Chapter No 25

DIFFERENTIAL
COST ANALYSIS
 Differential Cost
Differential cost is the difference in the cost of
alternative choices. OR
Differential cost is the difference in cost between two
alternative courses of action. It is also known as
incremental cost or marginal cost.
It involves identifying the relevant costs and benefits of
each alternative and then determining the difference
between them. Differential cost analysis is an
accounting technique used to make decisions by
comparing the costs and benefits of different
alternatives.
 Applications of Differential Cost
Analysis
1. Taking or Refusing Certain Orders
 Analyze: Will accepting the order bring in revenue that exceeds the additional
(differential) cost?
 Use when: You get a special order at a lower price than usual.
 Focus: Only incremental costs and additional revenue, not sunk costs.
2. Increasing, Curtailing, or Stopping Production of Certain Products
 Analyze: Does the product cover its variable costs and a portion of fixed costs?
 Use when: A product is underperforming.
 Focus: Compare contribution margin and opportunity cost of resources.
3. Selecting New Sales Territories
 Analyze: What are the extra costs of entering a new territory versus the expected
revenue?
 Use when: Expanding market reach.

 Applications of Differential Cost
Analysis
4. Spending Additional Amounts for Sales Promotion
 Analyze: Will the extra promotion costs lead to enough additional sales?
 Use when: Launching a campaign or boosting a slow product.
 Focus: Marginal revenue from promotion vs. its cost.
5. Reducing the Price of a Single, Special Order
 Analyze: Can the order be fulfilled without affecting regular sales and still cover
variable costs?
 Use when: Idle capacity is available.
 Focus: Short-term gain vs. long-term pricing strategy.
6. Making a Price Cut in a Competitive Market
 Analyze: Will a lower price increase sales volume enough to offset the lower margin?
 Use when: Facing price pressure from competitors.
 Focus: Changes in profit from increased volume vs. reduced unit margin.
 Applications of Differential Cost
Analysis
7. Evaluating Make-or-Buy Alternatives
 Analyze: Is it cheaper to produce in-house or outsource?
 Use when: Looking to cut costs or reallocate internal
resources.
 Focus: Cost of making vs. cost of buying, including hidden
costs (e.g., quality, reliability).
8. Replacing Present Equipment with New Machinery
 Analyze: Do the savings from efficiency and lower
maintenance justify the cost of new equipment?
 Use when: Equipment is outdated or inefficient.
 Focus: Cost of new machine vs. operating cost savings and
salvage value.
DIFFERENTIAL COST STUDIES
ILLUSTRATED
 The Importance of Variable Costs
 Historical Cost Allocation vs. Differential Cost Presentation
 The Flexible Budget and the Differential Cost Statement
 Application of the Flexible Budget for Differential Cost
Analysis
 Application 1: Sell or Process Further
 Application 2: Price to Pay for an Intermediate Stock
 Applications 3: Choice of Alternate Routings
 Application 4: Proposed Construction of Additional Capacity.
 The Importance of Variable Costs
The term "differential cost" applies to those costs that will
change.
•Variable costs change with the level of activity or output.
•In differential analysis, only costs that change between
alternatives matter.
•Fixed costs are often irrelevant unless they change due to the
decision.
•Focus on Contribution Margin = Sales – Variable Costs
 The Importance of Variable Costs
• Plant has a maximum
capacity of 100,000 Units
• Normal capacity
production is 80,000 units
• predetermined overhead
rate fully absorbed fixed
expenses at 80,000-units
• Less units produced=
unabsorbed fixed
overhead
• more units=fixed
overhead is over absorbed
 Historical Cost Allocation vs.
Differential Cost Presentation
Historical cost allocation refers to the method of
assigning costs to a particular period based on the
actual cost incurred in that period. This method is used
to report the costs of assets, such as property, plant,
and equipment, and to determine the cost of goods
sold for manufacturing and inventory accounting.
Historical cost allocation is useful for reporting actual
costs incurred
Historical Cost Allocation vs.
Differential Cost Presentation
manufacturing Unit=
450,000 units (90%
Capacity)
Fixed factory
overhead=
$335,000/unit
FFOH cost =$•67
(335000/500000
units)
Variable FOH=
$0.50/Unit
Direct Material=
$1.80/Unit
Direct Labour= $
1.40/Unit
Sales= $5/Unit
 The Flexible Budget and the
Differential Cost Statement
Flexible Budget adjusts costs based on activity level (e.g., units
produced).
Differential Cost Statement compares the net differences in cost and
revenue between two options.
Together, they help evaluate scenarios more accurately by accounting
for changes in volume.
A flexible budget is a budgeting technique that allows for adjustments
and changes in the budget based on actual activity levels or changes in
assumptions. Unlike a static budget, which remains fixed regardless of
actual activity, a flexible budget is designed to adapt to different levels
of activity and provides a more accurate reflection of costs and
revenues.
 Application of the Flexible Budget
for Differential Cost Analysis
The flexible budget is commonly used for differential cost analysis, which involves
comparing the costs and benefits of alternative courses of action or decision-
making. By applying the flexible budgeting approach, organizations can assess the
impact of different levels of activity on costs and determine the most cost-
effective option.
Here's how the flexible budget can be applied for differential cost analysis:
 Identify the decision scenario: Determine the decision or alternative courses of
action that need to be evaluated. For example, deciding between two
production methods or choosing between outsourcing and in-house production.
 Determine the relevant cost factors: Identify the cost elements that are relevant
to the decision. These may include direct materials, direct labor, variable
overhead, and any other costs directly affected by the decision.
 Establish the base level of activity: Determine the level of activity that
represents the base case or initial plan. This could be the expected or current
 Application of the Flexible Budget
for Differential Cost Analysis
 Prepare the flexible budget: Develop a flexible budget for each alternative course of action by
adjusting the budgeted amounts for relevant costs based on the actual or expected activity
level. This involves calculating the cost at different activity levels, considering the behavior of
each cost element (fixed, variable, or semi-variable).
 Compare the costs: Compare the total costs associated with each alternative based on the
flexible budget amounts. Analyze the cost differentials between alternatives to identify the most
cost-effective option.
 Consider other factors: While the flexible budget provides insights into differential costs, it's
important to consider other qualitative factors and non-financial aspects related to the decision.
These may include quality, reliability, customer preferences, and long-term implications.
 Make an informed decision: Evaluate the differential costs, along with other relevant factors, to
make an informed decision. Select the alternative that offers the best combination of costs and
benefits for the organization.
 By applying the flexible budget to differential cost analysis, organizations can assess the
financial impact of various alternatives and make more informed decisions. This approach
allows for a thorough evaluation of costs at different activity levels, helping to identify cost-
saving opportunities, optimize resource allocation, and improve overall efficiency.
Application 1: Sell or Process Further
The decision to sell a product or
process it further is a common
scenario in many industries,
especially those involved in
manufacturing or production. The
flexible budget can be used to
analyze the costs and benefits
associated with selling a product at
its current stage or investing in
additional processing to enhance its
Scenario: FreshFruit Inc. – Apple
Juice
FreshFruit Inc. produces raw apple juice. They can sell it as is, or
process it further into sparkling apple juice, which can sell for a
higher price.
 Per Gallon Info: Revenu Additional
Option Total Cost Profit
e Cost
Sell as Raw
$3.00 $0.00 $2.00 $1.00
Apple Juice
Process into $2.00 +
Sparkling $4.50 $1.20 $1.20 = $1.30
Juice $3.20
 Step-by-Step Analysis Using Flexible Budget
(for 1,000 gallons)

