unit. The components of an item are manufactured by another unit under the same management. (i) To process category:computer file systems wikipedia the entire quantity of ‘utility’ so as to convert it into 600 numbers of ‘Ace’. The concern at present produces per day 600 numbers of each of the two products for which 2,500 labour hours are utilised.
Differential cost
Congrats on reading the definition of differential cost. It is advisable to accept the second proposal provided facilities exist for the production of additional numbers of ‘utility’ and to convert them into ‘Ace’. The first proposal results into a loss and hence is not acceptable. 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. Discontinuing a product to avoid the losses and increase profits – decision to drop a product line.
Raw Material 2
If the company earned $10,000 using the current marketing platforms, moving to the more advanced advertising platforms might result in a 40% revenue increase to $14,000. (iii) The selling price recommended for the company is Rs. 16/- per unit at an activity level of 1,50,000 units. The data used for differential cost analysis are cost, revenue and investments involved in the decision-making problem. Differential cost is the same as incremental cost and marginal cost.
The move places the opportunity cost of choosing to stick to the old advertising method at $4,000 ($14,000 – $10,000). The $4,000 is the income that ABC would forego for remaining with the old marketing techniques and failing to adopt the more sophisticated marketing models. They have an alternative to increasing the production of up to 900 by reducing the selling price to 28.
It differs from the marginal cost because marginal cost includes labor, direct expenses, and variable overheads, whereas differential cost includes both fixed and variable costs. The incremental revenue of Rs. 10,000 is much more than the differential cost of Rs. 3,000, it will increase the profit by Rs. 7,000. Differential cost may be referred to as either incremental cost or decremental cost.
Which product to make, how much to sell it for, to make or buy raw materials and components, how and where to distribute the product and so forth. From the above analysis, we can observe that with the change in the alternative, an entity will have to incur an additional cost of $1,000. Differential cost is a technique of decision-making in which the cost between various alternatives is compared and contrasted with choosing between the most competing alternative. It is useful when you want to understand a) Whether to process the product further or not and b) Whether to accept an additional order at a lower current price.
(ii) To continue the present level of output of ‘utility’ but double the production of ‘Ace’. You are required to work out the incremental profit/loss involved in each of the two proposals and to offer your suggestions. A company has a capacity of producing 1,00,000 units of a certain product in a month. Differential cost can then be defined as the difference in cost between any two alternative choices. Differential costing involves the study of difference in costs between two alternatives and hence it is the study of these differences, and not the absolute items of cost, which is important. Moreover, elements of cost which remain the same or identical for the alternatives are not taken into consideration.
- The cost occurs when a business faces several similar options, and a choice must be made by picking one option and dropping the other.
- They have an alternative to increasing the production of up to 900 by reducing the selling price to 28.
- Instead, it is simply an analysis concept used to optimize decisions.
- The new regulation renders the machine and the produced plastic bags obsolete, and the company cannot change the government’s decision.
The marketing director estimates that it will spend approximately $1,000 on television ads every month. The company will also need to hire a millennial at $250 per week to oversee its social media marketing efforts. If the telecom operator adopts the new advertisement techniques, they will spend $2,000 per month in advertising expenses. The differential cost, in this case, is $1,500 ($2,000 – $500). 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?