Marginal revenue and cost: Differences, calculations, and how-to guide

While it can be challenging to determine your marginal revenue and costs, if you’re researching these metrics, your business is at a crossroads. You’re ready to start producing more products, but you want to make sure it’s worth it. 

A growing business comes with growing pains. Including finding the balance between increasing your profitability and overproduction. Let’s look at what marginal revenue and marginal costs are and how to analyze your profits best: 

What is marginal revenue?

Marginal revenue is the revenue or income you gain from producing additional units. Marginal revenue is an important business metric because it’s a measure of revenue increase due to an increase in unit sales. When marginal costs exceed marginal revenue, a business isn’t making a profit and may need to scale back production.

Marginal revenue formula

The marginal revenue formula divides the change in revenue by the change in quantity or number of units sold: 

Marginal revenue = Change in revenue / Change in quantity

The change in revenue is your new revenue minus your previous revenue, while the change in quantity is your new quantity minus your old quantity. 

The major cause of a decrease in marginal revenue is simply the rise in marginal cost. The sweet spot is anything that results in marginal cost being equal to marginal revenue, also known as break-even. Otherwise, the company is either underproducing or overproducing, and either way that creates a loss of money. 

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 inventory shortages, but you also don’t want to overproduce and not see the return on your investment (ROI). 

To avoid this, look at your fixed costs and variable costs. Fixed costs are the costs that don’t change with production, like employee salaries. Variable costs, like operating costs, are more flexible and change depending on the production output.

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.

Margin cost can help you find the sweet spot for 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

Note that producing at a quantity where marginal costs are greater than marginal revenue can negatively impact your profit formula.

Marginal costs are a direct reflection of production quantity and costs. And since production is a product of cost and quantity, your output directly affects marginal costs. 

How to calculate the marginal cost

The marginal cost formula is the change in cost divided by the change in quantity: 

Marginal cost = Change in cost / Change in quantity

Say you own a hat company and you want to know the marginal cost of producing additional hats. It currently costs your company $100 to produce 10 hats, and we want to see the marginal cost of producing an additional 10 hats at $150.

Step 1: Calculate the change in cost, which is the new cost minus the original cost. For our hat company, it’s $50 ($150 -$100). 

Step 2: Calculate the change in quantity, which is the new quantity minus the original quantity. For our hat company, it’s 10 hats (20 hats - 10 hats). 

Step 3: Calculate the marginal cost, which divides the change in cost by the change in quantity. For our hat company, it’s $5 (50 / 10).

Since it costs less money to produce more hats, it makes sense for the hat company to produce the additional units and seize the opportunity to make additional profits. 

Marginal cost is the cost to produce one more unit of merchandise. For example, the marginal cost to produce more hats in our last equation was $5. 

Marginal cost vs. marginal product

Marginal product is simply the change in output as a result of the change in input from those additional units. This is different from marginal cost, which is the cost of producing one additional unit or product. 

Going back to the hat example, where the additional hats cost $50 instead of $100, there was an incentive to produce more hats. Those additional 10 hats are what is known as the marginal product.

Marginal revenue vs. marginal benefit

Marginal revenue is the income from producing one additional unit of merchandise. Marginal benefit is the maximum amount a consumer is willing to pay for a product. Both are important metrics for knowing your production costs.

To determine which pricing strategy works best for your business, you’ll need to understand how to analyze marginal revenue. The key to sustaining sales growth and maximizing profits is finding a price that doesn’t dampen demand. When setting prices by unit cost, you have two options. 

You can increase sales volume by producing more items, charging a lower price, and realizing a boost in revenue. Or you can produce fewer items, charge a higher price, and realize a higher profit margin.

A good example of this would be the marginal cost of production being more expensive than the original production. For instance, if the first batch of hats in the earlier example costs $100 to make but the second batch costs $200, the company is now in a tough spot. It has to either decide on finding a more efficient way to produce the product or raise the prices to see a profit.

Let's put that last concept in reverse—what causes marginal revenue to increase? Simply put, less production costs. The less money the company is using to produce more products, the more profits it can retain.

Streamline your accounting and save time

Knowing your marginal revenue and cost is critical for pricing and production planning. You’ll need to experiment with both before you find an optimal profit margin to sustain sales. And with accounting software, finding these metrics gets easier, helping you build efficiency for your business.