Differential Cost in Accounting: Definition, Analysis & Formula

Lesson Transcript
Instructor: Anthony Aparicio

Tony taught Business and Aeronautics courses for eight years; he holds a Master's degree in Management and is completing a PhD in Organizational Psychology

Each day we make decisions, but how much thought goes into all of the differences for each choice? Differential costs in accounting analyze those variations in depth; this lesson shows you how.

Differential Cost in Accounting

When you wake up in the morning, your choices begin. What do I wear? Do I eat cereal or toast? Will I brew my own coffee or pick up some at the drive-thru? Each decision you make has some impact on your day, but we rarely think about them in detail.

Some of the decisions would provide obvious benefits. For example, wearing a suit and tie to a job interview would clearly provide an advantage over wearing your pajamas. But other times the differences are more subtle. Eating healthy cereal, as opposed to fruit and toast, will probably not make a huge difference either way.

When it comes to accounting, each business decision has some type of financial measurement associated with it. Effective managers and accountants are able to look at all of the things that would change depending on which direction the company goes. This is known as the concept of differential cost.

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  • 0:56 Examples and Analysis
  • 2:34 Differential Cost Formula
  • 4:42 Lesson Summary
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Examples and Analysis

Let's look at an example. 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. Each choice comes with certain costs. For the past six months, the company has spent $150 per month for a weekend newspaper advertisement and $25 per month for web server space.

In contrast, the new suggestion would mean spending $500 per week on television advertising as well as a $1,000 one-time cost to hire actors, producers, and a film crew to shoot the commercial. Additionally, a new person would have to be hired, at least on a part-time basis, at a cost of about $300 per week. The new hire would manage the different social media channels and keep their audience engaged on a regular basis.

Looking at the basic costs, it appears that the current advertising system only costs $175 per month, while the proposed advertising plan would be $3,200 per month with the additional $1,000 one-time cost.

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. One example would be the ability to establish a two-way dialogue with customers through social media that would allow the company to hear suggestions on how to improve its products and services.

Differential Cost Formula

The formula for differential cost won't be exactly the same in every scenario since each situation has different things that are being compared, but the basic concept remains the same. The following questions will help you build the formula needed for our specific example:

  1. What are the financial benefits? (For example, economies of scale, more sales, or increased productivity)
  2. Are there any non-financial benefits?
  3. What are the current costs?
  4. What are the proposed costs?
  5. What additional direct costs will be involved? (For example, direct labor, materials, or advertising)
  6. Are there any non-financial drawbacks to consider?

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