Decision: Process Further

Because $1,300 > $1,000, processing the apple juice further gives more
profit.
 Application 2: Price to Pay for an Intermediate
Stock
To determine the price to pay for an intermediate stock, you typically
need to consider various factors, such as the stock's intrinsic value,
market conditions, and your investment objectives. The price you are
willing to pay may depend on your valuation analysis, risk tolerance,
and desired return on investment. Here are some key steps to
consider:
 Conduct valuation analysis
 Assess market conditions
 Determine your desired return
 Set a target purchase price
 Monitor the stock's market price
 Adjust your analysis if necessary
 Scenario: Evaluating a Stock –

TechTrend Inc.
You're interested in buying shares of TechTrend Inc., but you're not sure
what price you should pay for it.

Step-by-Step Process with Sample Numbers

1️⃣Conduct Valuation Analysis (Estimate Intrinsic Value)
•You estimate the intrinsic value using a discounted cash flow (DCF)
method.
•Future expected cash flows = $5 per share per year
•Your required return (discount rate) = 10%
Using the perpetuity formula:
2️⃣Assess Market Conditions
• Current stock price = $55
• The market seems optimistic, but you're cautious.
3️⃣Determine Desired Return
• You want a 12% return to justify the investment risk.
Adjusted valuation for 12% return:

