Difference Between Marginal Costing and Differential Costing

The key difference between marginal costing and differential costing is that marginal costing considers the change in costs in order to produce an additional unit of output whereas differential costing is the difference between the cost of two alternative decisions, or of a change in output levels. Both marginal costing and differential costing are two key concepts in management accounting that are widely considered in decision making by considering the revenues earned and resulting costs of a given scenario.

CONTENTS
1. Overview and Key Difference
2. What is Marginal Costing
3. What is Differential Costing
4. Side by Side Comparison -Marginal Costing vs Differential Costing
5. Summary

What is Marginal Costing?

Marginal costing is the investigation of the costs of a marginal (small) change in the production of goods or an additional unit of output. This is an important decision-making tool businesses can use to decide how to allocate scarce resources in order to minimize costs and maximize earnings. Marginal cost is calculated as,

Marginal Cost = Change in Total Cost/Change in Output

In order to make effective decisions, marginal cost has to be compared with marginal revenue (increase in revenue from additional units)

E.g. GNL is a shoe manufacturer who produces 60 pair of shoes at a cost of $55,700. Cost per pair of shoes is $928. Sales price of a pair of shoes is $ 1,500, thus the total revenue is $90,000. If GNL produces an additional pair of shoes, the revenue will be $91,500 and the total cost will be $ 57,000.

Marginal revenue = $91,500- $90,000 = $1,500

Marginal cost        = $57,000-$55700 =$1,300

The above results in a change in net benefit of $200 ($1,500-$1,300)

Marginal costing helps businesses decide whether it is beneficial or not to produce additional units. Increasing the output alone is not advantageous if the selling prices cannot be maintained. Therefore marginal costing supports the business to identify the optimal level of production.

What is Differential Costing?

Differential costing is the difference between the cost of two alternative decisions, or of a change in output levels.  The concept is used when there are multiple possible options to pursue, and a choice must be made to select one option and drop the others.

E.g. 1. Decision between two alternatives

ABV Company is a clothing retail business that experiences a significant increase in sales during seasonal times. ABV wishes to refurbish the store and increase the parking space before the upcoming season time, however, they do not have sufficient capital to carry out both options. The cost of refurbishment is estimated to be $ 500,750 whereas the cost of increasing parking space is estimated to be $ 840,600. Thus, the differential cost between the two alternatives is $339,850.

Using differential cost to evaluate between two options only provides a financial analysis and should not be used as the sole decision-making criteria. In the above example, assume that ABV’S majority customers have been giving feedback that the store does not have adequate parking space. In that case, investing in expanding parking space is the alternative that will be beneficial in the long run even though refurbishment is the less costly alternative. In other words, businesses should always consider the ‘opportunity cost’ (benefit foregone from the next best alternative) prior to selecting an alternative.

E.g. 2. Change in output level

JIH operates a manufacturing plant that can produce 50,000 units at a cost of $ 250,000 or 90,000 units at a cost of $410,000. The differential cost for additional 40,000 units is $160,000

‘Sunk cost’ and ‘committed cost’ are two cost concepts that become important in differential costing. These two types of costing are excluded from differential cost decisions since either they are already incurred or the company has an obligation to incur, thus do not impact a new decision.

Sunk Cost

Sunk costs are already incurred and cannot be recovered, thus are irrelevant in making a new decision. In e.g. 2, assume that JIH incurred a fixed cost of $450,300. This is a sunk cost that does not have any impact irrespective of whether JIH produces 50,000 or 90,000 units.

Committed Cost

Committed cost is an obligation to incur a cost which cannot be altered.

What is the difference between Marginal Costing and Differential Costing?

Summary – Marginal Costing vs Differential Cost

The difference between marginal costing and differential costing is predominantly dependent on the nature of decision making required. Marginal costing is used for decision making in case of the need to evaluate a change in the level of output whereas differential costing is used to assess the effects of two or more alternatives. These two concepts are used for better decision making by efficiently allocating scarce resources.

References:
1. “Marginal Analysis in Economics: Definition, Formula & Examples – Video & Lesson Transcript.” Study.com. N.p., n.d. Web. 27 Mar. 2017.
2. “Break-Even Point & Marginal Revenue.” Chron.com. Chron.com, 19 May 2013. Web. 27 Mar. 2017.
3. “What is a differential cost? – Questions & Answers.” AccountingTools. N.p., n.d. Web. 04 Apr. 2017.
4. “Decision Making-Notional Costs, Sunk Costs & Committed Costs – College Accounting Coach.” Decision Making-Notional Costs, Sunk Costs & Committed Costs – College Accounting Coach. N.p., n.d. Web. 04 Apr. 2017.

Image Courtesy:
1. “Costcurve – Marginal Cost 2” By Costcurve_-_Marginal_Cost_2.png: User:Trampled, User:Jarry1250.derivative work: Jarry1250 (talk) – Costcurve_-_Marginal_Cost_2.png (CC BY-SA 3.0) via Commons Wikimedia