What is Differential Cost?

Differential cost is the difference between the cost of two alternative decisions, or of a change in output levels. The concept is used when there are multiple possible options to pursue, and a choice must be made to select one option and drop the others. The concept can be particularly useful in step costing situations, where producing one additional unit of output may require a substantial additional cost. Here are two examples:

Example of alternative decisions. If you have a decision to run a fully automated operation that produces 100,000 widgets per year at a cost of $1,200,000, or of using direct labor to manually produce the same number of widgets for $1,400,000, then the differential cost between the two alternatives is $200,000.
Example of change in output. A work center can produce 10,000 widgets for $29,000 or 15,000 widgets for $40,000. The differential cost of the additional 5,000 widgets is $11,000.

In essence, you can line up the revenues and expenses from one decision next to similar information for the alternative decision, and the difference between all line items in the two columns is the differential cost.

Types of Differential Costs

A differential cost can be a variable cost, a fixed cost, or a mix of the two – there is no differentiation between these types of costs, since the emphasis is on the gross difference between the costs of the alternatives or change in output. Nonetheless, we make note of all three types of costs below:

Variable cost. A variable cost is one that changes in accordance with an associated activity. For example, the cost of commissions will increase as sales increase, and decline as sales decline. There are relatively few types of variable costs in most businesses, usually just direct labor, direct material, credit card fees, and commissions.
Fixed cost. A fixed cost is one that stays relatively fixed, irrespective of the activity level of a business. For example, a firm will incur rent expense for its premises, no matter what level of sales it generates. Depending on the business, it may have a relatively large base of fixed costs.
Mixed cost. A mixed cost is one that contains both a fixed and variable element. This means that there will be a baseline cost, irrespective of the activity level, plus a variable cost that changes to a degree as the activity level changes.

Accounting for a Differential Cost

Since a differential cost is only used for management decision making, there is no accounting entry for it. There is also no accounting standard that mandates how the cost is to be calculated. Instead, it is simply an analysis concept used to optimize decisions.

Terms Similar to Differential Cost

Differential cost is the same as incremental cost and marginal cost. The difference in revenues resulting from two decisions is called differential revenue.