What Is Marginal Cost And How Do You Calculate It?

‍What is marginal cost?

Marginal cost is the expense incurred on producing an extra unit of a product or service. It is an accounting concept used by companies to optimise production and achieve economies of scale. Economies of scale, as you might know, occur when an increase in production volume brings about a decrease in costs due to a business having achieved efficiency.

For a greater grasp of the meaning of marginal cost, business owners need to know that it includes two types of costs:

Fixed costs

Fixed costs are expenses that remain constant and do not necessarily change with an increase or decrease in production volume. For example, factory rent, property tax, insurance payments, etc.

Variable costs

Variable costs are directly linked to production and change with output. For example, the cost of raw materials, labour, utilities, shipping, and so on.

Furthermore, marginal costs can be categorised as short-run marginal costs and long-run marginal costs.

Short-run marginal cost

Short-run marginal cost is incurred when a company increases production output for a brief period by keeping fixed costs (cost of factory, machinery, storage, etc) constant and variable costs (cost of raw material, labour, etc) fluid.

Long-run marginal cost

Long-run marginal cost occurs during a production run when all input is variable. This can happen when a company is setting up a new factory, entering a new market, or adding more employees to its roster.

Marginal cost formula

Marginal cost = Change in total cost / Change in total quantity

How to calculate marginal cost

Here’s a marginal cost example. A company that manufactures furniture produces 100 chairs for SGD 5,000. That’s a per-unit cost of SGD 50. If it produces an extra chair, it will cost the company an additional SGD 50. Now, let’s use the marginal cost formula to calculate:

Change in total cost: 5,050 - 5,000 = 50

Change in total quantity: 101 -100 = 1

Marginal cost = 50 / 1 = 50

Marginal cost and its use in business

Now that we know what is marginal cost and how to calculate marginal cost, the next step is to understand how it works in business.

Marginal cost is a financial analysis tool that helps companies reach their most efficient level of production. This concept of marginal costs works on the expectation that at a certain level of production, making an additional unit and earning revenue from it will lower the overall cost of production, making the process more efficient and profitable. By calculating the marginal costs of products at various levels of production and analysing this data, business owners can reach that optimum point of production.

How can you tell if you have reached the optimum production level? Well, it is the point where marginal cost is equivalent to marginal revenue (which is revenue earned from selling an additional unit of a product or service). Beyond this point, the cost of producing an additional unit will exceed the revenue earned from it, making production unprofitable.

Why is marginal cost important?

While its primary use is to help companies determine their optimum level of production, calculating and analysing marginal costs have several other benefits:

1. Increasing sales and profitability: Marginal cost helps companies optimise production levels and achieve economies of scale. This, in turn, allows them to lower their product prices and attract more customers, especially those who are price-sensitive. Minimising prices while maximising sales normally lead to an increase in profits. 
2. Entering new markets: Using marginal costs to sell at competitive rates can help companies attract new customers, even in so far unexplored markets and locations.
3. Focusing on bestsellers: If your business has multiple product lines, you can calculate the marginal costs of each and compare the results to get a fair idea of which products are successful and which aren’t as much. Armed with this insight, you can invest in the products that are capable of earning the most revenue and put your precious resources to better use.
4. Taking additional and bulk orders: If a business has the capacity to produce more goods than it currently does, a marginal cost analysis will tell if it is financially viable to accept an additional order or a bulk order at a lower per-unit price.
5. Making informed investment decisions: Let’s say a company is considering increasing its production output but will have to invest in a new factory and equipment to do so. However, marginal cost calculations indicate that increasing production volume is counter-productive and the company is saved from investing in a non-lucrative venture. Furthermore, marginal cost studies help investors gauge the profitability and potential of companies they are looking to invest in.

Marginal cost example

If you’re interesting in how to find marginal cost of your products, this example of a sporting goods manufacturer making 500 footballs a month will serve as a guide:

Variable cost: Each football is made of synthetic leather and rubber, which costs the factory SGD 2 per unit.

Fixed cost: The factory incurs fixed expenses (rent, utilities, taxes, etc) of SGD 1,500 for the entire month. That means, each football incurs SGD 3 in fixed costs.

Total cost per unit: SGD 2 + SGD 3 = SGD 5

Total production cost: SGD 2,500

The factory has the production capacity to manufacture an additional 300 footballs while keeping its fixed expenses constant. So, it increases production volume to 800 footballs per month.

