Differential cost refers to the cost of choosing one of various alternatives when making business decisions. Using the technique to compare viability of two or more similar options, the most lucrative one is selected based on profit vs. loss or revenue generated.
Differential costs may also be fixed cost or variable cost or a combination of both. Fixed cost refers to the amount that is unaffected by any number of goods or services for any period of time. Hence, these become unavoidable for any company. For example, rent, lease, property cost, utility billing, equipment costs, etc.
Variable costs are affected by the amount, volume, or increase/decrease in services/goods production over a period of time. These shift with business performance, hence change continuously and may affect your profit margins. For example, part-time wages, sales commissions, raw materials, credit card fees etc.
Calculating the differential cost can highlight the most cost-effective option for any business, particularly when testing opportunity costs (measuring benefits lost by choosing one option over the other). It can also help with making decisions for analyzing the break-even point, enhancing revenue, defining what areas need more or less expenditure, and re-evaluating your growth strategy if any particular department is underperforming. For businesses today, this can be applied to evaluate staffing costs amidst a labor crisis.