Differential, opportunity and sunk costs explanation and examples

This helps the company make safe business decisions since they understand the various profits and costs that come along with their decision. It is a technique of decision-making based on the differences in total costs. However, the decision to accept or reject the alternative depends on the net gain/loss.

This refers to the total price of parts or raw materials that go into producing a product, which can vary depending on the company. In the example of Make Money, Inc., the direct material cost was the fee for hiring a new employee. The Differential cost analysis should show that further direct material costs will come when it is time to re-film and update the commercial.

Differential Cost and Differential Revenue:

For example, when shopping online, Daniel saw two of the same pair of jeans on two different websites. One website listed them for $80, while the other listed them for $65. Daniel thought, “Why would I not go with the cheaper website?” Without even understanding what he was doing, Daniel had completed a differential cost analysis. We now have to look at the differential cost between the two choices. The move places the opportunity cost of choosing to stick to the old advertising method at $4,000 ($14,000 – $10,000). The $4,000 is the income that ABC would forego for remaining with the old marketing techniques and failing to adopt the more sophisticated marketing models.

Marginal costing helps businesses decide whether it is beneficial or not to produce additional units. Increasing the output alone is not advantageous if the selling prices cannot be maintained. Therefore marginal costing supports the business to identify the optimal level of production.

Differential Cost Formula

Differential revenues and costs (also called relevant revenues and costs or incremental revenues and costs) represent the difference in revenues and costs among alternative courses of action. Therefore, keep things in control and do not let of balancing your strategy. For example, if the production cost of your product is $100 and the selling price is between $75 and $100, you won’t generate higher profits. As stated earlier, differential pricing enables you to set different price points for customers who purchase the same product. Differential pricing, also known as price differentiation or dual-pricing system,” depends on various factors, including location, time of day, the season of the year, and your brand or product. The company’s prices go up when there is a high demand from consumers.

Pablo road constructors has been using Double XX plant machinery to prepare 1000 kilometers of road at a cost of $250. A new plant machinery known as Double TT which is using new technology is now in use to do the same 1000 kilometers at $215. Assume that managers have to decide whether to close a store that is not meeting its sales quota or keep it open even if sales have not hit the breakeven point for several months. On one hand, closing the store will eliminate all other costs, but lease of ​$5,000​ per month will continue for the next six months.

Accounting Details

Although differential pricing is a part of dynamic pricing, they are different. Differential pricing refers to a product’s price base on customer characteristics, buying behavior, and purchasing patterns. On the other hand, dynamic pricing is pricing set by a company based on the current market conditions and related factors. Differential pricing is a sophisticated method that benefits almost all businesses if used correctly. It enables you to reach a wider audience, increase your sales, and generate more revenue. It is crucial to develop a differential pricing strategy carefully.

The costs that do not change in the alternatives are not part of the analysis. Financial managers conduct a comparative analysis to ascertain the difference in the cost due to the change in operations. It involves estimating cost differences either by replacing the existing operation or introducing new procedures. Which product to make, how much to sell it for, to make or buy raw materials and components, how and where to distribute the product and so forth. Using these quantitative factors to make decisions allows managers to support decisions with measurable data. With the help of activity-based costing, costs can be assigned to activities within each category.

Products

Differential costs are often taken as marginal costs or incremental costs. In business, each alternative will have certain costs and benefits that must be compared to the costs and benefits of the other available alternatives. A difference in cost between any two alternatives is known as differential cost. A difference in revenue between any two alternatives is known as differential revenues. Differential cost includes both cost increase (incremental cost) and cost decrease (decremental cost). In general the difference (cost and revenue) between alternatives are relevant in decision making.

• Company’s total allocated fixed costs are allocated based on sales.
• If you decide to give up your job and return for you to school to acquire a Master’s degree, you would not receive $25, 000.
• Differential cost is the variation in costs (increase/decrease) between two available opportunities.
• To illustrate a sunk cost, assume that a company paid $50,000 several years ago for a special purpose machine.
• There are further benefits of increased product sales for a business.
• Sunk costs are already incurred and cannot be recovered, thus are irrelevant in making a new decision.

The company will also need to hire a millennial at $250 per week to oversee its social media marketing efforts. If the telecom operator adopts the new advertisement techniques, they will spend $2,000 per month in advertising expenses. It is not entered in the accounting records but must be considered while making decisions. Unlike other forms of cost, opportunity cost will not require the check of cash or its equivalent. It is a potential benefit or income which is given up due to selecting an option over another.

This is an extremely important principle in management accounting. This paper reviews the economic case for patents and the potential for differential pricing to increase affordability of on-patent drugs in developing countries while preserving incentives for innovation. Differential pricing, based on Ramsey pricing principles, is the second best efficient way of paying for the global joint costs of pharmaceutical R&D. Assuming demand elasticities are related to income, it would also be consistent with standard norms of equity.

Differential Costing is helpful in a comparative evaluation of the substitutes available. Among several alternatives, management opts for the most profitable one. Differential cost can then be defined as the difference in cost between any two alternative choices. ABC Company is a telecom operator that primarily relies on newspaper ads and the company website for marketing.

It is not advisable to increase the level of production to such a level where the differential costs are more than the incremental revenue. In the given problem, the company should set the level of production at 1,50,000 units because after this level differential costs exceed the incremental revenue. Differential cost, also known as incremental cost, is the difference in cost that results from choosing one option over another in decision-making scenarios. These costs can either increase or decrease depending on the decision made.

• In the given problem, the company should set the level of production at 1,50,000 units because after this level differential costs exceed the incremental revenue.
• This can help them hear suggestions on improving their services and products.
• However, it would still be responsible for the $1,000 in fixed overhead costs.
• A company’s revenue determines its turnover, meaning your business or brand value depends on the generated revenue.
• This paper looks at the issues related to the comparison of cost data over time focusing on discounting and annualization adjustments, which are used by economists to calculate financial and economic costs.

One way to use this concept to make decisions is to perform a differential cost analysis. This is especially helpful in the case of a project that incurs costs on several levels. Keeping track of all these costs and the alternatives can help business managers accurately assess the situation. Keeping the differential costs down can ensure potential for a high profit margin. Plus, they would need to hire someone to track the online sales and market the products to the public, resulting in an additional $1,000 a week to hire a new employee. Rather than paying $150 a month for website and sales, the company would now be paying $4,650 a month.