4️⃣Set a Target Purchase Price

• To get your desired 12% return, your maximum price to pay is $41.67.
5️⃣Monitor the Market Price
• Current market price = $55
• Target price = $41.67
So, wait for the stock to drop or find a better opportunity.
 Applications 3: Choice of Alternate
Routings
The choice of alternate routings refers to the decision-making process of selecting
different paths or routes to accomplish a particular task or reach a specific
destination. This concept is commonly used in logistics, transportation, and project
management when multiple options are available.
 To make an informed choice of alternate routings, consider the following steps:
 Identify available options
 Assess advantages and disadvantages
 Quantitative analysis
 Consider trade-offs
 Risk assessment
 Make a decision
Remember that the choice of alternate routings may require input and collaboration from
different stakeholders, such as logistics personnel, supply chain managers, project teams, or
customers. By involving relevant parties and considering the various aspects mentioned
above, you can make a more informed decision regarding the most suitable alternate routing
Scenario: Logistics Routing for Delivering
Goods
A company needs to deliver 100 boxes of electronics from
City A to City D. There are two alternate routes available:
Routing Options:
Route 2 (Through
Factor Route 1 (Highway)
Rail & Road)
Total Distance 400 km 480 km
Cost per km $2/km $1.5/km
Time Required 6 hours 9 hours
Risk (delays/weather) Low Medium
Environmental Impact Medium Low
Step-by-Step Quantitative Analysis
1️⃣Total Cost Calculation
• Route 1: 400 km × $2 = $800
• Route 2: 480 km × $1.5 = $720
2️⃣Time vs Cost Trade-off
• Route 1 is faster (6 hours) but costs more
• Route 2 is cheaper ($720) but takes 3 hours longer
3️⃣Risk & Environmental Trade-off
• Route 1 is less risky, but more emissions
• Route 2 is eco-friendly, but higher chance of delay
Decision (Example Outcome)
 If the priority is on-time delivery and low risk, choose Route 1.
If the priority is cost-saving and sustainability, choose Route
2.
Application 4: Proposed
Construction of Additional Capacity

The proposed construction of additional

capacity refers to the plan to expand or
build new infrastructure, facilities, or
production capabilities to meet increased
demand or improve operational efficiency.
Scenario: Sunny Drinks Co. – Juice
Production Capacity Expansion
Sunny Drinks Co. is facing increased demand for its
bottled juices. They currently operate at full capacity
(100,000 units/month) and are considering building a
new production line to add 50,000 more units/month.
Key Data: Proposed Additional
Factor Current Facility
Line
Monthly Production 100,000 units +50,000 units
Fixed Cost of
— $300,000
Expansion (Annual)
Variable Cost per Unit $1.50 $1.50
Selling Price per Unit $3.00 $3.00
Expected Demand 140,000
—
(new total) units/month
Step-by-Step Financial Analysis
1️⃣Calculate Annual Additional Revenue:
• New Units Sold = 40,000 units/month × 12 months = 480,000 units
• Revenue = 480,000 × $3.00 = $1,440,000
2️⃣Calculate Annual Additional Costs:
• Variable Costs = 480,000 × $1.50 = $720,000
• Fixed Costs (new line) = $300,000
Total Cost = $1,020,000
3️⃣Calculate Annual Profit from Expansion:
Profit=Revenue−Costs=
1,440,000−1,020,000=$420,000
Decision Point: Since the expansion gives a positive profit
($420,000/year) and helps meet growing demand, construction is
recommended.
 LINEAR EQUATIONS FOR DIFFERENTIAL
COST STUDIES

Linear equations are commonly used in differential cost studies to

analyze and compare costs under different scenarios or levels of
activity. These equations help quantify the relationship between
costs and various factors, such as production volume, labor hours,
machine hours, or any other relevant cost driver.
A linear cost equation typically looks like:
Total Cost=Fixed Cost+(Variable Cost per Unit×Number of Units)
 We use this to compare two alternatives and decide which
one is more cost-effective under different levels of activity.
 Scenario: Comparing Two Machines
A company is considering two different machines (A and B)
for producing widgets. Each has different fixed and
variable costs.
Fixed Cost Variable Cost
Machine
(per month) (per unit)

