DR Rachna Mahalwala - B.Com III Year Management Accounting

Differential Cost Analysis
Meaning of Differential Cost Analysis
Differential costing is a technique where mainly differential costs are

considered relevant. Differential cost is the difference in total costs
between two acceptable alternative courses of action.
The alternative actions may arise due to change in sales volume, price,
product mix, or such actions as make or buy or continue or stop
production, etc.
The key emphasis in differential costing is on change in total costs

associated with alternative decisions. When the change in costs occurs due
to change in the activity from one level to another, it may result in
incremental cost [i.e., increase in costs] or decremental cost [i.e., decrease
in costs]. Differential costing is a broader term that includes both
incremental costing and decremental costing.
The differential cost analysis is a useful tool for the management to know
the results of any proposed changes in the level or nature of activity.
Under this method, the differential costs are ascertained for each proposal
and compared with the expected changes in revenue associated with each
proposal.
When there is net excess revenue, the proposal will be accepted; otherwise
it will be rejected. The determination of differential cost is simple. It
represents the difference in the relevant costs for the alternative proposal
under consideration.
When two levels of activities are being considered, the differential cost is
obtained by deducting the cost at one level from another level.
In the above analysis, it is ascertained that the fixed overheads and a

portion of semi-variable overheads remain constant for both the
alternatives. Hence, they will be considered irrelevant for decision-
making, as they are not affected by increase in sales volume. However, if
some additional fixed costs are incurred for increased sales volume that
will be considered for computation.
Practical Applications of Differential Cost Analysis:
Some of the decision-problems where it may be applied are as follows:
(a) Determination of the most profitable levels of production and price
(b) Acceptance of special orders – offer at a lower price or offering a

quotation at lower selling price in order to increase the capacity.
(c) Sell a product as it is or after further processing
(d) Determination of right price at which materials may be purchased
(e) Decisions regarding alternative capital investment and plant

replacement
(f) Decisions such as changing the product mix, method of production,
make or buy, adding new product, etc.
Decision Making Through Differential Costing

Question 1.
In a light engineering company, Kitchen mixer machines are
manufactured. Prepare a schedule showing the total differential costs and
increments in revenue from the following data. At what volume the
company should set its level of production?
Analysis:
In the above case, the output level should be fixed at Rs.3 lakhs where the
selling price is at Rs.160 per machine. Under differential cost method, the
decision criterion is that it would be profitable to increase the output as
long as the incremental revenue equals or exceeds the differential cost. Up
to Rs.3 Lakhs level the incremental revenue is more than differential cost
thereby adding to the profit figure. After that level the differential cost is
more than the incremental revenue thus resulting in a loss on additional
output.
Question 2
A company is at present working at 90% capacity producing 13 500 units

per annum. It operates a flexible budgetary control system.
The following figures are obtained from its records budget:
Labour and material costs per unit are constant under present conditions.
Profit margin is 10%.
(a) You are required to determine the differential cost of producing 1500
units by increasing capacity to 100%.
(b) What would you recommend for an export order the minimum price
taking into account that overseas prices are much lower than indigenous
prices?
Solution:
Total differential cost = Rs.97 267
Minimum price for export = Rs.97 267/1500 = Rs.64.84 per
This price is the minimum that should be charged to avoid any loss.
Hence, any price above Rs.64.84 may be acceptable.
Working Notes:
Cost of labour and material at 100% = [Rs. 807000/90] x 100 = 896667.

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Differential Cost Analysis

Meaning of Differential Cost Analysis

Differential costing is a technique where mainly differential costs are

The key emphasis in differential costing is on change in total costs

In the above analysis, it is ascertained that the fixed overheads and a

Practical Applications of Differential Cost Analysis:

Some of the decision-problems where it may be applied are as follows:

(a) Determination of the most profitable levels of production and price

(b) Acceptance of special orders – offer at a lower price or offering a

(c) Sell a product as it is or after further processing

(d) Determination of right price at which materials may be purchased

(e) Decisions regarding alternative capital investment and plant

Decision Making Through Differential Costing

A company is at present working at 90% capacity producing 13 500 units

The following figures are obtained from its records budget:

Minimum price for export = Rs.97 267/1500 = Rs.64.84 per

Cost of labour and material at 100% = [Rs. 807000/90] x 100 = 896667.

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