Question

1. plain the meaning of (a) differential revenue, (b) differential cost, and (c) differential income.
2. A company accepts incremental business at a special price that exceeds the variable cost. What other issues must the company consider in deciding whether to accept the business?
3. Cite and give credit to the author that you are citing

Answer 1

(a) Differential Revenue:

Differential Revenue refers to the difference in revenue that will result from undertaking two different courses of actions by the business. The courses of action may be either acceptance of a new project or decision of selection from two alternative projects. Either way differential revenue helps in identifying the incremental revenue that one plan of action has over the other. Take for example if a company is considering purchase of a new machine and the current sales of company is $ 10,000 after the machine is purchased, the sales is predicted to be $ 12,000 then

Incremental revenue = $ 12000- 10000 = $ 2,000

(b) Differential Cost:

Differential cost refers to the difference in cost of undertaking two different courses of action. This is calculated to identify the incremental cost that will result in accepting one project over the other, or a new project over the current existing system.

For a project to be preferred over other, the differential revenue must be higher than differential cost of the said project.

The cost incurred by a company can largely be classified in to fixed and variable costs. The fixed costs are those that are incurred irrespective of the production and sales made by the business. These costs are not affected by increase in sales or production. Whereas variable costs are influenced by sales or production as they are incurred only if the product is manufactured/ purchased and sold.

Generally when a company is contemplating to accept incremental business, it only considers the incremental variable costs since the fixed costs will be incurred irrespective of the incremental business being accepted or rejected. Thus the fixed cost expense is not allocated to the incremental business. If the incremental revenue is more than the incremental variable cost the company will accept the business. Thus it can be said that the company will accept the business at a special price that exceeds the variable cost.

The other issues that the company considers while accepting a business is the pay back period in which the company will receive back its investment. It also considers the cost of borrowing the capital required for investment. The opportunity cost of utilizing the funds that are to invested elsewhere can also be considered. The speed with which technological changes occur in the industry shall also be considered as it may render the entire investment obsolete before the incremental revenue is earned completely. The accuracy with which the future estimates can be made is also very important consideration while deciding whether a project shall be accepted.