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
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.
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:
- What are the financial benefits? (For example, economies of scale, more sales, or increased productivity)
- Are there any non-financial benefits?
- What are the current costs?
- What are the proposed costs?
- What additional direct costs will be involved? (For example, direct labor, materials, or advertising)
- Are there any non-financial drawbacks to consider?
Once you've answered all these questions, you can build your formula to compare the results of each choice. Here is a financial analysis based on the proposal to begin television and social media advertising:
Our formula begins with the proposed additional sales that would occur based on the number of new people being reached through television and social media advertising. This number is an educated guess that is completed by experts in that area. We also may have benefits due to economies of scale.
Economies of scale come when you order a large enough quantity and get a discount for each one. It's like purchasing one candy bar for $1 or a bag of six candy bars for $3.50. The price for each one decreases as you purchase more of them. Sometimes additional sales mean that suppliers will give a better price for purchasing higher quantities.
The additional sales would increase the amount of total sales for Profits, Inc. Remember that we also have to take into account all of the extra costs that come about due to the new sales. To make additional products, we have to use more materials and more people to build the items, so more labor hours. There are also the additional advertising expenses and overhead that need to be paid as well.
After taking all of the new expenses into account, we see from our formula that if the projected additional sales are accurate, Profits, Inc. can make an additional $50,000 of profit by reaching more customers through the new advertising.
Differential costs take an in-depth look at all of the things that change when comparing two possible choices. Sometimes those choices are simple. However most times, many different things are affected and the decision becomes less clear until a full analysis is made. Asking the right questions about the two choices will allow you to develop a formula similar to the one discussed earlier. Remember to take all of the potential benefits and subtract all of the expected costs in order to see if there is a gain or loss in the end. You might have to think creatively to figure out all of the things that will change under each of the proposals.
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