COST & MANAGEMENT ACCOUNTING

DIFFERENTIAL COST ANALYSIS

CHAPTER OBJECTIVES

 Meaning
 Characteristics of Differential Cost
 Difference between Differential Cost Analysis and Marginal Costing
 Practical Applications of Differential Cost Analysis

 Determination of Optimum level of production

 Accept or Reject Decision
 Adding or Dropping a Product line
 Make or buy decisions
 Sell or process decisions
 Introduction of Additional shift
(with Illustrations)

Differential cost is the change in the costs which may take place due to increase or
decrease in output, change in sales volume, alternate method of production, make or buy
decisions, change in product mix etc. So, differential cost is the result of an alternative course
of action. For example, difference in costs may arise because of replacement of labour by
machinery and difference in costs of two alternative courses of action will be the differential
cost.
If change in cost occurs due to change in level of activity, differential cost is referred to
as incremental cost in case of increase in output and decremental cost in case of decrease in
output.
In differential cost analysis costs are calculated on the basis of absorption or total
costing technique, but in marginal costing technique, costs are calculated on the basis of
variable costs only and fixed costs are not taken. But if the alternate course of action does not
involve any extra fixed costs change in variable costs will become differential costs and there
will be no difference between marginal costs and differential costs.

Differential cost is the change in cost which may result from the adoption of an
alternate course of action or change in the level of activity. Change in cost may take place due
to change in fixed costs and variable costs, so differential cost is the aggregate of changes in
fixed costs and variable costs which take place due to the adoption of an alternate course of
action or change in the level of output.

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Output Output Differential Total Differential Differential Cost

Levels Unit Unit Cost ($) Cost ($) Per Unit ($)

1 1,00,000 30,00,000 - 30

2 1,20,000 20,000 35,00,000 5,00,000 27.5

Characteristics of Differential Cost

The following are the essential characteristics of differential costs:

1. Differential cost analysis is not made within the accounting records rather it is made
outside the accounting records. Differential costs may, however, be incorporated in the
flexible budgets because they budget costs at various levels of activity.

2. Total differential costs are considered in differential cost analysis. Cost per unit is not
taken into consideration.

3. Total differential revenues are compared with total differential costs before advocating
an alternate course of action. A change in course of action is recommended only if
differential revenues exceed differential costs.

4. The items of cost which do not change for the alternatives under consideration are
ignored, only the difference in items of costs are considered because differential costs
analysis is concerned with changes in costs.

5. The changes in costs are measured from a common base point which may be a present
course of action or present level of production.

6. Differential cost analysis is related to the future course of action or future level of
output, so it deals with future costs. Historical costs or standard cots may be used but
they should be suitably adjusted to future conditions.

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7. For making a choice among the various alternatives, the alternative which gives the
maximum difference between the incremental revenue and incremental cost is
recommended to be adopted.

Application of Incremental/Differential Cost Techniques in Managerial Decisions:

The areas in which the above techniques of cost analysis can be used for making managerial
decisions are:

1. Whether to process a product further or not.

2. Dropping or adding a product line.
3. Making the best use of the investment made.
4. Acceptance of an additional order from a special customer at lower than existing price.
5. Opening of new sales territory and branch.
6. Make or Buy decisions.
7. Submitting tenders
8. Lease or buy decisions
9. Equipment replacement decision.

Difference Between Differential Cost Analysis and Marginal Costing

Differential costs are often confused with marginal costs; so it is better to compare the
two to remove the confusion. The points of similarity and difference between the two
are summarized as follows:

Similarity
1. Both are techniques of cost analysis and cost presentation.
2. Both are used for taking managerial decisions such as effect on profits by following
changes in sales volume, product mix, price or method of production.
3. Marginal costs and differential costs are the same when there is no change in fixed
costs on account of increase or decrease in output.

Difference
1. Under marginal costing technique, fixed costs are not added to get the marginal
cost of a product whereas differential cost analysis takes into consideration changes in
fixed costs due to change in output.
2. Differential cost analysis is helpful in taking the managerial decisions and is not
incorporated in accounting records. In other words, differential costs are calculated

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separately as analysis statements. On the other hand, marginal costs may be

incorporated in the accounting records.
3. Marginal costs are calculated on the basis of contribution approach whereas
differential costs may be ascertained on the basis of both absorption costing as well as
marginal costing.
4. In marginal costing, margin of contribution, contribution per unit of limiting factor
and profit-volume ratio are the main yardsticks for evaluating the managerial decisions
whereas in differential cost analysis, differential costs are compared with the
differential revenues of determine whether alternate course of action should be
followed or not.

