Differential Cost Pricing
Under full-cost pricing, a selling price is proposed for all units produced at any given level of activity. It is designed to recover both fixed and variable costs in a proposed product price. The full-cost pricing ignores the above fact and as a result, the proposed selling price calculated for the additional units may be unnecessarily inflated.
The recognition of differential cost on incremental cost pricing makes it possible to overcome the above said limitation of full-cost pricing. Since differential costs equal variable cost per unit times the number of units of additional production plus the new fixed costs that may be incurred, it is necessary to have a clear delineation between fixed costs and variable costs.
Let us consider the following data to illustrate differential cost analysis. The data given below relates to the assumed facts for product Q by a company.
Product Q
Assumptions
|
Practical Capacity
|
15,000 direct labor hours
|
|
Budgeted Capacity
|
12,000 direct labor hours = 12,000 × 2 = 24,000 units
|
| |
|
|
Units produced/D.L. hour
|
|
2 units
|
|
|
|
Estimated Variable Costs
|
|
Total
|
|
Per unit
|
|
|
Rs.
|
Rs.
|
Rs.
|
Rs.
|
|
Direct Material
|
|
1,92,000
|
|
8.00
|
|
Direct Labor
(Rs.4 per hour)
|
|
48,000
|
|
2.00
|
|
Manufacturing Overhead
|
|
|
|
|
|
Fixed
|
1,20,000
|
|
5.00
|
|
|
Variable
|
24,000
|
1,44,000
|
1.00
|
6.00
|
|
Selling and Administrative
|
|
|
|
|
|
Fixed
|
96,000
|
|
4.00
|
|
|
Variable
|
24,000
|
1,20,000
|
1.00
|
5.00
|
|
|
|
5,04,000
|
|
21.00
|
We also assume that the fixed costs are to remain unchanged within the range of 90 to 120 percent of budgeted activity.
The analysis of differential costs is shown below.
Differential Cost Analysis
|
Percentage of Budgeted Capacity
|
90%
|
100%
|
110%
|
120%
|
|
Level of Activity in Units
|
21,600
|
24,000
|
26,400
|
28,800
|
|
Total Variable Costs
|
2,59,200
|
2,88,000
|
3,16,800
|
3,45,600
|
|
Fixed Costs
|
2,16,000
|
2,16,000
|
2,16,000
|
2,16,000
|
|
Total Costs
|
4,75,200
|
5,04,000
|
5,32,800
|
5,61,600
|
|
Average Unit Differential Cost
|
12.00
|
12.00
|
12.00
|
12.00
|
|
Average Unit Cost
|
22.00
|
21.00
|
20.18
|
19.50
|
|
Average Unit Cost Change
|
1.00
|
0.82
|
0.68
|
|
In the above illustration, since the fixed cost does not change over the change in level of activity, only the variable costs account for the difference in total costs between any two levels of activity. In each instance, the average unit differential cost is computed by dividing the increase in variable costs by the number of additional units produced. It is evident from the above that although the average unit cost ranges from Rs.22.00 to Rs.19.50, the average unit differential cost stays at Rs.12.00 whenever additional units are produced.
It follows that, if 21,600 units can be profitably disposed off at a unit price in excess of Rs.22.00, the sale of additional units at any unit price in excess of Rs.12.00 will increase profits when the overall marketing conditions remain stable. The problem is now for holding the original market intact and looking for the outlet for the additional production. Perhaps, the solution may be found by using differential cost analysis to guide the decision on the desirability of bidding for added production.
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