Difference Between Marginal Costing and Differential Costing

The main difference between marginal costing and differential costing is how they look at costs. Marginal costing focuses on the extra costs of making one more unit of a product, while differential costing compares the costs of different choices or changes in production levels. Both are important in management accounting, helping businesses decide by weighing the revenues they make against the costs involved in various scenarios.

What is Marginal Costing?

Marginal costing involves examining the expenses associated with a small increase in production or an extra unit of output. It's a vital tool for businesses to make decisions on how to utilize limited resources best to reduce costs and boost profits. Marginal cost is calculated by dividing the change in total cost by the change in output.

To make informed decisions, businesses need to compare marginal cost with marginal revenue, which represents the increase in revenue from producing additional units.

For instance, consider GNL, a shoe manufacturer. They currently produce 60 pairs of shoes, costing them $55,700 in total, translating to a cost of $928 per pair. With each pair selling for $1,500, their total revenue amounts to $90,000. Now, if GNL decides to produce one more pair, their revenue would increase to $91,500, but their total cost would rise to $57,000.

Calculating the marginal revenue, we find it to be $1,500 ($91,500 - $90,000), while the marginal cost is $1,300 ($57,000 - $55,700). This results in a net benefit change of $200 ($1,500 - $1,300).

Marginal costing aids businesses in determining the viability of producing additional units by assessing whether maintaining selling prices justifies increasing output. Consequently, it assists in pinpointing the most advantageous production level.

What is Differential Costing?

Differential costing refers to the variance in costs between two alternative decisions or changes in output levels. This concept is applied when faced with multiple choices, requiring a decision to proceed with one option while disregarding others.

Example1 - Decision between two alternatives

For instance, consider a scenario where ABV Company, a clothing retailer, faces a choice between two options due to limited funds. They aim to either refurbish their store or expand parking space before the upcoming peak season. The refurbishment costs are estimated at $500,750 while expanding parking would cost $840,600. The differential cost between these alternatives amounts to $339,850.

However, relying solely on the financial analysis provided by the concept of differential costing may not suffice for decision-making. Take, for example, if ABV's customer feedback consistently highlights insufficient parking space as a major issue. In such a case, despite refurbishment being the less expensive option, investing in parking expansion could yield greater long-term benefits. This underscores the importance of considering opportunity costs-the potential benefits foregone by choosing one alternative over another-before finalizing a decision.

Example2- Change in output level

In the case of JIH, a manufacturing plant can produce either 50,000 units for $250,000 or 90,000 units for $410,000, resulting in a differential cost of $160,000 for an additional 40,000 units.

In differential costing, "sunk costs" and "committed costs" are vital concepts. These costs are disregarded in decision-making as they are either already expended and irrecoverable (sunk costs), or the company is obliged to incur them regardless of the decision (committed costs). For instance, in the scenario described, if JIH has already incurred a fixed cost of $450,300, it is considered a sunk cost that does not influence the decision between producing 50,000 or 90,000 units. Similarly, committed costs represent obligations that cannot be changed.

Conclusion

In summary, while both Marginal Costing and Differential Costing are indispensable tools in management accounting, they differ in their approach to cost analysis. Marginal Costing primarily focuses on assessing the incremental costs associated with producing additional units, aiding businesses in optimizing production levels for enhanced profitability. On the other hand, Differential Costing compares the costs of different alternatives or changes in output levels, assisting in selecting the most advantageous option among available choices. These methods cater to distinct decision contexts and offer valuable insights for businesses seeking to maximize efficiency and profitability in their operations.