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