What Is Differential Revenue?
When making decisions that affect your company's financials or operations, you generally have at least two options, if not more, to choose from. Comparison of these options aids in decision-making. Differential revenue is one such comparison. Calculate the total revenues for each alternative and subtract the higher revenue alternative from the lower one to obtain differential revenue.
Differential Revenue Defined
When making business decisions, it is typically the difference between the various alternatives that drives your decision making. Differential revenue calculates the total revenue generated by a project, action or plan and compares that with the total revenue that another viable project you could undertake produces. For example, if Project A generates total revenue of $100,000 and Project B generates total revenue of $90,000, the differential revenue is $100,000 less $90,000, or $10,000.
When variables are the same between two alternatives, this means there is no real difference between the two. You can ignore all items that are the same under both options. When considering how to best utilize your company’s resources, the use of differential revenue can be highly beneficial. Your company has limited resources at any particular point in time, whether measured in personnel or available funds. You must allocate those resources in the most efficient and productive manner to drive revenue and profits to the company. Therefore, you would typically also determine differential costs because costs impact profitability.
JKL Automotive Products Inc. has decided to expand its after-market seat cover product line. For a near-term product launch, it narrowed the additional products down to two. The production, sales and marketing costs for the two products match. JKL can produce both within the same period of time. However, test customers loved the first product design but did not exhibit the same enthusiasm for the second design. Based on the market analysis, JKL Automotive calculates the first design will generate $150,000 in revenue and the second one will generate $100,000 in revenue. The differential revenue is $50,000 in favor of design one. Not surprisingly, JKL Automotive Products decides to launch design one.
Red Manufacturing Inc. has decided to grow its business faster. The first option is to use external manufacturing reps to sell its products to distributors. The second option is to partner with companies offering complementary products that can package Red’s products with their offering. The first option would provide Red Manufacturing with higher margins on each product sold and the second option would provide a higher volume. After analyzing various factors including market penetration rates and total expected sales volume, Red Manufacturing determines that the manufacturer rep option would generate $3.5 million in three years. The partner option would generate $5 million in three years. The differential revenue is $1.5 million.
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