An entrepreneur is always faced with two real dilemmas when they have to make crucial business decisions.
The first is a limiting factor and the second is knowing how to pick the best among alternatives at a given time.
The limiting factor, otherwise known as the principal budget factor is a key factor that works against unlimited profits and indefinite growth and expansion.
Unlimited profits and indefinite growth are impossible in business because at a point, there is going to be instability of any of productivity, demand and supplies.
A business is certainly going to get to that point where available fixed space is not going to be enough to meet increase in demand. And don’t forget the availability of finance to meet expansion needs.
There will always be a limiting factor in the business world as long as revenues depend on costs. And profits remain the lifeline of every business venture.
It’s fairly easy for an entrepreneur to maximize contribution per unit of a single limiting factor by choosing an alternative. For instance, where there is constraint of space to meet exploding demand, an entrepreneur may decide to either outsource or focus only on the production of profitable products. But constraints are often more than one.
An entrepreneur faced with limiting factors can use the differential costing principle to assess the revenue and cost differentials among alternatives to reach the most appropriate decision.
Differential costing can be used for both short run and long run decisions as it considers changes in both fixed and variable costs.
Differential cost is the difference between the cost of two alternative decisions. The cost arises when a business is faced with similar alternatives where the choice of one option means the forgoing of others.
It is important to note that only costs which will react to a decision are relevant. The following costs are irrelevant;
- Any fixed cost that can be defined as unalterable is not a differential cost and should not be considered,
- Already incurred (sunk) costs are not considered,
- Values of assets from which depreciation expenses have deducted are not considered,
4. All future costs which can’t be renegotiated and avoided are not considered.
What is a Differential Cost example?
Assuming. A business at present operating at full capacity, sells product xyz it manufactures at $5 each. The present volume per annum is 150,000 units. The company’s cost structure is;
Operating Statement for year 20xy;
|sales: 150,000 @ $5||$750,000|
|less: marginal cost|
|less fixed costs||$ 70,000|
|= Net profits||$ 80,000|
There is an offer to supply an additional 50,000 units of product xyz per annum at $4.5 each. If this offer is accepted, the company would incur an extra fixed cost of $10,000 per annum for more machines and an extra $40,000 for extra direct labor.
Differential costing can be used to determine whether to accept or reject this offer;
|present production level||present production level . 150,000 units||projected production level||projected production level. 200,000 units||difference||difference|
|less: marginal cost|
|less fixed costs||$ 70,000||$ 80,000||$10,000|
|= Net profits||$ 80,000||$188,000||$108,000|
By accepting the offer, the business will make a profit of $108,000. The available costs indicate that accepting the offer may be a good business decision but other factors should be taken into consideration.
Price stability, the capacity of existing personnel and the accuracy of projected additional costs should be considered before a decision is made