Machine A $5,000 $2.00

Machine B $3,000 $3.00

•Step 1: Write
Machine A: Linear Cost Equations
CA=5000+2x
•Machine B:
CB=3000+3
Where x = number of units
produced
Step 2: Find the Break-Even Point
To find the point where both machines cost the same:
5000+2x=3000+3x
Solve:
2000=x⇒x=2000 units
Interpretation:
• If production is less than 2,000 units, choose Machine B (lower
fixed cost).
• If production is more than 2,000 units, choose Machine A (lower
variable cost).
Linear equations help compare costs at different volumes. Plotting
them gives a visual of which option is better at which production
level.
 USE OF PROBABILITY ESTIMATES
 Probability estimates are widely used in various fields to assess and
quantify uncertainty, make informed decisions, and conduct risk
analysis. In the context of differential cost studies, probability
estimates can be valuable in several ways:
 Decision-making under uncertainty: To assess the likelihood of
different outcomes, evaluating alternative courses of action,
probability estimates can help quantify the likelihood of different cost
scenarios and their associated probabilities.
 Sensitivity analysis: To assess the impact of uncertain variables on
differential costs, such as sales volumes, input prices, or demand
patterns, analysts can evaluate how changes in these variables
affect the overall cost estimates.
 USE OF PROBABILITY ESTIMATES
 Risk assessment: managing risks associated with differential costs. By quantifying the probability of
different cost outcomes, decision-makers evaluate the potential financial impact of various scenarios
and develop risk mitigation strategies accordingly.
 Monte Carlo simulation: A technique used to model the uncertainty of inputs and generate probability
distributions for the outputs. By running multiple simulations with different probability estimates for
cost variables, analysts can generate a range of possible outcomes and their associated probabilities.
 Cost estimation and budgeting: Instead of relying solely on deterministic cost figures, incorporating
probability estimates allows for a more comprehensive understanding of the range of potential costs
and their likelihoods, enabling better resource allocation and contingency planning.
 Project evaluation: Investment decisions with uncertain outcomes. By assigning probabilities to
different cost scenarios, analysts can calculate expected values, net present values, or other risk-
adjusted metrics to assess the feasibility and profitability of projects.
 Decision tree analysis: A technique used to evaluate decision options with associated probabilities
and outcomes.
 Overall, probability estimates provide a quantitative framework for dealing with uncertainty in
differential cost studies. They help decision-makers assess risks, evaluate alternatives, and make
more informed decisions in the face of uncertain cost scenarios.
Differential cost studies for make or
buy decisions
 Differential cost studies are commonly used in make or buy decisions, which
involve determining whether to produce a product or service internally (make) or
purchase it from an external supplier (buy). These help to compare the costs and
benefits of each option to make an informed decision. Here's how differential cost
analysis can be applied in make or buy decisions:
 Identify relevant costs: Identify and categorize the costs associated with each
alternative (make and buy). These costs may include direct materials, direct
labor, variable and fixed overhead costs, equipment and facility costs, quality
control expenses, transportation costs, inventory carrying costs, and any other
relevant expenses specific to the decision.
 Analyze direct costs: Compare the direct costs of making and buying the product
or service. Calculate the direct materials cost, direct labor cost, and any other
direct costs involved in each alternative. Consider factors like economies of
scale, price discounts, or supplier expertise when analyzing the buy option.
 Differential cost studies for make or
buy decisions
 Consider indirect and overhead costs: Evaluate the indirect and overhead costs
associated with each alternative. These costs may include facility-related expenses,
utilities, maintenance, depreciation, quality control, administrative costs, and any
other relevant overhead expenses. Allocate or assign these costs to the make or buy
alternatives appropriately.
 Assess capacity utilization: Analyze the capacity utilization of existing internal
resources. If the internal capacity is underutilized, the incremental cost of making the
product internally may be lower. However, if internal capacity is already strained,
buying the product externally may be more cost-effective.
 Evaluate qualitative factors: Consider qualitative factors that may impact the
decision. These could include supplier reliability, quality control, intellectual property
considerations, lead time, flexibility, technological expertise, and strategic
implications. Evaluate the risks associated with each option and their potential
impact on cost, quality, and customer satisfaction.
Differential cost studies for make or
buy decisions
 Perform a cost comparison: Compare the total costs of making and buying the
product/service by summing up all the relevant costs identified in steps 2 and 3.
Consider both the short-term and long-term costs. It's important to consider the
entire life cycle of the product/service and any potential cost changes over time.
 Make the decision: Compare the costs, benefits, and qualitative factors of the
make and buy options. Select the alternative that provides the lowest total cost
or best meets the strategic objectives of the organization. It's crucial to consider
the financial implications, risks, and any trade-offs between cost, quality,
control, and flexibility.
By conducting a thorough differential cost analysis, businesses can evaluate the
financial and non-financial implications of making or buying a product/service. This
analysis helps in optimizing resource allocation, reducing costs, enhancing
competitiveness, and aligning the decision with the overall business strategy.
OTHER COST CONCEPTS
 Opportunity Costs
 Imputed Costs
 Out-Of-Pocket Costs
 Relevant-Irrelevant Costs
 Sunk Costs.
 Opportunity Costs
Opportunity cost is the cost of the best alternative forgone when a particular
choice is made. It represents the value of the next best alternative that must
be given up in order to pursue a certain choice. Opportunity cost is a key
concept in economics and decision-making because resources, including
time, money, and labor, are scarce and must be used efficiently.
Opportunity Cost = The value of the next best alternative you didn’t
choose.
 It reminds us that every decision has a trade-off, especially when
resources like time, money, or labor are limited.
 Example: Summer Job vs. Internship
A student has two options this summer:Option Earnings / Value
Paid Job $3,000 over the summer
They choose the internship.
Unpaid $0 (but gains experience
What’s the Opportunity Cost?
Internship worth future earnings boost)

