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Accounting and bookkeeping

What are Marginal Costs?

Definition, formula, and examples

A business’s marginal cost is the cost required to produce an 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 a marginal cost?

Your business’s marginal cost includes two types of costs: your fixed costs and variable costs. Fixed costs don’t change as your production increases, while variable costs change with your production volume. 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.

For example, let’s say a company produces 5,000 watches in a single production run at 1000 RM per watch. That company needs to analyse the cost of another multi-unit run to determine their marginal cost. The average cost of producing the first run is 1000 RM, while the marginal cost is the cost to produce an additional unit.

How to calculate marginal cost

In our above example, the cost to produce 5,000 watches at 1000 RM per watch is 5,000,000 RM. If our example business were to produce another 5,000 watches, they’d need their marginal cost projection first.

So, this business finds the cost to produce one more watch is 900 RM. If they had a lower marginal cost, they’d enjoy higher profits. If this business charges 1500 RM per watch, they earn a 500 RM profit per watch from their first production run and another 600 RM profit on additional watches they produce.

Marginal cost formula and examples

To calculate your business’s marginal cost, first determine your fixed and variable costs. Fixed costs are expenses you can predict over a certain period of time. Fixed costs remain the same regardless of how many units you produce, and they include leases, fixed-rate mortgages, annual insurance costs, and annual property taxes.

Variable costs change when your production level increases and when you need to expand your capacity and make adjustments. These variable costs can go up or down: for example, larger manufacturers may decrease their overall unit costs by negotiating lower prices on bulk purchases, which are cost advantages known as economies of scale. Other variable costs, though, such as labour, may increase as production increases. Variable costs include labour, raw materials, equipment repairs, and commissions, all of which you must consider if you want to know how to write your final business plan.

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:


marginal-cost-formula

Let’s revisit our watch production example. The total cost of the second batch of 5,000 watches is 4,500,000 RM, so dividing the change in cost by the change in quantity produces a marginal cost of 900 RM per additional unit produced.

How production costs affect marginal costs

Most business plan examples should consider potential investments to increase production down the line; these additional investments your business makes in the future can affect its marginal costs.

Let’s say, for example, that our watch manufacturer needs to invest 300,000 RM in new equipment to increase its production by 5,000 units. The total cost to produce these 5,000 watches is 4,500,000 RM plus the 3,000,000 RM investment. The marginal cost, therefore, increases to 1500 RM. The manufacturer needs to raise the price per watch to over 1500 RM to enjoy a profit. Otherwise, they must find a more cost-effective manufacturing process.

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 is similar to the one you use to calculate your marginal cost. The marginal revenue formula divides your change in revenue by the change in quantity or number of units sold. The marginal revenue formula is shown below:

marginal-revenue-formula

The key to sustaining sales growth and maximising your 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 your sales volume by producing more items and charging a lower price to enjoy a boost in revenue. You can also 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.

Understanding the marginal cost curve

The graph below presents what’s called the marginal cost curve. This graph provides production quality on its x-axis and price on its y-axis. On the graph, the marginal cost curves down before increasing. This curve represents the initial decrease in marginal cost as additional units are produced. The marginal cost rises as production increases.

diminishing-marginal-returns

This graph’s curve represents diminishing marginal returns. At some point, your business will incur greater variable costs as its output increases, which is important to consider when writing a business plan. The point in the above graph where the curve begins to slope upward represents the point at which operations become less efficient.

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

Variable costs are costs that change as a business produces additional product units, but they’re not the only thing that makes up the marginal cost. 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.

How to use marginal costs in your business

Your business’s marginal cost and how it relates to its marginal revenue is critical to pricing and production planning. As you refine your business plan, it’s important to experiment with your pricing and production planning to determine an optimal profit margin and sustain your sales numbers and revenue over time. You may need to experiment with both before you find an optimal profit margin and start sustaining your sales and revenue increases.