Question

Explain how differential cost analysis might be used in the following non-routine decisions: expanding an existing service, decreasing an existing service, starting a new service, and closing an existing service,

Answer 1

Differential Costing: It is a technique where difference of two different level of activities are calculated to compare with change in revenues or profits.

Differential Cost Analysis for expanding an existing service:

When a firm wants to expand its services from its existing level of production it may have increases sales with increased cost. The decision could be analyzed by differential costing:

	Existing	Expanded	Differential Cost
Sales	60000	100000	40000
Direct Material	10000	20000	10000
Direct Wages	15000	20000	5000
Semi Variable Cost	5000	6000	1000
Fixed Overheads	10000	10000	0
Total Cost	40000	56000	16000
Profit	20000	24000	24000

From the above table, we can see that incremental profit i.e. 24000 is in excess of differential cost i.e. 16000, therefore the firm should go for expanding decision.

I the same manner, if the firm wants to downsize its production capacity and the differential cost are more than reduced profit than the firm can downsize its operations.

Starting a new service: When a firm compare the existing plans with the new alternatives and finds that the incremental revenue and profits are more than the differential cost, the firm should accept the new offer.

Closing of an existing service: While comparing with the past performances it is found that the sales is continuously going down but the differential cost is not much. If the differential cost (changes in cost) is not more than differential profits or revenues than firm should close down the project.