Marginal Costs: What it is, the formula and examples

​“Marginal cost” is the extra cost a business incurs when it produces an additional unit of a product. Also known as the “marginal cost of production”, this includes all the additional expenses – such as labour and materials – directly related to making that extra unit.

In this article, we’ll cover everything you need to know about marginal cost, its meaning, how to calculate it accurately, and how to use it.

To jump ahead to a section, click the links below:

• What is a marginal cost?
• Benefits of knowing your marginal costs
• What is an example of a marginal cost?
• How to calculate marginal costs
• The marginal cost formula
• How production costs affect marginal costs
• Understanding the marginal cost curve
• Contribution in marginal costing
• What is marginal revenue, and why is it important?
• Marginal cost vs variable cost: what’s the difference?
• The relationship between marginal cost and average cost
• How to use marginal costs in your business

What is marginal cost?

Marginal cost is a very important consideration for any business because it determines the most cost-efficient production level, as well as unit pricing.

Your business’s marginal cost will include fixed costs and variable costs: 

• Fixed costs: These are expenses you can predict over a certain period of time, such as fixed-rate leases and insurance costs.

• Variable costs: These are expenses that change when your production level increases, such as labour and raw materials. 

The most simple way to calculate marginal cost is to divide the change in total production costs by the change in output. 

Technically, marginal costs measure your cost to produce an additional unit of a product, but manufacturers often use batches of units to decide whether to continue producing their products.

Benefits of knowing your marginal costs

Knowing your marginal costs unlocks a number of benefits, making it easier to:

• Cover costs and generate profit by making informed pricing decisions.
• Optimise production levels by identifying the most cost-effective production quantities.
• Determine which of your business’s products or services are most profitable.
• Allocate resources and investments wisely.
• Reduce overheads and make efficiency improvements.
• Plan strategically to scale production or enter new markets.

What are examples of marginal costs?

Let’s say a company produces 5,000 watches in one production run at $100 a piece. The manufacturer will want to analyse the cost of another multi-unit run to determine the marginal cost. The average cost of producing the first run is $100, but the marginal cost is the additional cost to produce one more unit.

How to calculate marginal cost

In the example above, the cost to produce 5,000 watches at $100 per unit is $500,000. If the business were to consider producing another 5,000 units, they’d need to know the marginal cost projection first.

The business finds the cost to produce one more watch is $90. If the business has a lower marginal cost, it can see higher profits. If the business charges $150 per watch, they will earn a $50 profit per watch on the first production run. And they’d earn a $60 profit on the additional watch.

The marginal cost formula

To calculate your business’s marginal cost, divide your change in cost by your change in quantity (or the number of additional units you produce). 

The marginal cost formula is shown below:

Let’s look at the watch production example again. The total cost of the second batch of 5,000 watches is $450,000. Dividing the change in cost by the change in quantity produces a marginal cost of $90 per additional unit of output.

What is “change of costs?”

“Change of costs” refers to the variation in expenses that occurs when there is a change in the level of business activity or production volume. This change can result from increasing or decreasing the number of units produced or sold, and it typically affects variable costs, which fluctuate with production levels. 

For example, if a company produces more units, the costs for raw materials, labour, and other variable expenses will rise, leading to a higher total cost. Conversely, reducing production will lower these costs.

What is “change of quantity?”

“Change of quantity” refers to the variation in the number of units produced or sold by a business over a specific period. This change can occur due to fluctuations in demand, production capacity, market conditions, or strategic decisions made by the business. 

For example, if a company increases its production from 100 units to 150 units, the change in quantity is 50 units. 

How production costs affect marginal costs

Most business plan examples should consider potential investments to increase production down the line. Additional investments your business might make in the future can affect its marginal costs.

For example, let’s say the watch manufacturer needs to invest $300,000 in new equipment to increase production by 5,000 units. The total cost to produce another 5,000 watches would be $450,000 plus the $300,000 investment. So the marginal cost would increase to $150. The manufacturer would need to raise the $150 price per watch to see a profit or find a more cost-effective manufacturing process.

Understanding the marginal cost curve

The marginal cost curve is presented in a graph. Production quality is on the x-axis, and price is on the y-axis. On the graph, the marginal cost curves down before increasing. The u-shaped curve represents the initial decrease in the marginal cost when additional units are produced. The marginal cost rises as production increases.

Why does the marginal cost curve slope upwards?

The curve represents diminishing marginal returns. At some point, your business will incur greater variable costs as your output increases. The point where the curve begins to slope upward is the point where operations become less efficient.

Contribution in marginal costing

Contribution in marginal costing is another factor to be aware of. In marginal costing, "contribution" refers to the difference between the selling price of a product and its variable costs. 

For example, if a product sells for $100 and the variable costs to make it are $60, the contribution is $40. This $40 helps pay for the business's fixed costs, like rent and salaries, and anything remaining after that is profit. 

What is marginal revenue, and why is it important?

Marginal costs reflect the cost of producing additional units of goods and products, while marginal revenue is the revenue produced from the sale of those additional units.

When marginal costs meet or exceed marginal revenue, a business is no longer making a profit and needs to scale back its production. So marginal revenue is an important business metric and one of the key components of a thought-out business plan.

How to calculate marginal revenue

Your pricing strategy is an essential part of your business plan format and, to determine which pricing strategy works best, you’ll need to know how to analyse your marginal revenue. 

The formula to calculate your marginal revenue divides your change in revenue by the change in quantity or number of units sold. This formula is shown below:

The key to sustaining sales growth and maximising your profits is finding a price that doesn’t dampen demand. 

When setting prices by unit cost, you have two options: 

• Increase your sales volume by producing more items and charging a lower price to enjoy a boost in revenue. 

• Produce fewer items, charge a higher price, and realise a higher profit margin.

But be careful. Relying on just one of the above strategies may only work if you have your market cornered and can accurately project adequate sales numbers regardless of your price point. Ultimately, you’ll need to strike a balance between production quantity and profit.

Marginal cost vs variable cost: what’s the difference?

There is sometimes confusion around the terms “marginal cost” and “variable cost”. Marginal and variable costs are related concepts, but they serve different purposes and are calculated differently:

• Marginal costs are used to determine the optimal level of production and pricing by understanding the cost of producing an additional unit.

• Variable costs, on the other hand, help in understanding the overall expenses directly associated with production levels. They are crucial for budgeting and financial forecasting. 

To calculate marginal costs, businesses should add variable costs to their fixed costs to arrive at their total cost of production. Then you can divide by the change in output. If you need to buy or lease another facility to increase output, this variable cost influences your marginal cost.

What’s the difference between marginal cost and average cost?

While marginal cost focuses on the incremental cost of the next unit, average cost provides a broad measure of cost efficiency across all units produced.

Here’s a quick guide to calculating these two costs:

• Marginal cost: Divide the change in total cost by the change in quantity produced.

• Average cost: Divide total cost by the quantity of units produced.

Understanding both assists with pricing, production planning, and assessing overall cost efficiency.

How to use marginal costs in your business

Knowing your marginal cost and how it relates to your marginal revenue is critical for pricing and production planning. You may need to experiment with both before you find an optimal profit margin and sustain sales and revenue increases.

If you’d like to optimise the productivity and financial health of your business, QuickBooks can help. Our accounting software makes it easy to view your cash flow and track expenses as you go. With our easy-to-use range of financial tools, you can take back control and focus on what matters most.