It's the $3,000 they gave up by not choosing the paid job.
So:
 Opportunity Cost=$3,000
But let’s say the internship increases future job chances and
boosts starting salary by $5,000 annually. Then the long-
term gain outweighs the short-term cost.
 Imputed Costs
Imputed costs are costs that are not explicitly incurred or
recorded as cash outflows, but are assigned or allocated to
reflect the economic value or opportunity cost associated with a
particular resource or decision. They are not actual expenses but
are used to account for the economic impact of using or forgoing
resources. Imputed costs are used in certain situations where it
is necessary to capture the full economic costs of an activity
An imputed cost is a cost that is incurred by virtue of using
an asset instead of investing it or the cost arising from
undertaking an alternative course of action.
Imputed cost = A non-cash cost, not recorded in financial
accounts, but used in decision-making to reflect the true
economic impact of using a resource.
 Owner-Operated Business – Forgone
Salary
Imagine Sarah owns a small café. She works full-time in her café
but doesn't pay herself a salary.
She could have worked at another company and earned
$40,000/year.
So, What’s the Imputed Cost?
Even though no money changes hands, the value of her time is:
Imputed Cost=$40,000
This is the opportunity cost of her labor — what she gave up
to run the café.
In decision-making (e.g. "Should I continue running this café or
take a job?"), we must include imputed costs to understand
the true profitability.
Imputed costs help capture the real economic value of using
 Out-Of-Pocket Costs
Out-of-pocket costs, also known as outlay costs or
explicit costs, are expenses that require a direct cash
outflow or payment by a business or individual. These
costs are typically tangible and measurable and are
incurred as a result of a specific decision or action.
Out-of-pocket costs are considered relevant costs in
decision-making because they directly impact the
financial position and cash flow of the entity.
An out-of-pocket expense is a payment you make with
your own money that may be reimbursed later by an
employer.
 Relevant-Irrelevant Costs
Relevant costs and irrelevant costs are terms used in cost analysis to
distinguish between costs that are important and should be considered in
decision-making and costs that are not relevant and should be ignored.
Relevant Costs: Costs that will change based on the decision.
➤ These affect the future and differ between alternatives.
Include in decision-making.
Irrelevant Costs: Costs that do not change regardless of the decision.
➤ These are often past (sunk) costs or common fixed costs.
Example: Weekend Plan – Road Trip vs. Campus Event
Alex has two options for the weekend:
• Option A: Go on a road trip with friends
• Option B: Stay on campus and attend a paid workshop
 Campus
Cost Item Road Trip Relevant?
Workshop

Gas and Travel Expenses $80 $0 ✅ Yes (only applies to road trip)

Workshop Fee $0 $50 ✅ Yes (only applies to workshop)

Meals (he eats out either
$40 $40 ❌ No (same in both cases)
way)
Concert Ticket (already
$25 $25 ❌ No (sunk cost, already paid)
bought)
Relevant Costs:
•Gas/Travel ($80) — only if Alex goes on the road trip
•Workshop Fee ($50) — only if Alex stays on campus
Irrelevant Costs:
•Meals ($40) — same for both options
•Concert Ticket ($25) — already spent, can’t be recovered
When making decisions, ignore costs that don’t change or are already
spent. Focus on what will actually differ between your options.
 Sunk Costs
Sunk costs refer to costs that have already been incurred
and cannot be recovered or changed by any present or
future decision.
These costs are irrelevant for decision-making because
they have already been spent and are independent of any
current or future choices.
When conducting a differential cost analysis or making
decisions, it is important to understand the concept of sunk
costs and treat them appropriately.
These costs are irrelevant when making new decisions
Example: Movie Ticket Decision
Imagine you paid $12 for a movie ticket, but halfway
through the movie, you realize it's boring and not
enjoyable.
Now you’re trying to decide:
• Stay and finish the movie
• Leave and do something more enjoyable
 Don’t say “I already paid, so I might as well stay.”
 That’s the sunk cost fallacy.
 The smart move is to base your decision only on:
 "What will make the rest of my time better right now?“
Ignore sunk costs when making decisions. Focus only on
future benefits and costs that can still be influenced.