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Differential analysis compares commercial alternatives by considering relevant costs and benefits, ignoring sunk costs and non-essential costs. It can also include non-monetary and intangible benefits. This method helps businesses make consistent decisions, especially for potentially costly choices. Relevant costs are those that relate to how each alternative will play out for the company in the future. Differential analysis can be extended beyond just numbers to include intangible benefits and non-monetary issues.
Differential analysis is a method of comparing two or more commercial alternatives to each other in an attempt to decide which is the right choice. If this type of analysis is used with a strictly numerical approach, a company compares only the relevant costs of the alternatives and the resulting benefits. This means that costs already incurred and identical costs for the alternatives would be ignored. Firms can also consider the non-monetary and intangible benefits of choices when performing differential analyses.
Most businesses are forced to make tough financial decisions every day, and the consequences of those decisions can have a big impact on the ultimate success of the business. For that reason, entrepreneurs need to develop consistent ways to make these decisions, especially when it comes to potentially costly decisions. Differential analysis is one such method, as it takes all the relevant numbers associated with possible choices and gives the business owner an idea of where they will stand with each possible decision.
The key concept in understanding differential analysis is the concept of relevant costs. This essentially means that the only costs that should be considered when making a choice between alternatives are those that actually relate to how each alternative will play out for the company in the future. Non-essential costs for this type of analysis will include those costs that would not differ between the alternatives, as well as sunk costs, which are costs that were incurred prior to the current analysis.
For example, a business may want to purchase a new machine that will significantly reduce the cost of manufacturing from an old machine. It would seem an easy decision, but the new machine would have to be spent significantly in the first year of its existence, thereby affecting the profit margin. The depreciation of the old machine, on the other hand, is a sunk cost and irrelevant to differential analysis. Therefore, the company may have to decide if it can afford the financial success of the first year in order to reap the future benefits of the machine.
It is important to note that differential analysis is a process that can be extended beyond just numbers. There may be intangible benefits to any given decision that could eventually impact the company’s bottom line or even go beyond monetary gain. For example, an advertising campaign might be costly for a business but could be important in getting the brand across to the public, therefore making it more beneficial than saving marketing costs. In terms of non-monetary issues, a company may be able to save money and produce more using a new production technique, but if the technique is not environmentally sound, it could generate ill will in the community that would outweigh the monetary benefits.
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