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Differential analysis is a method of comparing two or more business alternatives to each other in an attempt to decide which is the right choice. If using this type of analysis with a strictly numerical approach, a business would compare only the relevant costs of the alternatives and the resulting benefits of each. This means that costs already incurred and ones that are the same for the alternatives would be ignored. Businesses may also consider the non-monetary, intangible benefits of the choices when performing differential analysis.
Most businesses are forced to make difficult financial decisions each day, and the consequences of these decisions can have a great impact on whether the business is ultimately successful. For that reason, business owners must develop consistent methods for making these decisions, especially when it comes to potentially costly ones. Differential analysis is one such method, as it takes all of the relevant numbers associated with the possible choices and gives the owner of the business an idea of where he or she will stand with each possible decision.
The key concept in understanding differential analysis is the concept of relevant costs. This essentially means that the only costs that should be considered when making a choice between alternatives are the ones that actually relate to how each alternative will play out in the future for the business. Non-essential costs for this type of analysis would include those costs that would not differ among the alternatives as well as sunk costs, which are costs that have been incurred prior to the current analysis.
For example, a business might want to purchase a new machine that is going to cut production costs significantly from an old machine. It would seem like an easy decision, but the new machine would have to be expensed significantly high in its first year of existence, thus affecting the profit margin. The old machine's depreciation, on the other hand, is a sunk cost and irrelevant for the purposes of differential analysis. Thus, the business might have to decide whether it can afford the financial hit of the first year in order to reap the machine's future benefits.
It's important to note that differential analysis is a process that may be stretched beyond mere numbers. There could be intangible benefits to a certain decision that might eventually affect the business' profits or even go beyond monetary gain. For instance, an advertising campaign might be costly to a business but might be important in getting the brand name out to the public, thus making it more beneficial than saving the marketing costs. In terms of non-monetary issues, a company might be able to save money and produce more using a new production technique, but if the technique isn't environmentally sound, it might engender bad will among the community that would outweigh the monetary benefits.
Any analysis that doesn't contemplate those intangibles is, more often than not, useless. For example, let's say we're looking at two printing presses that both cost about the same amount of money. One is made in Germany while the other is made in the United States. The one from Germany is more durable, but very expensive to fix and it takes a long time to get parts. The one made in America may not be as durable, but parts are readily available locally and the press can be repaired quickly and less expensively than the German one.
In that scenario, one has to look at the unpredictable qualities such as expense of repair and potential downtime to make a reasonable decision.