When a growing company experiences an increase in customer demand, it may need to produce a larger quantity of goods or services. Although ramping up production is necessary for keeping pace with customers’ needs, it’s also important to determine how having larger outputs affects profitability.

By understanding marginal costs, finance executives can find the right balance between production volumes, pricing, and workforce management.

Read on to learn the importance of marginal costs for mid-sized businesses, the advantages and disadvantages, and when it’s most appropriate to use this pricing strategy. We’ll also walk through the formula and steps to calculate marginal costs, and we'll review an industry example. 

Table of Contents

• Overview of marginal costs
• When finance teams should use marginal cost pricing
• Marginal cost formula
• How to calculate marginal costs
• Industry example: Manufacturing medical devices
• Marginal cost curve and economies of scale
• Benefits and challenges of using marginal cost
• Real-world applications of marginal cost
• Streamline your production costs with QuickBooks
• FAQ

Overview of marginal costs

Marginal cost is the additional cost to produce one extra unit of a good or service. It’s widely known as the marginal cost of production or incremental cost. It’s commonly used in manufacturing, agriculture, and service-based industries.

When companies grow, they seek to boost their production volume to help gain efficiency and reduce their marginal cost. In managerial accounting, this process is referred to as achieving economies of scale. Once a business reaches maximum efficiency, however, the marginal cost may begin to escalate.

This is why the accounting team should have well-established cost accounting practices in place to track fixed and variable costs. External stakeholders such as investors and analysts can also use marginal cost to help predict the profitability of a company as it scales.

When finance teams should use marginal cost pricing

For businesses looking to scale their production, proper financial management is vital. Gaining insights into a company’s marginal cost can propel a business to the next level. When financial analysts use the marginal cost pricing strategy, it can enhance their budgeting and forecasting plans, pricing decisions, and resource allocation. 

A key part of this is understanding the extra cost of producing additional units, in order to decide if it’s cost-effective to pursue this new production volume or continue with the original production run. Marginal costing is a powerful tool for finance teams to deploy in conjunction with other pricing strategies, allowing for a big-picture overview of their financial performance.

Marginal cost formula

Here are the steps to calculate the marginal cost, which requires that you first calculate the change in total cost and the change in total quantity.

To determine the change in total cost, take the original production cost from the first batch and subtract it from the second production cost with the increased quantity:

Change in total cost = New cost - Original cost

To determine the change in total quantity, take the original quantity from the first batch and deduct it from the second batch with the increased quantity:

Change in total quantity = New quantity - Original quantity 

Now calculate the marginal cost with the following formula:

Marginal cost = Change in total cost / Change in total quantity 

Depending on the situation, there could be cost efficiencies with higher volume output.

However, there may be times when the marginal costs become too high and the company will lose money, in which case they will need to make adjustments to future production runs.

How to calculate marginal costs 

Taking the formula above, let’s walk through an example of how to calculate the marginal cost.

In this scenario, a furniture manufacturer produces 1,000 chairs, which costs $20,000. 

If the company produces 1,100 chairs, it costs $21,000. 

1. Find the change in total cost:

First, calculate the change in total cost: $21,000 - $20,000 = $1,000 

2. Find the change in total quantity: 

Then, calculate the change in total quantity: 1,100 - 1,000 = 100 units

3. Calculate the marginal cost:

Take the change in total cost and divide it by the change in quantity to get the marginal cost: $1,000/100 = $10 

4. Analyze the findings:

The original cost to produce a chair was $20 ($20,000 / 1,000 = $20 per chair). The marginal cost is $10 for each additional chair. So we can see that the marginal cost is less than the original cost.

As a result, producing an additional 100 chairs provides cost efficiencies for this furniture manufacturer. 

Industry example: Manufacturing medical devices

The following instance demonstrates how marginal cost can be applied in an industry setting.

A healthcare business that manufactures medical devices is looking to enter a new region in Canada. The company wants to expand production from 30,000 to 35,000 units to accommodate the forecasted demand in the next quarter.

They need to find out if the revenue will be higher than the additional cost of the materials, wear and tear of the machinery, and extra staff needed to produce the additional 5,000 units. 

Based on their marginal cost analysis, they discover three key pieces of information:

First, the increased cost of materials is aligned with the increased number of units. 

Second, based on this proposed production level, they determine that they can use the existing machinery and that no new machinery is required. 

Third, their employees can be scheduled on weekday evening work shifts instead of on weekends at a higher wage. 

With these three findings, they determine that they can keep the marginal costs low to maintain a healthy profit margin.

Therefore, they decide to proceed with the increased production run to increase inventory and boost sales in the near term. 

Marginal cost curve and economies of scale 

Finance managers can plot their marginal costs based on the different levels of production. On a graph, the x-axis shows the increasing levels of output, whereas the y-axis indicates the rising marginal costs. 

Plotting marginal costs generally produces a U shape. This is because costs are typically high at the beginning and gradually decrease until they reach a break-even point, when production levels are able to cover the fixed costs. 

