Marginal Cost

What Is the Marginal Cost?

In economics, the marginal cost is the change in total production cost that comes from making or producing one additional unit. To calculate marginal cost, divide the change in production costs by the change in quantity. The purpose of analyzing marginal cost is to determine at what point an organization can achieve economies of scale to optimize production and overall operations. If the marginal cost of producing one additional unit is lower than the per-unit price, the producer has the potential to gain a profit.

Key Takeaways

  • Marginal cost is an important concept in managerial accounting, as it can help an organization optimize its production through economies of scale.
  • A company can maximize its profits by producing to where marginal cost (MC) equals marginal revenue (MR).
  • Fixed costs are constant regardless of production levels, so higher production leads to a lower fixed cost per unit as the total is allocated over more units.
  • Variable costs change based on production levels, so producing more units will add more variable costs.
  • Companies must be mindful of when increasing production necessitates results in step costs due to changes in relevant ranges (i.e. additional machinery or storage space needed).
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Marginal Cost of Production

Marginal Cost Formula

Marginal cost is calculated as the total expenses required to manufacture one additional good. Therefore, it can be measured by changes to what expenses are incurred for any given additional unit.

Marginal Cost = Change in Total Expenses / Change in Quantity of Units Produced

The change in total expenses is the difference between the cost of manufacturing at one level and the cost of manufacturing at another. For example, management may be incurring $1,000,000 in its current process. Should management increase production and costs increase to $1,050,000, the change in total expenses is $50,000 ($1,050,000 - $1,000,000).

The change in quantity of units is the difference between the number of units produced at two varying levels of production. Marginal cost strives to be based on a per-unit assumption, so the formula should be used when it is possible to a single unit as possible. For example, the company above manufactured 24 pieces of heavy machinery for $1,000,000. The increased production will yield 25 total units, so the change in quantity of units produced is one (25 - 24).

The formula above can be used when more than one additional unit is being manufactured. However, management must be mindful that groups of production units may have materially varying levels of marginal cost.

Understanding the Marginal Cost

Marginal cost is an economics and managerial accounting concept most often used among manufacturers as a means of isolating an optimum production level. Manufacturers often examine the cost of adding one more unit to their production schedules.

At a certain level of production, the benefit of producing one additional unit and generating revenue from that item will bring the overall cost of producing the product line down. The key to optimizing manufacturing costs is to find that point or level as quickly as possible.

Marginal cost includes all of the costs that vary with that level of production. For example, if a company needs to build an entirely new factory in order to produce more goods, the cost of building the factory is a marginal cost. The amount of marginal cost varies according to the volume of the good being produced.

Marginal cost is an important factor in economic theory because a company that is looking to maximize its profits will produce up to the point where marginal cost (MC) equals marginal revenue (MR). Beyond that point, the cost of producing an additional unit will exceed the revenue generated.

Important

Economic factors that may impact marginal cost include information asymmetries, positive and negative externalities, transaction costs, and price discrimination.

Benefits of Marginal Cost

When a company knows both its marginal cost and marginal revenue for various product lines, it can concentrate resources towards items where the difference is the greatest. Instead of investing in minimally successful goods, it can focus on making individual units that maximum returns.

Marginal cost is also essential in knowing when it is no longer profitable to manufacture additional goods. When marginal cost exceeds marginal revenue, it is no longer financially profitable for a company to make that additional unit as the cost for that single quantity exceeds the revenue it will collect from it. Using this information, a company can decide whether it is worth investing in additional capital assets.

Marginal cost is also beneficial in helping a company take on additional or custom orders. Consider a company that sells a good for $50. It has additional capacity to manufacture more goods and is approached with an offer to buy 1,000 units for $40 each. Marginal cost is one component needed in analyzing whether it makes sense for the company to accept this order at a special price.

Example of Marginal Cost

Production costs consist of both fixed costs and variable costs. Fixed costs do not change with an increase or decrease in production levels, so the same value can be spread out over more units of output with increased production. Variable costs refer to costs that change with varying levels of output. Therefore, variable costs will increase when more units are produced.

For example, consider a company that makes hats. Each hat produced requires $0.75 of plastic and fabric. Plastic and fabric are variable costs. The hat factory also incurs $1,000 dollars of fixed costs per month.

If you make 500 hats per month, then each hat incurs $2 of fixed costs ($1,000 total fixed costs / 500 hats). In this simple example, the total cost per hat would be $2.75 ($2 fixed cost per unit + $0.75 variable costs).

If the company boosted production volume and produced 1,000 hats per month, then each hat would incur $1 dollar of fixed costs ($1,000 total fixed costs / 1,000 hats), because fixed costs are spread out over an increased number of units of output. The total cost per hat would then drop to $1.75 ($1 fixed cost per unit + $0.75 variable costs). In this situation, increasing production volume causes marginal costs to go down.