Variable cost: SGD 2

Fixed cost: SGD 1.80 (1,500 / 800)

Total cost per unit: SGD 2 + SGD 1.80 = SGD 3.80

Total production cost: SGD 3,040

Now, using the marginal cost formula, here’s how to calculate the marginal cost of producing an additional football:

Change in total cost: SGD 3,040 - SGD 2,500 = SGD 540

Change in total quantity: 800 - 500 = 300

Marginal cost = 540 / 300 = SGD 1.80

Marginal cost curve

When companies compute marginal costs, they plot it on a graph. The horizontal X-axis represents product quantity and the vertical Y-axis product cost. Marginal costs typically follow a U shape, which is called the marginal cost curve. The U shape is on account of the marginal cost starting off high, then gradually dipping. This dip is because fixed costs remain constant even as production levels go up. The marginal cost then reaches its lowest point and stays at this point for a while. This is the bottom of the U shape and is called the ‘equilibrium’. However, from this point on, the marginal cost starts inching upwards. This increase can be attributed to several factors, such as exhaustion of resources, acquisition of fresh resources, loss of production efficiency, and so on.

Marginal cost pricing

In the process of computing and analysing marginal costs, you might come across the term ‘marginal cost pricing’. Marginal cost pricing refers to pricing a product at the additional amount it costs to produce an additional unit, excluding overhead expenses. Companies resort to marginal cost pricing when sales are down or when they are unable to set a higher price for their products. The benefit of marginal cost pricing is that it helps companies increase customer demand and receive a short-term boost in revenue. For example, if a company has a small inventory of unsold seasonal products that are set to go out of date soon, it can deploy marginal cost pricing as a short-term solution.

Marginal cost vs average cost

Average cost is the total cost of products or services divided by the total number of products or services. Unlike marginal cost, which is specific to a single unit of a product and is not consistent from one unit to another, average cost relates to all the units produced. Another difference is that the purpose of marginal cost is to tell if it is profitable to produce an additional product unit while average cost aims to determine how a change in output affects production cost. One can, therefore, say that marginal cost exists to maximise profit while average cost serves to minimise cost.

Marginal cost vs average cost: Key differences

‍Marginal cost vs opportunity cost

Opportunity cost is the potential return on an investment that your company loses because it chose to invest its funds elsewhere. In simpler terms, opportunity cost is what you potentially lose by making one investment decision over another. Unlike marginal cost, opportunity cost is a more intangible concept because the value of the lost benefit isn’t only in monetary terms but could also be in terms of time and other resources. Opportunity cost is computed to help you make sound and informed investment decisions by understanding the potential gains, losses, and risks associated with each choice.

Marginal cost vs variable cost

A variable cost is a fluctuating expense. It increases when production increases and decreases when production decreases. The cost of electricity to run a factory is an example of a variable cost. Marginal costs and variable costs have a close association. In order to calculate marginal cost, there must be a change in production cost. A change in production cost almost always happens due to changing variable costs as fixed expenses tend to remain constant. Therefore, marginal costs exist only when variable costs are involved.

Limitations of marginal cost

Limited to short-term pricing

Marginal cost pricing is almost always unsuitable for long-term pricing. This is because it does not account for the possibility that a company’s fixed costs might turn into variable costs – for example, when it invests in a new plant or new machinery – over a longer period of time and varying levels of production.

Price-oriented

To a great extent, marginal cost focuses on cutting prices by achieving optimum levels of production and maximising sales. This might help a company attract price-sensitive customers and earn a profit in the short term. But such a one-dimensional approach that ignores all other aspects of production isn’t helpful if a business aspires to offer high quality products and services in the long run. Additionally, the fixation on producing and selling at a minimum price might cost a company a much higher profit margin if it had sold at or near the market rate.

Incomplete information

While it is certainly useful as an analytical tool, marginal cost computing does not provide any other reasons for why a company should increase or decrease its production output apart from the pricing factor.

Not foolproof

Due to the limitations mentioned so far, accuracy isn’t guaranteed in marginal cost analysis. A miscalculation can lead to a company producing more than it can sell, leading to heavy losses. One must also remember that certain costs cannot always be categorised as strictly fixed or strictly variable. This can lead to miscalculations and inaccuracies.  

Irrelevant to accounting statements

You will not find a company’s marginal costs in any financial statements. Calculating and analysing marginal cost is strictly meant for internal reporting with the aim of informing a company’s business strategy and policies.

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