Differential / Incremental Cost

Differential Cost or Incremental Cost is the difference in total relevant cost between two alternatives. Commonly, these alternatives are ‘make or buy’, ‘two different level of activity’, etc.

Incremental Cost

Differential cost is known as an incremental cost. It is that additional cost which will incur if one alternative is chosen in place of other. In short, two options are compared in terms of their total costs and the difference between their total costs is termed as an incremental cost. The change in the revenues of two alternatives is termed as incremental revenue.

Differential Cost Analysis

Differential Cost Analysis is conducted to take important decisions such as ‘make or buy’, change in the level of activity, adding/sinking a product, change in product mix, export orders, goods marketed in a new market etc. In differential / incremental cost analysis, only the relevant costs are taken into consideration. Fixed costs or costs that have already incurred in past are not relevant. Future costs that are mainly variable costs are taken into consideration. The use of differential cost analysis is only to take management decision and has no relevance to accounting or book-keeping. There is no journal entry suggested by any accounting standard for a differential cost.

Differential Cost Example

Differential Cost Example of ‘make or buy’ decision and ‘different level of activity’ are explained to understand the concept better. Please refer the table below. Make or buy situation appears when the management has an option to either manufacture a particular product or buy from the market. Apparently, if we see, per unit cost of buying from the market is less than the manufacturing cost. Here, we will have to think twice because the $15 includes $5 of fixed manufacturing cost. The $50,000 is already spent and will become idle capacity in case product is bought from the market. Therefore, the comparison should be done between $10 of manufacturing and $13 of buying and the decision is quite clear. ‘MAKE’ is a better option here.

Particulars

Total No. of Units

10000

Total Costs ($) Per Unit Costs ($)
Variable Costs 1,00,000.00 10.00
Fixed Costs 50,000.00 5.00
Total Manufacturing Costs 1,50,000.00 15.00
Price of Product in Open Market
1,30,000.00 13.00

Similarly, in a case of different level of activity in the following example, 2.5 (30-27.5) is the differential / incremental cost due to change in activity.

Output

Levels

Output

Unit

Differential

Unit

Total

Cost ($)

Differential

Cost ($)

Differential Cost

Per Unit ($)

1

1,00,000

 

30,00,000

30

2

1,20,000

20,000

35,00,000

5,00,000

27.5

Long run incremental cost is another concept which is given importance especially when forecasting exercise is done. Long run incremental costs are those costs which a company can forecast beforehand. Examples are fuel price increases, repairs and maintenance cost, rent expenses, etc.

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