Differential cost and opportunity cost have one thing in common: They both involve a choice between options. Every day we make choices. Some of these choices have more obvious benefits than others. However, some choices are much less clear-cut.
For example, a choice between a donut for breakfast and a smoothie is simple if your goal is to eat healthily. The smoothie is the obvious choice. But if your choices are between an omelet with vegetables or granola with fruit, the healthy choice becomes less obvious.
The same type of problem can arise in business situations. The leader is given several choices, but none of them are as clear-cut as the donut or smoothie choice.
Differential cost and opportunity cost are two ways to assess a variety of choices that are seemingly comparable. A differential in accounting compares the cost of two or more items or the outcome of one choice over another. The difference in cost between the choices is the differential cost.
Opportunity cost, on the other hand, represents the benefits you might miss out on when choosing one alternative over another.
Differential cost is much easier to calculate and assess than opportunity cost. However, while financial reports don't show opportunity cost, business owners often use it to make educated decisions when multiple options or a choice cost is presented.
Opportunity Cost: A Closer Look
When a business owner or investor is assessing the potential profitability of various investments, they seek the option that is likely to yield the greatest return. Looking at the expected rate of return is a simple way to do this. However, businesses also need to consider the opportunity cost of each option, which is unclear and ambiguous in many cases.
For example, a business might have to decide between investing funds in securities or using those funds to purchase new equipment. No matter which option the business chooses, the potential profit lost by not investing in the other option is what's known as the opportunity cost.
Assessing Opportunity Cost
Because neither option's return is clear-cut, it can be hard to assess the opportunity cost, which is a forward-looking calculation. This means that the actual rate of return for both options is unknown. Assume the fictional company mentioned above decides not to buy equipment and invests in the stock market instead. Money could potentially be lost, depending on the performance of the stocks. Or, the company could reap great rewards if the stocks do well.
Once the choice has been made between the two options, the business has a committed costs definition. This is an investment that a business has already made and cannot recover.
Differential Cost: A Closer Look
Differential cost is the difference between the cost of two decisions or the difference in output levels. For example, if the cost of alternative A is $8,000 per year and the cost of alternative B is $5,000 per year, the difference is $3,000. So, $3,000 is the differential cost.
The concept can also be applied to revenue instead of cost. Let's say alternative A’s revenue is $10,000 and alternative B’s revenue is $5,000. In this case, $5,000 is the differential revenue.
Part of being an effective business leader is predicting how a certain choice or major decision will affect the company as a whole. The right decision will yield profit and growth. The wrong decision could incur losses. Business leaders use differential cost to make these critical long- and short-term financial decisions. Differential cost also provides concrete numbers that can inform the decision-making process.
Because differential cost is used primarily for management decision-making, there is no accounting entry for it.