Businesses use differential and opportunity costs to make critical decisions regarding financial matters for the short-term and the long-term. Differential and opportunity costs give managers tangible numbers with which to work when developing strategy. If a business does not use the two cost methods for making decisions, it risks making choices that are not optimal or financially lucrative.
Differential Cost Definition
A differential cost is simply the cost difference between two separate possible decisions. Business managers often face situations that require choosing a solution out of two or more different alternatives. If the first solution costs a company $2,000 and the second solution costs $1,000, the differential cost between the two solutions is $1,000. Similarly, managers may have more than two solutions from which to choose. In that case, managers must specify the two solutions to which the differential cost applies.
Opportunity Cost Definition
An opportunity cost is typically expressed in terms of benefits that are lost when one solution is selected over another. Managers may face solution alternatives that are all appealing in some way. Finding the opportunity costs of each alternative makes managerial decisions more analytical and less instinctual. Two solutions to a problem may appear profitable, but a closer inspection of the opportunity costs might show that one solution could create $50,000 in profit while the other creates $45,000. The opportunity cost for picking the latter solution is $5,000.
Differential Cost Example
Equipment breaks during the course of business, and it is up to managers to decide whether the business should pay to fix the equipment or purchase entirely new equipment. For example, a coffee shop's old industrial coffee grinder might break and require repairs that cost $1,000. If a brand new industrial coffee grinder costs $3,000, the differential cost between the two alternatives is $2,000.
Opportunity Cost Example
Using the coffee shop example, the opportunity cost between choosing to fix the coffee grinder versus buying a new grinder creates a complete picture of the decision the coffee shop managers must face. Fixing the old grinder might cost $2,000 less than buying a new grinder, but the new grinder comes with a warranty that lasts for six years. If managers know that the old grinder breaks down approximately once a year, they also know the cost for maintenance over six years will equal approximately $6,000. The opportunity cost in this example is $3,000 because the managers would miss the long-term monetary benefits of the new coffee grinder versus repairing the old one.