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Differential Income: Definition & Formula

Instructor: Douglas Stockbridge

DJ Stockbridge is currently pursuing a Masters degree in Accounting.

In this lesson, we will discuss differential income, and the related concepts of differential revenue and differential expenses. Differential income is often used in the business world to make decisions about what investment to make, what new product to launch, and where to launch it.

Which Company Should You Invest In?

Imagine you are the CEO of a large, publicly traded company. Your company sales and profit over the past five years have been flat, and your stock price has languished behind the returns in the market and the returns of your competitors. Your board of directors are (as expected) upset. They keep pressuring you to do something to reignite growth in the company.

However, the company's fundamentals are just not that enticing. No matter how much money you throw into your existing business, growth will never amount to greater than a few percentage points each year.

That's why you have decided to invest the cash on hand in a new business, either Pretty Rocks Inc. or Vacation Caves Corp. Both companies have prospects that shine much brighter than your own company's. You just don't know which company to invest in. You heard differential income is often used to make decisions like this, but you just aren't sure what the concept is or even how to determine it.

Let's take a look at differential income and differential income analysis.

Definition of Differential Income

Differential income is the change in income compared with the change in income for another project or investment. Put another way, differential income is the difference in income of two or more projects or investments. It also can be used to identify differences outside of the investing world.

For example, if Bob has an income of $45,000 and Paul has an income of $60,000, then the difference between the two is $15,000. Paul makes $15,000 more than Bob. Pretty simple concept that you've probably been exposed to before. Differential income analysis, then, is when you compute differential income to make decisions.

You may have seen this equation: Revenue - Expenses = Income. Even if you haven't seen the equation, you probably know the logic behind it. For any business venture, if you take total revenues earned and subtract all your expenses, you are left with income, also known as profit. Well, you can calculate differential income if you know differential revenue and differential expenses. The equation becomes 'Differential Revenue - Differential Expenses = Differential Income'.

For example, let's compare Company A's 2016 and 2015 results. Income increased from $60 million to $70 million, so the income differential is $10 million. You could also find this if you knew revenue increased from $100 million to $120 million, and expenses increased from $40 million to $50 million. You take differential revenue of $120M - $100M = $20M and subtract differential expenses of $50M - $40M = $10M. That means the differential income equals $10 million.

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