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Differential Revenue: Definition, Formula & Example

Instructor: Douglas Stockbridge

DJ Stockbridge is currently pursuing a Masters degree in Accounting.

In this lesson, we will discuss differential revenue. This is an important concept used in business to understand the attractiveness, or unattractiveness, of pursuing one investment over another.

Newspaper, Coca Cola or Comics?

Imagine you are an elementary school kid who wants to make money. You've delivered newspapers in your town for the last few years, but you've just heard of two other businesses that may bring in more money.

The first business is you have a friend in another town who buys a 12-pack of Coca Cola for $4.80 and sells each bottle for 50 cents. The friend only buys the 'old-fashion' coke bottles with the contour fluted glass. They are a good seller, especially on hot summer days.

The other business is to buy and rent out comic books. You already have a good-sized collection, but if you spend some of the money you've saved your collection could get even larger. And many of your friends talk about how they'd love to read more comic books. They just don't have the money to do it.

You aren't sure what business you should pick. Should you stick to selling newspapers? Or sell cokes or rent out comic books? You've done a little research and you've heard that differential revenue may help you make this decision.

In this lesson, we will first give the definition of differential revenue, and then we'll show how it can be used to identify which business (mentioned above) you should pursue, and finally we'll give some additional examples of differential revenue you may experience in the business world.

Definition

Differential revenue is the anticipated increase or decrease in revenue in one project, or investment, relative to the increase or decrease in revenue of another project or investment. Put another way, it's the difference in revenue of two or more projects or investments. Differential revenue analysis is when you compute differential revenue to make your decision. We use a form of this kind of analysis all the time. We are just unaware of it because its subconscious.

For example, at a restaurant, as you go through the menu choices you are subconsciously ranking the choices based on your expected utility (or happiness). If you are in the move for a hamburger, a bacon cheeseburger will sound good, and rank higher than a pasta dish, for example. As you go through the list, you continuously rank and update, rank and update. Differential revenue is a form of ranking and updating. There are just 'hard' numbers behind the process.

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