CHAPTER

10

Differential Cost Analysis

This chapter deals with the use of differential cost analysis in financial management decision making situations. The basic premise of differential cost analysis is that different costs are treated differently in different financial management decision situations. Hence the name differential costs. Two major applications of differential cost analysis are presented. The first application is called break-even analysis. In break-even analysis, differential cost analysis is used to answer the question, How much service must a human service program provide during a fiscal year in order to recover its total costs? The second application can be called decrease/discontinue decisions. In these types of financial management decisions, differential cost analysis answers the question, What will be the effect on fixed and variable costs of a decision to reduce or discontinue a human service program?

Some Concepts and Definitions
Before proceeding to the discussion of the applications of differential cost analysis, some basic concepts and definitions need to be introduced including fixed costs, variable costs, step costs, maximum efficiency, and surplus capacity.

Fixed Costs and Variable Costs
In Chapter 8 the concepts of direct and indirect costs were introduced as part of the discussion of cost analysis. As was noted in Chapter 8, the full cost, or total cost, of a human service program is the sum of its direct costs and indirect costs. In differential cost analysis, the full cost, or total cost, of a human service program is the sum of its fixed costs and variable costs. Items of cost in the budget of a human service program can also be classified as either fixed costs or variable costs. It is the classification of costs as fixed and variable and the analysis of how these costs behave, or differ, in various financial