WebFinance, Inc. (2016, para. 1) defines differential analysis as a
decision-making technique in which evaluation is confined to only those factors which are different or unique among possible alternatives. It usually involves four steps: (1) compute all costs associated with each alternative, (2) ignore the sunk costs, (3) ignore costs that remain largely constant among the alternatives, and (4) select the alternative offering the best cost-to-benefit ratio. Also called incremental analysis or relevant cost analysis.
Differential analysis, in a nutshell, is a way of understanding "what-if" scenarios based upon changes that are happening. This process deals only with the items that are different from one scenario to the next.
In order for costs to be properly analyzed, the process must ensure that certain costs are excluded from consideration. When making a decision, any costs that remain the same regardless of which choice is made are irrelevant. One example of this type of cost would be a sunk cost, or a cost that has already been incurred. You cannot make any changes to these costs; therefore, they are not relevant to future decisions. Another example would be any fixed costs that cannot be avoided.
Decisions are based upon the changes that are expected from the options under consideration, namely the differential revenue and differential cost of each course of action. Differential revenue refers to the change (increase or decrease) in revenue that is predicted, while differential cost refers to the predicted change in expenses.
Differential analysis looks at how operating income would differ under each decision alternative, leaving out anything that is irrelevant. It includes only differential revenue and differential costs. This lesson will review the following kinds of short-term decisions:
WebFinance, Inc. (2016). Differential analysis. In BusinessDictionary.com. Retrieved from http://www.businessdictionary.com/definition/differential-analysis.html