A differencing disk is a virtual hard disk (VHD) that stores changes made to another VHD or to the guest operating system. The purpose of differencing disks is to make it possible to maintain information about changes made so that they can be reversed if necessary.
Differencing disks are based on either a fixed-size or dynamically expanding VHD and can be configured with parent-child relationships to form a hierarchy of VHD types. The disks store all of the changes that would otherwise be written to the parent VHD. However, it's important to remember that, as a rule, any VHD that serves as a parent must remain read-only.
Differencing disks can increase manageability, especially when multiple VMs share a similar configuration, and can dramatically reduce the amount of disk space required on a Virtual Server host computer. The drawbacks are that differencing disks can be difficult to manage and large hierarchies of disks can potentially lead to performance problems, especially if all of the physical VHD files are located on the same disks or arrays. Within Virtual Server, you can merge a differencing disk with its parent -- an operation that commits all the changes and either updates the base VHD or creates a new VHD file.