Differential Cost in Managerial Decision Making

Differential Cost in Managerial Decision Making
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  • 0:05 What Is a Differential Cost?
  • 1:02 How to Find the…
  • 1:32 How Managers Use…
  • 1:59 Differential Cost Example
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Lesson Transcript
Instructor: Kevin Newton

Kevin has edited encyclopedias, taught middle and high school history, and has a master's degree in Islamic law.

Differential cost calculations are an important part of how managers make the best decisions for their businesses. In this lesson, we'll see how it's used and learn how to a find differential cost.

What Is a Differential Cost?

Different businesses have different costs associated with them. After all, you could run a cookie baking business from your kitchen, but you couldn't run a jumbo jet manufacturing business in your backyard. Simply put, even if you had the massive amount of land necessary, the cost of building a jumbo jet is simply too much for most of us to imagine.

The same is true with business. Each business has to examine the costs associated with doing what it does. Now, not every choice is as dramatic as the difference between a cookie baking outfit and an aircraft manufacturer. However, there are still some pretty important decisions that have to be made.

Luckily, a company can use the differential cost of different courses of action to find out what's the best plan for moving forward for the business. Differential cost is the cost difference of one plan or procedure when compared to another. In this lesson, we'll see how differential costs are used as well as look at an example.

How to Find the Differential Cost

But first, how do you go about calculating the differential cost? Simply put, subtract the cost of one course of action from another. This includes both fixed costs, or costs incurred regardless of output, and variable costs, or those costs that can change depending on output. The resulting difference is the differential cost. And the good news is that there are no forms to fill out! Differential costs are only used by managers to make decisions. They don't really have a role in accounting.

How Managers Use Differential Cost

So, how do managers use differential costs? Differential costs help a manager understand the real cost of a particular course of action. An additional per-unit cost may not reflect the additional costs that come along with pursuing a different plan. For example, many companies may have to add increased capacity if they choose to create more units beyond a certain point. Differential cost allows us to see the cost of that added capacity.

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