Practical Applications of Differential Costs

Many managerial decisions involving problems of alternative choices are made with the
help of differential cost analysis. Such decisions include the following:

(1) Determination of the Optimum Level of Production

The optimum level is that level of production where profit is the maximum. In order to
arrive at a decision of this type, the differential costs are compared with incremental revenue at
various levels of output. So long as the incremental revenue exceeds differential costs, it is
profitable to increase the output. But as soon as the differential cost equals or exceeds
increments revenue, it is no more profitable to increase the volume of output.

Illustration 1: A company has a capacity of producing 1,00,000 units of a certain product in a

month. The sales department reports that the following schedule of sale prices is possible:

Volume of production Selling price per unit Re.

At 60% capacity 60,000 units 0.90

At 70% capacity 70,000 units 0.80
At 80% capacity 80,000 units 0.75
At 90% capacity 90,000 units 0.67
At 100% capacity 1,00,000 units 0.61

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Variable cost of manufacture is 15 paise per unit and total fixed cost Rs.40,000. Prepare
a statement showing incremental revenue and differential cost of each stage. At which volume
of production will the profit be maximum?

Solution: Statement of Differential Cost and Incremental Revenue

Capacity Units of Variable Fixed Total Differential Sales Incremental

output cost @ cost cost cost Rs. revenue
Re.0.15 Rs. Rs.
Rs. Rs. Rs.

60% 60,000 9,000 40,000 49,000 -- 54,000 --

70% 70,000 10,500 40,000 50,500 1,500 56,000 2,000

80% 80,000 12,000 40,000 52,000 1,500 60,000 4,000

90% 90,000 13,500 40,000 53,500 1,500 60,300 300

100% 1,00,000 15,000 40,000 55,000 1,500 61,000 700

At 80% volume of production, profit is maximum. This is because at this level,

incremental revenue is Rs.4,000 whereas, differential cost is Rs.1,500, resulting in additional
profit of Rs.2,500 (i.e. Rs.4,000 – 1,500). After 80% level, differential cost exceeds incremental
revenue thereby resulting in a loss.

(2) Accept or Reject Decision

Sometimes a concern may receive special offers from its regular customers to sell its
regular products. Special offers may be received from the home customers for one time
quantity sales or sales to foreign customers. Such offers generally are received at lesser prices
than the usual customary prices. The decision to accept or reject special offers is based entirely
on differential cost and the contribution margin approach. The point to be considered is
whether incremental revenue is more than the differential costs to be incurred. The use of

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absorption costing is not preferred as it may show misleading results. While deciding about
special offers rejection or acceptance the following factors should be taken into consideration:
(i) The impact on future earnings of temporarily reduction in he selling price.
(ii) The effect of reducing selling prices on the existing customers when it comes to their
knowledge.
(iii) The possibility of selling additional units to the new customers beyond the special offer.
(iv) The reliability of cost estimates associated with the offer.
(v) The effect on current and future capacity in terms of an expansion of plant, personnel,
financial requirements and other capacity constraints.

Illustration 1(Continued): If there is a bulk offer for export at 50 paise per unit for the balance
capacity over the maximum profit volume and the price quoted will not affect the internal
sales, will you advise accepting this bid and why?

Solution:

Internal Market Special Order for Total

export (20,000
(80,000 units) units) (1,00,000 units)
Rs. Rs. Rs.
Variable cost @ 12,000 3,000 15,000
15 paise per unit
Fixed cost 40,000 ------- 40,000
Total Cost 52,000 3,000 55,000
Sales 60,000 10,000 70,000
Profit 8,000 7,000 15,000

It is advisable to accept the bulk offer @ Re.0.50 per unit for the balance capacity of 20,00 units
(i.e. 1,00,000 – 80,000) for export as it will result in an increase of profit by Rs.7,000.

(3) Adding or Dropping a Product Line

In a multi-product company, the management may have to decide on adding or

dropping a product line. When a new product line is added, its sales and certain costs will also
be increased and reverse will happen when a product line is dropped. In order to arrive at such
a decision, the management should compare the differential cost and incremental revenue and
study its effect on the overall profit position of the company.

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Illustration 2: The management of a company is thinking whether it should drop one item from
the product line and replace it with another. Given below are present cost and output data:

Product Price Variable costs per Percentage

of sales

Rs. unit Rs.

Book shelf 60 40 30%

Table 100 60 20%
Bed 200 120 50%

Total fixed costs per year Rs. 7,50,000

Sales Rs. 25,00,000

The change under consideration consists in dropping the line of Tables and adding the
line of Cabinets. If this change is made, the manufacturer forecasts the following cost and
output data:

Product Price Variable costs per Percentage of sales

Rs. unit Rs.

Book shelf 60 40 50%

Cabinet 160 60 10%
Bed 200 120 40%

Total fixed cost per year Rs. 7,50,000

Sales Rs.26,00,000

Should this proposal to be accepted? Comment.

