- Define differential cost
Managers have a multitude of decisions to make. 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. Each of the decisions has at least two options.
When we work to make decisions, we need to look at the pros and cons of each option. The key to making these decisions is called differential analysis-focusing on the pros and cons (costs and benefits) that differ between the two options.
Differential cost can then be defined as the difference in cost between any two alternative choices.
So if we go back to Mary and Ben’s choices for Hupana Running Company:
- Lower quality raw material that is the budgeted price, but will raise the units needed per pair of shoes
- Higher quality raw material that costs more than the budgeted price, but will use the budgeted number of units per pair on budget.
How do we choose? We need to look at the overall difference in cost between the two options!
So let’s put it into numbers:
- Raw material 1: $2.50 per unit × 5 units per pair = $12.50 per pair
- Raw material 2: $2.00 per unit × 6 units per pair = $12.00 per pair
Both options are higher than the direct materials budget per pair, but which one is the better option? What other factors may come into play here? Let’s think back to our production time, and how they correlate to direct labor. Might that be an issue as well? What if raw material 2, at its lower cost, ends up adding to the direct labor time per pair?
Raw Material 1
$2.50 per unit × 5 units per pair = $12.50 per pair
Direct labor per pair = .45 hr, @ $20 per hour = $9 per pair so a total of $21.50 per pair
Raw Material 2
$2.00 per unit × 6 units per pair = $12.00 per pair
Direct labor per pair = .5 hr @ $20 per hour= $10 per pair so a total of $22.00 per pair.
So how does that change our decision? We now have to look at the differential cost between the two choices. The best choice now, is raw material 1, right? It has a higher cost per unit, but it saves production time.
In this example, which costs are relevant costs? The raw material price and the direct labor cost both make a difference, so both of these costs would be relevant as you looked at your options. What if there was no change in the direct labor needed, regardless of the cost of the raw material? Then the direct labor cost would be come in irrelevant cost. If that was the case, we could disregard that option to save us time in our decision making process.
Now onto costs we can avoid!