Differential cost is a business term that refers to the difference in costs for a business when choosing between two alternatives. It is an important tool in the decision-making process for businesses looking to make possible changes to a business model. Closely associated with marginal cost, a term favored by economists, it can refer to either fixed or variable costs. The relevance of these costs is obvious when judged alongside of differential revenue to give businesses a perspective on the positives or negatives of a decision.
In any decision-making process, a choice is made between alternatives. When it comes to the business world, those choices include costs and benefits that must be weighed in order to assess what decision to ultimately make. Differential cost is the difference in costs, either negative or positive, between two or more alternatives. This cost must be considered along with the difference in revenue generated by these alternatives in order to come to a significant conclusion.
For example, a company has decided to make a change in its advertising approach, doing away with its radio advertising in favor of advertising on television. Due to the increased production costs and the higher rate charged by television stations, the weekly advertising budget rises by $100 US Dollars (USD), which would be the differential cost. If the company gets a significant boost in weekly sales of the product higher than the $100 USD cost difference, then the change was worth it, because the net operating revenue will have increased.
Businesses can encounter costs that are either fixed, meaning that they don't change, or variable, which means that they can vary depending on certain circumstances. Marginal cost is a closely associated term used by economists for a similar calculation. The difference with marginal cost is that it refers to the cost associated with making just one more unit of product.
Two other types of costs are often discussed along with differential costs. Opportunity costs are those incurred when taking on an alternative that might produce no immediate benefit. For example, a business owner chooses to shut down his or her business for a week to attend a marketing seminar that might ultimately improve the business, but in the short term, he or she incurs the loss of any income the business might have generated for that week, which would represent the opportunity cost. Sunk costs are costs incurred in the past that may not be recouped. These costs should never factor into the decision-making process if they bear no relevance to the alternatives available in the present decision.