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Solution: Comparative Profit Statement

Existing situation Proposed situation

Book Table Bed Total Book Cabinet Bed Total

Shelf Shelf

Sales 7,50,000 5,00,000 12,50,000 25,00,000 13,00,000 2,60,000 10,40,000 26,00,000

Less: V.C. 5,00,000 3,00,000 7,50,000 15,50,000 8,66,667 97,500 6,24,000 15,88,167

Cont. (C) 2,50,000 2,00,000 5,0,000 9,50,000 4,33,333 1,62,500 4,16,000 10,11,833

Less: F.C 7,50,000 7,50,000

Profit 2,00,000 2,61,833

Incremental revenue = Rs.26,00,000 – Rs.25,00,000 = Rs.1,00,000

Differential cost = Rs.15,88,167 – 15,50,000 = Rs.38,167

Additional profit = Incremental revenue – Differential cost

= Rs.1,00,000 – 38,167 – Rs.61,833

Total profit has increased by Rs.61,833 from Rs.2,00,000 to Rs.2,61,833 by accepting the
proposal. Thus, the proposal to drop the line of Tables and add the line of Cabinets should be
accepted.

Working notes: Variable cost is calculated as under:

Book shelf (Present situation).

Sales = 25,00,000 x 30% = Rs. 7,50,00

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When selling price of book shelf is Rs.60, its variable cost is Rs.40.

Thus:
Book shelf (Proposed situation)
Sales = 26,00,000 x 50% = Rs.13,00,000

Similar calculations are made for other lines of products.

(4) Make or Buy Decisions

In assembly type concerns, different components parts are assembled in order to

manufacture the product. Such component parts can be manufactured in the concern or these
can be purchased from external suppliers. If the concern has idle capacity and idle workers that
can be used to make component parts, it is preferable to make and realize cost savings. If there
is no idle capacity, the parts can be purchased from the outside. The other uses of idle capacity
should be examined before reaching a final decision as the available facilities have to be put to
best utilisation. Differential costing technique an be used for solving make or buy problem.
Costs associated with buying and making is to be compared. The sum of purchase price plus
transportation, insurance and ordering cost represents the amount applicable to the buying
alternative. On the other hand costs associated with the make alternative include the
differential variables to make the component parts such as materials, labour and variable
overheads. Allocated fixed costs remain unchanged in aggregate when components are made,
cannot be relevant to make or buy decisions. While making decision not only the present cost
but projections for future costs are to be taken into consideration.

In addition to the quantitative factors discussed above, the qualitative factors which are
taken into consideration to influence the make or buy decision are as follows:

(i) Quality of goods supplied by the supplier.

(ii) Uninterrupted supply by the supplier meeting the delivery dates.

(iii) If secrecy is to be maintained and manufacturing know-how is not to be passed on to the

supplier of the component part, the decision will be to manufacture part even though
the manufacturing cost may be more than the price to be charged by the supplier.

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(iv) Any adverse effect on labour relations if it is decided to buy from outside instead of
making.

(v) The facility of wider selection in case of buy-decision.

(5) Sell or Process Decisions

A product can be sold by a company when it has been partially processed or of

processing it further and then selling it. When a product passes through a series of
manufacturing operations, it may be a saleable product at a number of different points along
the way. Thus a company has an option to sell he product at various physical stages of
completion. For example in petroleum refinery, the refinement of oil can be stopped a several
points during the process and can be sold as fuel oil, diesel oil, kerosene or gasoline as market
exists or all these intermediate semi-manufactured products. In sell or process decision
incremental analysis provides the solution. In all alternatives incremental revenue is to be
compared with incremental costs after the decision point as all costs incurred before the sell or
process further decision must be treated as sunk costs. The alternative which gives more
benefit (incremental revenue – incremental cost) must be adopted.

Illustration 3: The Hi-Tech Manufacturing Company is presently evaluating two possible

processes for the manufacture of a toy and makes available to you the following information:

Process A Process B

Rs. Rs.
Variable cost per unit 12 14
Sale price per unit 20 20
Total fixed costs per year 30,00,000 21,00,000
Capacity (in units) 4,30,000 5,00,000
Anticipated sales (next two years in units) 4,00,000 4,00,000
You are required to suggest:

(i) Which process should be chosen? Substantiate your answer.

(ii) Would you change your answer as given above if you were informed that the capacities
of the two processes are: A – 6,00,000 units, B – 5,00,000 units? Why? Substantiate your
answer.