If the hat factory was unable to handle any more units of production on the current machinery, the cost of adding an additional machine would need to be included in marginal cost. Assume the machinery could only handle 1,499 units. The 1,500th unit would require purchasing an additional $500 machine. In this case, the cost of the new machine would need to be considered in the marginal cost of production calculation as well.

Marginal cost also has an impact on average cost. When marginal cost is less than average cost, the production of additional units will decrease the average cost. When marginal cost is more, producing more units will increase the average. cost per unit.

Special Considerations

Marginal cost is often graphically depicted as a relationship between marginal revenue and average cost. The marginal cost slope will vary across company and product, but it is often a "U" shaped curve that initially decreases as efficiency is realized only to later potentially exponentially increase.

Internal vs. External Reporting

Marginal cost is strictly an internal reporting calculation that is not required for external financial reporting. Publicly-facing financial statements are not required to disclose marginal cost figures, and the calculations are simply used by internal management to devise strategies.

In many ways, a company may be at a disadvantage by disclosing their marginal cost. Competitors would gain the advantage of knowing the company's cost structure, and the market could attempt to apply pressure to a company knowing the specific manufacturing levels where operations become unprofitable for other companies.

Relevant Range

Marginal cost highlights the premise that one incremental unit will be much less expensive if it remains within the current relevant range. However, additional step costs or burdens to the existing relevant range will result in materially higher marginal costs that management must be aware of.

Consider the warehouse for a manufacturer of landscaping equipment. The warehouse has capacity to store 100 extra-large riding lawnmowers. The margin cost to manufacture the 98th, 99th, or 100th riding lawnmower may not vary too widely. However, manufacturing the 101st lawnmower means the company has exceeded the relevant range of its existing storage capabilities. That 101st lawnmower will require an investment in new storage space, a marginal cost not incurred by any of the other recently manufactured goods.

Pricing Strategy

Marginal cost figures significantly into the marginal cost pricing doctrine, aka marginal cost theory, an economic principle that dictates that prices for products or rates for service should be predicated upon marginal costs for the purpose of economic efficiency.

The doctrine stems from political economist and professor Alfred E. Kahn's seminal work, The Economics of Regulation (1970 and 1971). “Under pure competition, price will be set at marginal cost” (the marginal price will equal the marginal cost)," Kahn wrote, and this results in “the use of society's limited resources in such a way as to maximize consumer satisfaction.”

What Is Marginal Cost?

Marginal cost is the cost to produce one additional unit of production. It is an important concept in cost accounting as marginal cost helps determine the most efficient level of production for a manufacturing process. It is calculated by determining what expenses are incurred if only one additional unit is manufactured.

What Is an Example of Marginal Cost?

Imagine a company that manufactures high-quality exercise equipment. The company incurs both fixed costs and variable costs, and the company has additional capacity to manufacture more goods.

Let's say it cost the company $500,000 to manufacture 1,000 exercise bikes. The company has determined it will cost an additional $400 to manufacture one additional bike. Although the average unit cost is $500, the marginal cost for the 1,001th unit is $400. The average and marginal cost may differ because some additional costs (i.e. fixed expenses) may not be incurred as additional units are manufactured.

What Is the Formula for Marginal Cost?

Marginal cost is calculated by dividing the change in costs by the change in quantity. For example, suppose that a factory is currently producing 5,000 units and wishes to increase its production to 10,000 units. If the factory’s current cost of production is $100,000, and if increasing their production level would raise their costs to $150,000, then the marginal cost of production is $10, or ($150,000 - $100,000) / (10,000 - 5,000).

Why Is Marginal Cost Important?

Marginal cost is an economics concept that plays an important role in business management since it can help businesses optimize their production levels. It refers to the incremental cost of adding one more unit of production, such as producing one more product or delivering one more service to customers. It is generally associated with manufacturing businesses, although the concept can be applied to other types of businesses as well.

What Is the Difference Between Marginal Cost and Average Cost?

Marginal cost is the expenses needed to manufacture one incremental good. As a manufacturing process becomes more efficient or economies of scale are recognized, the marginal cost often declines over time. However, there is often a point in time where it may become incrementally more expensive to produce one additional unit.

On the other hand, average cost is the total cost of manufacturing divided by total units produced. The average cost may be different from marginal cost, as marginal cost is often not consistent from one unit to the next. Marginal cost is reflective of only one unit, while average cost often reflects all unit produced.

The Bottom Line

During the manufacturing process, a company may become more or less efficient as additional units are produced. This concept of efficiency through production is reflected through marginal cost, the incremental cost to produce units. To maximize efficiency, companies should strive to continue producing goods so long as marginal cost is less than marginal revenue.

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  1. ScienceDirect. "Marginal Cost Pricing."

  2. Alfred E. Kahn. "The Economics of Regulation, " Vol. I, Pages 16-17. The MIT Press, 1988.