Question

Please explain what is the main idea behind differential analysis. What are relevant or differential costs? What are the two necessary characteristics of differential costs? Can fixed costs be differential or relevant in your decision?

Answer 1

The main idea behind differential analysis is to be able to determine the viability or feasibility of a business idea by examining only those changes in revenues, costs and profits that will accrue due to the business decision. Here there is no need to make a complete income statement for each alternative. As we are doing an incremental evaluation the method of differential analysis is also known as incremental analysis.

Relevant or differential costs are those costs that change between two alternatives or business decisions being considered. In other words they are the difference between the costs of the two alternatives.

Two necessary characteristics of differential costs are – (i): These costs are incremental in nature. (ii): These costs are avoidable in nature. For example future cash flows, incremental costs, avoidable costs, opportunity costs are all differential in nature. On the other hand sunk costs, committed costs, etc. can be said to be non-differential in nature.

Usually fixed costs are not relevant but they can be relevant depending on the situation. Fixed costs can be relevant under the following two situations – (i): If fixed costs will change as a result of the decision (ii): If there is a need or a requirement that all products being manufactured by the company has to carry some level of fixed cost allocation.