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Solution: Comparative Profitability Statement

Process A Process B

Rs. Rs.
(i) Selling price per unit 20 20

Less: Variable cost per unit 12 14

_________ _________

Contribution per unit 8 6

Total annual contribution (as per anticipated

sales of 4,00,000 units)
32,00,000 24,00,000
Less: Total Fixed Cost per year
30,00,000 21,00,000

_________ _________
Total Income
2,00,000 3,00,000
======== ========
Decision: Process B may be chosen

Total contribution (if utilised to present capacity

& sold
34,40,000 30,00,000
Less: Total fixed cost per year
30,00,000 21,00,000
Total Income 4,40,000 9,40,000
======== =======
Decision – Process B may be chosen

(ii) Total contribution (if capacity of A 6,00,000

units and of B 5,00,000 units)
48,00,000 30,00,000
Less: Fixed cost per year
30,00,000 21,00,000
Total Income 18,00,000 9,00,000
Decision: Process A may be chosen

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Illustration 4: A food-processing company produces four products from a single raw material.
These four products are obtained simultaneously at the point of separation. The product R does
not require further processing before being taken to the market. The other three products P, Q
and S require further processing before being sold. The company follows the net market value
method for allocating common costs to products.

The cost of the raw material used for the year just ended was Rs.18,000. The initial
processing costs were Rs.30,000 for the same period. The output, sales and further processing
costs for the last year were as follows:

Product Output Further Sales

processing
(units) costs (Rs.) (Rs.)
P 4,000 5,000 36,000
Q 3,500 1,750 14,000
R 2,500 - 20,000
S 1,200 3,250 12,000

You are required to:

(a) Prepare a comparative profit and loss statement showing the profit/loss made on each
of the four products;

(b) Assess the change in the profit/loss [given in answer to (a) above], if a proposal (stated
below) made by the top management is accepted.

PROPOSAL: To sell all the products directly to other processors just after separation without any
further processing. The expected price per unit for the products are: P – Rs.7, Q – Rs.3.50, R –
Rs.8, and S – Rs.9.

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Solution:

Statement of Differential Cost and Incremental Revenue

Product Sales after Number Selling Sales Incremental Differential

further of units price before revenue cost
processing before further (further
further processing processing
processing cost)

Rs.
(1) (2) (3) (4) = 2 x 3 (5) = 1 – 4
P 36,000 4,000 7.00 28,000 8,000 5,000
Q 14,000 3,500 3.50 12,250 1,750 1,750
R 20,000 2,500 8.00 20,000 -- --
S 12,000 1,200 9.00 10,800 1,200 3,250
Total 10,950 10,000

Conclusion: Incremental revenue from further processing is higher at Rs.10,950 than

differential cost at Rs.10,000 resulting in additional profit of Rs.950. Thus, products should be
further processed.

(6) Introduction of Additional Shift

When an additional shift is introduced, certain costs are bound to rise. Such additional
costs should be compared with additional revenue so that their net effect on profit can be
known for managerial decision. Thus, differential cost analysis helps management to decide
whether additional shift should be introduced or not.

Illustration 5: (Differential Cost Analysis): A Company at present working at 90% capacity and
producing 13,500 units per year. It operates a flexible budgetary control system. The following
figures are obtained from its budget.

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90% 100%

Rs. Rs.
Sales 15,00,000 16,00,000

Fixed expenses 3,00,500 3,00,600

Variable expenses 1,45,000 1,45,900

Semi-fixed expenses 97,500 100,400

Units manufactured 13,500 15,000

Labour and material cost per unit are constant under present conditions. Profit margin
is 10% of sales at 90% capacity. (a) You are required to determine the differential cost of
producing 1,500 units by increasing capacity to 100%. (b) What price would you recommend for
export of these 1,500 units, taking into account that overseas prices are much lower than
indigenous prices.

Solution: The problem does not give the material and labour cost which is needed for
computing differential cost. It is computed by working backward from sales as follows:

At 90% capacity
Rs.
Sales (13,500 units) 15,00,000
Less: Profit (10% of sales) 1,50,000
Cost of goods sold 13,50,000
Less: Variable expenses 1,45,000
Semi-fixed expenses 97,500
Fixed expenses 3,00,500 5,43,000
Cost of labour and material (combined) 8,07,000
Prime Cost

Labour and material costs are variable in nature and thus at 100% capacity these will be
calculated as under :

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8,07,000 x = Rs.8,96,667 (approx.)

Statement of Differential Cost Analysis

90% 10% Differential

Production (units) 13,500 15,000 1,500
Labour and material cost 8,07,000 8,96,667 89,667
Variable expenses 1,45,000 1,49,500 4,500
Semi-fixed expenses 97,500 1,00,400 2,900
Fixed expenses 3,00,500 3,00,600 100
13,50,000 14,47,167 97,167

Differential cost per unit = Rs.64.78

At a price of Rs.64.78 there will be no additional profit. Therefore, any price above
Rs.64.78 which gives at least reasonable profit should be acceptable for export, assuming that
export will not affect the internal sales.

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