Advantages of Differential Cost Pricing
The differential cost analysis furnishes an excellent tool for pricing and provides useful information for profit planning when the entire productive output can be disposed off in a single market. To support this point, just take the illustration given above, where we need only to point out that the average unit cost change indicates the amount by which the unit price may be reduced to yield increased sales volume, while still permitting the earning of same profit on each unit sold. Under such conditions, profits will increase by an amount equal to the unit profit margin multiplied by the additional units to be sold. For instance, assume that 21,600 units can be sold for Rs.30 per unit. If the indicated price reduction of Re.1.00 will permit 24,000 units to be sold at Rs.29 each, the increase in total profits will be Rs.19,200 which is obtained by multiplying the constant unit profit margin of Rs.8.00 with 2,400 additional units.
Another advantage of differential cost analysis is that it is related closely to economic marginal analysis. As the economist maintains that to maximize income, a firm should produce at the point where the marginal revenue equals marginal cost, in differential cost analysis, the accountant reasons that the firm should produce at the point where differential costs equal differential income.
Even though differential costs render many benefits in guiding pricing policies, indiscriminate reliance upon this method can be dangerous. For example, it could bring about pricing decisions that tend to disregard the necessity of recovering total costs in the long run. Moreover special price reduction could have unfavorable repercussions on regular customers or impel competitors to take similar action.
To summarize, differential cost accounting can help management in taking price decisions, but does not replace judgment.
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