The marginal cost of production and marginal revenue are economic measures used to determine the amount of output and the price per unit of a product that will maximize profits.

A rational company always seeks to squeeze out as much profit as it can, and the relationship between marginal revenue and the marginal cost of production helps them to identify the point at which this occurs. The target, in this case, is for marginal revenue to equal marginal cost.

### Key Takeaways

• When it comes to operating a business, overall profits and losses matter, but what happens on the margin is crucial.
• This means looking at the additional cost versus revenue incurred by producing just one more unit.
• According to economic theory, a firm should expand production until the point where marginal cost is equal to marginal revenue.

## Calculating Marginal Cost of Production

Production costs include every expense associated with making a good or service. They are broken down into two segments: fixed costs and variable costs.

Fixed costs are the relatively stable, ongoing costs of operating a business that are not dependent on production levels. They include general overhead expenses such as salaries and wages, building rental payments or utility costs. Variable costs, meanwhile, are those directly related to, and that vary with, production levels, such as the cost of materials used in production or the cost of operating machinery in the process of production.

Total production costs include all the expenses of producing products at current levels. As an example, a company that makes 150 widgets has production costs for all 150 units it produces. The marginal cost of production is the cost of producing one additional unit.

For instance, say the total cost of producing 100 units of a good is $200. The total cost of producing 101 units is$204. The average cost of producing 100 units is $2, or$200 ÷ 100. However, the marginal cost for producing unit 101 is $4, or ($204 - 200) ÷ (101-100). ## Reaching Optimum Production At some point, the company reaches its optimum production level, the point at which producing any more units would increase the per-unit production cost. In other words, additional production causes fixed and variable costs to increase. For example, increased production beyond a certain level may involve paying prohibitively high amounts of overtime pay to workers. Alternatively, the maintenance costs for machinery may significantly increase. The marginal cost of production measures the change in the total cost of a good that arises from producing one additional unit of that good. The marginal cost (MC) is computed by dividing the change (Δ) in the total cost (C) by the change in quantity (Q). Using calculus, the marginal cost is calculated by taking the first derivative of the total cost function with respect to the quantity: ﻿ \begin{aligned}&MC=\frac{\Delta C}{\Delta Q}\\&\textbf{where:}\\&MC=\text{Marginal cost}\\&\Delta=\text{Dividing the change}\\&C=\text{Total cost}\\&Q=\text{Change in quantity}\end{aligned}﻿ The marginal costs of production may change as production capacity changes. If, for example, increasing production from 200 to 201 units per day requires a small business to purchase additional equipment, then the marginal cost of production may be very high. In contrast, this expense might be significantly lower if the business is considering an increase from 150 to 151 units using existing equipment. A lower marginal cost of production means that the business is operating with lower fixed costs at a particular production volume. If the marginal cost of production is high, then the cost of increasing production volume is also high and increasing production may not be in the business's best interests. ## Calculating Marginal Revenue Marginal revenue measures the change in the revenue when one additional unit of a product is sold. Assume that a company sells widgets for unit sales of10, sells an average of 10 widgets a month, and earns $100 over that timeframe. Widgets become very popular, and the same company can now sell 11 widgets for$10 each for a monthly revenue of $110. Therefore, the marginal revenue for the 11th widget is$10.

The marginal revenue is calculated by dividing the change in the total revenue by the change in the quantity. In calculus terms, the marginal revenue (MR) is the first derivative of the total revenue (TR) function with respect to the quantity:

﻿ \begin{aligned}&MR=\frac{\Delta TR}{\Delta Q}\\&\textbf{where:}\\&MR=\text{Marginal revenue}\\&\Delta=\text{Dividing the change}\\&TR=\text{Total revenue}\\&Q=\text{Change in quantity}\end{aligned}﻿

## The Bottom Line

Manufacturing companies monitor marginal production costs and marginal revenues to determine ideal production levels. The marginal cost of production is calculated whenever productivity levels change. This allows businesses to determine a profit margin and make plans for becoming more competitive to improve profitability.

The best entrepreneurs and business leaders understand, anticipate, and react quickly to changes in marginal revenues and costs. This is an important component in corporate governance and revenue cycle management.