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7 2: Using Differential Analysis to Make Decisions Business LibreTexts

In addition, the company will need to recruit a millennial at $250 a week to manage its social media marketing efforts. If the telecom operator uses the new advertising strategies, they will incur advertising costs of $2,000 per month. In this scenario, the differential in cost is $1,500 ($2,000 – $500). Based on this analysis, Pacific Paper should process product A further to increase income by $5 per unit sold. The company should not process product B further because that would decrease income by $1 per unit sold. For instance, a company can evaluate the unique costs involved with expansion and contrast them with prospective revenues when considering expanding into new regions.

  • As a result, the total incremental cost to produce the additional 2,000 units is $30,000 or ($330,000 – $300,000).
  • Sometimes management has an opportunity to sell its product in two or more markets at two or more different prices.
  • However, care must be exercised as allocation of fixed costs to total cost decreases as additional units are produced.
  • Opportunity cost refers to potential benefits or incomes that are foregone by choosing one option over another.

External costs are costs imposed on third parties or society as a whole, which are not accounted for by the business itself. These costs can include pollution, but they are not directly incurred by the business as a result of its decisions. instructions for the  requester of form w Making educated decisions is a vital requirement in the dynamic world of business. Companies must continually assess various options, including resource allocation, pricing patterns, manufacturing tactics, and product discontinuation.

Differential Cost Example

The attempt to calculate and accurately predict such costs assist a company in making future investment decisions that can increase revenue and reduce costs. Sunk costs refer to costs that a business has already incurred, but that cannot be eliminated by any management decision. An example is when a company purchases a machine that becomes obsolete within a short period of time, and the products produced by the machine can no longer be sold to customers. Businesses use differential cost analysis to make critical decisions on long-term and short-term projects. Differential cost also provides managers quantitative analysis that forms the basis for developing company strategies. Fixed costs are displayed in the income statement and have an impact on the business’s profitability.

The company controller looks up the standard cost for a green widget and finds that it costs the company $14. Incremental analysis is a decision-making tool used in business to determine the true cost difference between alternative business opportunities. Differential cost and incremental cost are two different concepts, though at times they are interchangeably used. The former is defined as a future cost that differs from one alternative to another, while the latter represents an increase in cost of one alternative over the cost of another. Ultimately, a thorough understanding of incremental cost empowers businesses to make well-informed decisions that can positively impact their bottom line. In this case, each additional unit costs $50 ($500 divided by 100 units), making it easier for ABC Manufacturing to evaluate the profitability of the promotional campaign.

Format of Differential Costing

The differential revenue is calculated by subtracting sales at one activity level from sales at the preceding level. To find the most profitable level of production and the best selling price, the differential cost is compared to the differential revenue. When the differential revenue exceeds the differential cost, management will opt to expand the level of output.

Long-Run Incremental Cost Analysis

Despite not being a typical “cost” in the sense of out-of-pocket expenses, they nonetheless represent the value of the second-best choice. For instance, the price of extra flour, yeast, and labor would be included in the incremental expenses if a bakery decided to create one more loaf of bread. They depict the alteration in costs that results from a particular choice. Businesses looking to maximize efficiency and profitability must thoroughly understand these costs and how they operate. The example below briefly illustrates the concept of incremental analysis; however, the analysis process can be more complex depending on the scenario at hand.

Accounting

In the long run, companies must cover all of their costs, not just the variable costs. Differential revenues and costs1 (also called relevant revenues and costs or incremental revenues and costs) represent the difference in revenues and costs among alternative courses of action. Analyzing this difference is called differential analysis2 (or incremental analysis). 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.

Opportunity Cost

The calculation of incremental cost needs to be automated at every level of production to make decision-making more efficient. There is a need to prepare a spreadsheet that tracks costs and production output. As output rises, cost per unit decreases, and profitability increases. Costs are determined differently by each organization according to its overhead cost structure. The separation of fixed costs and variable costs and determination of raw material and labor costs also differs from organization to organization.

This new department would contribute $35,000 to the bookstore’s income. Assume the company receives an order from a foreign distributor for 3,000 units at $10 per unit. This $10 price is not only half of the regular selling price per unit, but also less than the $17.60 average cost per unit ($88,000/5,000 units). However, the $10 price offered exceeds the variable cost per unit by $2. For example, the differential amount of $1,000,000 for revenue indicates Alternative 1 produces $1,000,000 more in revenue than Alternative 2. The differential amount of $750,000 for variable costs indicates variable costs are $750,000 higher for Alternative 1 than for Alternative 2.