What is Differential Cost?
Differential cost (also called incremental cost) is the difference in total cost between two business alternatives. It includes only the costs that change as a result of the decision and ignores items that stay the same in both scenarios. Managers use it to choose the most economical option.
How It Works
- Define the two alternatives clearly (for example, make in-house vs outsource).
- List all costs for each option, classifying as variable, fixed, and step costs.
- Eliminate costs that are identical in both options.
- Compare the remaining differential costs against differential revenues to find the better choice.
Saudi Context
Saudi companies use differential cost analysis when deciding to outsource logistics, set up regional warehouses under Saudi Vision 2030 hubs, or accept special export orders. ZATCA’s transfer pricing documentation also requires justification of cost-based pricing between related parties, often supported by differential cost data.
Example
A Riyadh bakery decides whether to bake bread in-house at SAR 1.20 per loaf or buy from a supplier at SAR 1.50. The SAR 0.30 differential cost per loaf, multiplied by 10,000 monthly loaves, is the financial impact of the decision.