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A differential cost is defined as a cost which represents either a decrease or an increase in cost from another business alternative. The significance of these costs is obvious, since finding costs that are lower than other alternatives can mean bigger profits for the firm. Of course, these costs are often compared to the revenues that they reap, which are known as differential revenues. Comparing these types of costs and revenues is at the heart of what's known as a differential cost analysis, a key tool in the decision-making process for most successful businesses.
Business managers are faced every day with crucial decisions that can have significant effects on the well-being of their firms or companies. These decisions are often important in terms of how they impact firms financially. It is impossible to do business without incurring costs along the way, but the ultimate objective is to minimize these costs as much as possible. For that reason, business management must be familiar with the concept of differential cost and what it means to the bottom line.
In essence, differential cost comes into play whenever a decision is made between two or more alternatives that will incur some kind of cost. For example, imagine that a company can pay a vendor to have a certain product shipped to them for $1,000 US Dollars (USD). The company can also choose to use its own labor to make the product, which will cost it $500 USD. In this case, the difference between the two costs is $500 USD more for the vendor option. Making the product itself will lower the company's differential costs.
Of course, the concept of differential cost only makes sense when the revenues each alternative can bring are factored into the equation. Using the above example, the option to ship the product is costlier, but it might result in a better product if the company's labor does not regularly produce it. Differential revenues are harder to judge, because they can often only be truly realized after the decision has been made.
One way to use this concept to make decisions is to perform a differential cost analysis. This is especially helpful in the case of a project that incurs costs on several levels. Keeping track of all these costs and the alternatives can help business managers accurately assess the situation. Keeping the differential costs down can ensure potential for a high profit margin.
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