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Running a business

Marginal Cost: Definition, Formula, and Examples

A business’s marginal cost is the cost required to make one additional unit of a product. The marginal cost formula is the change in total production costs—including fixed costs and variable costs—divided by the change in output.

What is Marginal Cost?

Marginal cost is how much money it costs your company to produce one additional unit of your product or merchandise. As a growing company, you don’t want to run the risk of an inventory shortage but you also don’t want to overproduce and not see the return on your investment. To avoid these risks, you need to look at your 2 types of business costs: fixed costs and variable costs. 

Fixed costs, as you may have already guessed, are the costs that are pretty much set in stone and they don’t change with production—like employee salary cost, for example. Variable costs are more flexible and change depending on the production output, like operating costs.

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Why is marginal cost important? 

Marginal cost is important because if you’re looking to maximize profits, you’ll want to plan production so that your marginal costs are equal to your marginal revenue. It’s the blueprint needed to find the sweet spot of effective output and can yield several other benefits, such as:

  • Preventing your company from losing money through loss of sales or overproduction
  • Determining how many products are needed to satisfy customer demand
  • Providing your company with important metrics for profit planning

If you're producing at a quantity where marginal costs exceed marginal revenue, that negatively impacts your profitability.

For example, let’s say a company produces 5,000 watches in 1 production run at $100 apiece. The manufacturer will want to analyze the cost of another multiunit run to determine the marginal cost. The average cost of producing a watch in the first run is $100, but the marginal cost is the additional cost to produce one more unit. Using the marginal cost formula, we can determine how an additional production run will impact profitability.

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.

Marginal Cost Formula and Examples

To calculate the marginal cost, determine your fixed and variable costs. Fixed costs are expenses that are known for a prescribed period. They remain the same, no matter how many units your business produces. Fixed costs include leases, fixed-rate mortgages, annual insurance costs, and annual property taxes.

 Variable costs change when a higher production level requires increased capacity or other adjustments. These costs can go up or down. For example, larger manufacturers may decrease overall unit costs by negotiating lower prices on bulk purchases. This is known as economies of scale. But other variable costs, such as labour, may go up as production increases. Variable costs include labour, raw materials, equipment repairs, and commissions.

The marginal cost formula

To calculate the marginal cost, divide the change in cost by the change in quantity or the number of additional units. The formula follows:

Change in costchange in quantity = marginal cost

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.

How production costs affect marginal costs

Any additional investment a business makes to increase production will 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.

What is Marginal Revenue and Why is it Important?

Marginal costs reflect the cost of producing one additional unit. Marginal revenue is the revenue produced from the sale of one additional unit. When marginal costs meet or exceed marginal revenue, a business isn’t making a profit and may need to scale back production. So marginal revenue is an important business metric.  

How to calculate marginal revenue

To determine which pricing strategy works best for your business, you’ll need to understand how to analyze marginal revenue. The formula is similar to the marginal cost calculation. It divides the change in revenue by the change in quantity or number of units sold. The formula follows.

Change in revenue/change in quantity = marginal revenue

The key to sustaining sales growth and maximizing profits is finding a price that doesn't dampen demand. When it comes to setting prices by unit cost, you have two options. You can increase sales volume by producing many items, charging a low price, and realizing a boost in revenue. Or you can produce fewer items, charge a higher price, and realize a higher profit margin.

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

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 marginal cost when additional units are produced. The marginal cost rises as production increases.

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.

Marginal Cost Vs. Variable Cost: What is the Difference?

Variable costs are costs that change as a business produces additional units. But they are only one component of the marginal cost. To calculate marginal costs, you need to add variable costs to fixed costs to get your 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.

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. QuickBooks Advanced can give your business the financial insight it needs.

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