What is Differential Cost?

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Differential cost is a business term that refers to the difference in costs for a business when choosing between two alternatives. It is an important tool in the decision-making process for businesses looking to make possible changes to a business model. Closely associated with marginal cost, a term favored by economists, it can refer to either fixed or variable costs. The relevance of these costs is obvious when judged alongside of differential revenue to give businesses a perspective on the positives or negatives of a decision.

In any decision-making process, a choice is made between alternatives. When it comes to the business world, those choices include costs and benefits that must be weighed in order to assess what decision to ultimately make. Differential cost is the difference in costs, either negative or positive, between two or more alternatives. This cost must be considered along with the difference in revenue generated by these alternatives in order to come to a significant conclusion.


For example, a company has decided to make a change in its advertising approach, doing away with its radio advertising in favor of advertising on television. Due to the increased production costs and the higher rate charged by television stations, the weekly advertising budget rises by $100 US Dollars (USD), which would be the differential cost. If the company gets a significant boost in weekly sales of the product higher than the $100 USD cost difference, then the change was worth it, because the net operating revenue will have increased.

Businesses can encounter costs that are either fixed, meaning that they don't change, or variable, which means that they can vary depending on certain circumstances. Marginal cost is a closely associated term used by economists for a similar calculation. The difference with marginal cost is that it refers to the cost associated with making just one more unit of product.

Two other types of costs are often discussed along with differential costs. Opportunity costs are those incurred when taking on an alternative that might produce no immediate benefit. For example, a business owner chooses to shut down his or her business for a week to attend a marketing seminar that might ultimately improve the business, but in the short term, he or she incurs the loss of any income the business might have generated for that week, which would represent the opportunity cost. Sunk costs are costs incurred in the past that may not be recouped. These costs should never factor into the decision-making process if they bear no relevance to the alternatives available in the present decision.


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Post 3

@pleonasm - Actually, I think the problem with calculating the differential cost versus the revenue is that usually it's impossible to see what the revenue will be until you've changed your system. And that's pretty inefficient in itself, since you might, for example, have to cancel the radio ads in order to get the TV ads, and if the TV ads don't work, you might not be able to get the same deal on the radio ads when you go back.

I guess this is more of a problem for small businesses, since larger ones could probably afford to have both going at the same time and figure it out that way.

Still, even finding out the cost of the differential cost will often entail an opportunity cost and possibly a sunk cost.

Post 2

@umbra21 - Yeah, but often the situation is more complex than that. Like, they might need the money for a specific reason.

While, if you are talking about differential cost and opportunity cost in a business, it's usually much easier to see which avenue is the best to take.

I do think that more businesses should go down the route of spending more on opportunity costs, even at the risk that they will turn into sunk costs. Investing in staff training and happiness always turns out positively in the end. Look at those famous internet companies who treat their staff like millionaires. They get the best and they produce the most innovative work and it's because they spend their money on ice-cream machines which are opportunity costs if I've ever seen one.

Post 1

I really think that the function of opportunity cost is something that a lot of businesses and indeed, a lot of people don't take into account. I mean, if you look at the most corrupt businesses, the ones that have eventually gone under because their top staff were basically robbing people of all their money, that's a blatant disregard to what they would eventually gain if they weren't giving into temptation.

I think it's just human nature, but honestly they should view running a clean business as an "opportunity cost" in their own lives. Yeah, they could grab the money and run, but they'd make much more over the long term if they don't do that.

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