After reading this article you will learn about Differential Cost:- 1. Meaning of Differential Cost 2. Determination of Differential Cost 3. Essential Features 4. Managerial Applications.
Meaning of Differential Cost:
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.
The alternative course of action may arise due to change in sales volume, alternative method of production, change in product/sales mix, make or buy, refuse or accept decisions, addition of a new product, exploring a new market, decision to drop a product line, etc.
Hence, differential cost is the change of cost arising from an alternative course of action, e.g., suppose cost of sales at present level of activity (60%capacity) is Rs. 12,00,000 and expected cost of sales at 80% capacity is Rs. 15,00,000, then differential cost will be Rs. 3,00,000, i.e., Rs. 15,00,000 – 12,00,000.
Differential cost may be referred to as either incremental cost or decremental cost. When there is an increase in the cost due to increase in the level of production, it is called incremental cost, and when there is decrease in the cost due to decrease in the level of production, it is called decremental cost. A few definitions of differential cost are given below.
According to the Institute of Cost and Management Accountant, London, differential cost may be defined as “the increase or decrease in total cost or the change in specific elements of cost that result from any variation in operations”.
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.”
Determination of Differential Cost:
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.
In the following illustration, differential cost, from two alternatives, i.e., running at 70% capacity and 90% capacity, has been discussed:
The differential costs can also be determined with the help of linear equations as follows:
At two levels of activity, the equations of costs can be represented as:
y1 =ma1 + F
y2= ma2 + F
where, y1 and y2 are costs at two levels of activity and
m = marginal cost per unit
a1 and a2= levels of activity
F = fixed cost.
Hence, Differential Cost, i.e., y2—y1 = (ma2+ F)-(ma1 + F)
= m (a2-a1)
Thus, in above illustration, where marginal cost at 70% level of activity is Rs. 49,000, the differential cost between 90% and 70% level of activity will be
= 49,000 x 20/70 = Rs. 14,000.
Essential Features of Differential Costing:
1. The data used for differential cost analysis are cost, revenue and investments involved in the decision-making problem.
2. Differential costs do not find a place in the accounting records. These can be determined from the analysis of routine accounting records.
3. The total cost figures are considered for differential costing and not the cost per unit.
4. Differential cost analysis determines the choice for future course of action and hence it deals with the future costs but even then historical or standard costs, adjusted to the future requirements may be used in differential costing.
5. 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.
6. The differences are measured from a common base-point.
7. The alternative which shows the highest difference between the incremental revenue and the differential cost is the one considered to be the best choice.
Managerial Applications of Differential Cost Analysis:
Differential cost analysis is very useful to the management in formulating policies and making decisions, such as:
1. Determination of the most profitable level of production and price.
2. Introduction of new products.
3. Acceptance of an offer at a lower selling price.
4. Changing the product mix.
5. Changing the method of product.
6. Discontinuing a product to avoid the losses and increase profits – decision to drop a product line.
7. Make or buy decisions.
8. Decision regarding the depth of processing.
9. Shut -down decisions.
10. Equipment replacement decisions.
11. Determining a suitable price at which raw materials may be purchased.
Illustration 1 (Determination of the most profitable level of production and price):
A company’s flexible budget at various levels of production reveals the following:
You are required to:
(i) Prepare a schedule showing the total differential costs and increments in revenue.
(ii) At what level should the company set its level of production?
(iii) What selling price is recommended by you in order to maximise the profits?
(ii) It is profitable for the company to increase the level of production so long as the incremental revenue is more than the differential costs. It is not advisable to increase the level of production to such a level where the differential costs are more than the incremental revenue. In the given problem, the company should set the level of production at 1,50,000 units because after this level differential costs exceed the incremental revenue.
(iii) The selling price recommended for the company is Rs. 16/- per unit at an activity level of 1,50,000 units.
Illustration 2 (Most profitable level of production and acceptance of an offer at a lower selling price):
A company has a capacity of producing 1,00,000 units of a certain product in a month.
The sales department reports that the following schedule of sale price is possible:
The variable cost of manufacture between these levels is 15 paise per unit and fixed cost Rs. 40,000.
(i) Prepare a statement showing incremental revenue and differential cost at each stage. At which volume of production will the profit be maximum?
(ii) If there is an offer at 50 paise per unit for the balance capacity over the maximum profit volume for export price, and price quoted will not affect the internal sale price, will you advise accepting this bid and why?
It is obvious from the above table that at 80% capacity profit will be the maximum as after this level the differential cost is more than the incremental revenue.
(b) It is advisable to accept the bulk order of export at a price of 50 paise per unit because the balance capacity of 20,000 units will add Rs. 10,000 (20,000 × 0.50) to the sales revenue and the cost shall increase by only Rs. 3,000 (20,000 x 0.15). 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.
Illustration 3 (Depth of processing and changing the product/sales mix):
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 concern at present produces per day 600 numbers of each of the two products for which 2,500 labour hours are utilised.
The factory overheads have been budgeted as under:
Labour Hours – 2,000 – 2,500 – 3,000 – 3,500
Factory overheads (Rs.) – 700 – 800 – 900 – 1,000
The following alternative proposals have been put forth for varying the sales mix:
(i) To process the entire quantity of ‘utility’ so as to convert it into 600 numbers of ‘Ace’. This will need an additional 500 labour hours.
(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.
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.
Illustration 4 (Make or Buy Decision):
The components of an item are manufactured by another unit under the same management.
The unit at present manufactures 1,00,000 units (the present requirements of the main factory) at the following costs:
Labour is paid @ Rs. 2 per unit, the fixed D. A. and other allowances monthly. The components required by the main factory are to be increased by 20 per cent. The components factory can increase production upto 25 per cent without any additional labour force. Overheads are variable to the extent of 25 per cent of the present amount.
The additional requirement may be purchased from the market at Rs. 8.50 per unit. Suggest which will be better.