Managers often face many options when they are trying to allocate money for new projects. Should the company fund this product line or that one? Which would bring the most immediate profit, and which would be the best long-term bet for the company's stability?
When a company has two alternatives on how to spend its money, then there is a differential cost associated with each alternative. A differential cost is the difference between the expenditure of one alternative and the expenditure of at least one other alternative. Examining differential costs is an internal mechanism to help management make informed decisions. Companies do not use differential costs in their external financial reporting—both because the law does not require it and because rival companies could gain valuable information about the company's priorities and future plans.For example, a company has the option to outsource the production of 50,000 units per quarter for a total cost of $300,000. The company calculates that it can produce the same number of units itself per quarter for a total cost of $400,000. The differential cost between outsourcing and the company producing the units itself is $100,000.
Differential costing essentially compares the revenue and expenses between options, and a company reaches its decision on that basis. The differential cost formula is simple enough and flexible enough that companies can apply it to variable costs, fixed costs, or even mixed costs.
However, differential cost should not be the only tool that managers use when deciding between two alternatives. The costs used to determine the differential cost between alternative paths are estimates and do not take into account unexpected expenses. In the example of the 50,000 outsourced units, transportation costs may increase greatly if the cost of oil increases. If the outsourced units have to be shipped a much longer distance, then higher fuel expenses might cut into that $100,000 differential cost.
Also, there are nonquantifiable benefits of one alternative over another that a differential-cost analysis cannot take into consideration. With the above example, assume that the cost of the company producing its own units is higher because there is a higher initial cost for purchasing equipment and materials for production of the units. The company would spend an extra $100,000 to produce the units in-house, but it would also have its own production infrastructure that it could use beyond the period being analyzed. Managers would not understand this benefit if they merely reviewed the differential cost between outsourcing and self-producing.
Sunk and Opportunity Costs
As managers examine costing information to help them make informed decisions going forward, they must also consider costs that the organization has already spent. A sunk cost is an expense that a company has incurred in the past during the course of business and that cannot be recuperated. Sunk costs could include rent, an overhead item, that a company has already spent on a factory or office space. It can also include machinery that a company has already paid for.
Efficient businesses assess sunk costs to avoid similar financial mishaps in the future. Consider a company that has taken the initial steps to switch its point-of-sale software to improve the customers' experience. The company bought the new software for $30,000. After the new system is implemented, the company learns that the software is incompatible with one of its basic needs: inventory tracking. The company goes back to using the original system and no longer uses the new system. The $30,000 the company spent on the new software is a sunk cost and should not be a consideration when determining whether to continue or discontinue using the software program. However, managers should analyze the decision-making process behind the software purchase and determine how to avoid similar mistakes.
Opportunity cost is the loss of possible gains when one alternative is chosen over another alternative. Calculating the opportunity cost is another way companies decide between alternatives. Opportunity cost can be calculated by subtracting the return from the alternative option that the company did not select from the return of the alternative it did select.For example, Jim is an accountant and bills his clients at a rate of $100 per hour. Jim is considering hiring someone to do some landscaping for $800 or doing it himself. If Jim does his own landscaping, it will take him 10 hours. The opportunity cost for Jim doing his own landscaping is the lost wages of 10 hours, which is , while the cost of paying someone else to do the landscaping is only $800. Jim would be better off paying $800 to have the landscaping done to save $200. It will cost Jim $200 in opportunity costs if he does his own landscaping. Thus, as long as Jim has accounting work available to him, it would be cheaper to hire a landscaper to do the landscaping work.
Opportunity Cost for Landscaping
|Jim's Opportunity Cost|
|Hours Landscaping Would Take Jim||10 Hours|
|Jim's Rate per Hour||$100|
|Jim's Accounting Rate per Hour||$100|
|× Hours It Would Take Jim to Complete Landscaping||10|
|= Opportunity Cost||$1,000|
|− Landscaper Rate||$800|