Eventually, as output increases, the line goes up due to the need to increase spending, such as paying employees for working extended or overtime hours, and maintaining or purchasing new equipment. 

When analyzing the marginal cost curve, you’ll notice the economies of scale when the marginal costs are falling. However, you may also see diseconomies of scale where the marginal costs are rising. 

Businesses should aim to have the price of their product above the marginal cost to maintain profitability. Otherwise, they will need to reduce inefficiencies or adjust the pricing strategy. 

Benefits and challenges of using marginal cost

Before you start incorporating marginal cost analysis, consider the following advantages and disadvantages: 

Pros 

• Pricing decisions: Knowing your marginal costs will help your business set competitive prices that cover the costs and generate profits.
• Forecasting and budgeting: Analyzing your marginal costs allows you to run different scenarios to understand the implications of varying production levels. This can help with financial planning and budgeting. 
• Resource and workforce allocation: This includes your employees, raw materials or supplies, and machinery or equipment. For example, using marginal cost analysis may reveal that you need your staff to work longer hours or that you must purchase new equipment to help with the increase in production volume.
• Maximizing production levels: Businesses looking to expand can take this valuable data to find efficiencies in their production output.
• Maintaining adequate inventory: In the short-term, it can help managers and supervisors prevent overproduction and avoid having excess inventory. 

Cons 

• Accuracy of fixed and variable costs: It can be challenging to split the fixed and variable costs accurately over the long-term. While it’s typically assumed that fixed costs are stable, this may not be the case.  
• Sacrificing quality: Marginal costs encourage a company to keep costs down in order to maintain profits. However, this may hinder a company that strives to produce high-quality products. 
• Ignoring customer demand: Although a company may find efficiencies with added output, using marginal cost neglects actual customer demand and buying behaviour. It’s imperative for cross-functional teams to determine if the added inventory will align with an increase in purchases. 
• Limited perspective: Since marginal costing focuses on variable costs, it may provide an incomplete overview of a company’s overall costs and potential profits. That’s why it’s prudent for finance professionals to use marginal cost analysis in combination with other pricing strategies. 
• Complicated calculations: Mid-size businesses with multiple product lines or production facilities may find it onerous to calculate marginal costs because of the added layer of complexity. 

Real-world applications of marginal cost

Marginal cost plays a crucial role in helping businesses make informed decisions across various industries. Whether it’s manufacturing, retail, or services, companies use marginal cost analysis to manage production, pricing, and special orders.

Let's explore a few practical applications to see how this concept drives smart decision-making.

Pricing strategies

Companies often rely on marginal cost to develop competitive pricing models.

For example, if the marginal cost to produce a product is $10, pricing it just above that — say at $15 — ensures that production costs are covered and some profit is earned to help offset fixed costs like rent or salaries.

Retailers may also use marginal cost to offer discounts during clearance sales. If the marginal cost remains low, selling excess inventory at a reduced price still generates a net gain, even if the price is lower than usual.

Managing production and capacity

Businesses must consider marginal cost to avoid overextending their resources. A factory that operates efficiently at 80% capacity might run into higher costs if pushed beyond that level due to overtime wages or machine maintenance. So companies need to know when to pull the chute — adjusting production before marginal costs climb too high and erode profits.

Understanding marginal cost dynamics allows managers to set optimal production limits without wasting resources.

Special orders and bulk deals

Service industries, like hospitality or event planning, often use marginal cost to decide whether to accept special pricing deals.

For example, a hotel might accept a bulk booking at a discount, knowing that the marginal cost of additional guests (such as housekeeping and amenities) remains low. Even if the rate is lower than usual, the deal contributes positively as long as the marginal cost stays below the income generated.

This principle also applies to manufacturing: businesses can take on custom orders as long as they don’t exceed production capacity and trigger steep marginal costs.

Cost-benefit analysis and resource allocation

Governments and organizations also apply marginal cost in cost-benefit analyses. For example, public transportation providers might assess the marginal cost of adding another bus to a route. If the additional service draws enough passengers to justify the expense, it makes financial sense. But if the new service barely covers costs, it may be better to allocate resources elsewhere.

By incorporating marginal cost into decision-making processes, businesses can optimize production, pricing, and resource allocation. Whether offering bulk discounts or managing factory capacity, staying on top of marginal cost helps companies remain agile and competitive.

Streamline your production costs with QuickBooks 

When CFOs and finance teams use marginal cost analysis, it enables them to improve their pricing strategy while providing concrete insights into financial costs, so they can scale their business. 

Harnessing this information and making cross-functional decisions that affect the company’s financial forecasts, decision-making process, and resource allocation can provide unique opportunities to improve efficiency and reduce costs. 

Having a deep understanding of the application of marginal costs can allow medium-sized companies to grow and maximize profits while standing out in a competitive industry. 

As your production needs grow, use QuickBooks Online Advanced to tap into pivotal manufacturing data that can help your business maintain costs, boost efficiency, and achieve maximum profitability.