What is marginal cost?

The marginal cost definition refers to the increase or decrease in the total costs a company will incur by producing one more unit of a good or serving one more customer. Also known as incremental cost, it includes the cost of any additional input required to produce the next unit at each level of production.

It is calculated by dividing the total change in the costs of producing additional goods by the change in the number of goods produced. Typically, the variable costs included in the calculation are materials, equipment and labour. Moreover, if there are any estimated increases in fixed costs, such as overhead, administration or selling expenses, these are also added to the calculation. The marginal cost formula can be used in financial modelling to optimise the generation of cash flow.

Key takeaways:

Where have you heard about marginal cost?

If you are familiar with the term “economies of scale”, then you may have probably heard about marginal cost as well. Marginal cost is evaluated by businesses to help them maximise their profits. The main goal of analysing marginal cost is to determine at what point a company can achieve economies of scale to optimise overall operations and production processes.

What you need to know about marginal cost

Marginal cost is a concept that is widely used in economics and managerial accounting. It is often employed by manufacturers in order to find an optimal production level. Manufacturers analyse the cost of adding one extra unit of good to discover a specific level of production at which the benefit of producing an extra unit and generating revenue from it will reduce the overall cost of the entire product line manufacturing. The main idea is to find that level as quickly as possible to optimise production costs.

Marginal cost consists of all the costs that differ with the new level of production. For instance, if a business needs additional equipment to manufacture more goods, the cost of purchasing this equipment is included in marginal cost. Marginal cost can vary depending on the volume of the product being manufactured.

The idea behind the concept is that a business that is interested in maximising its revenues will produce up to the point where marginal cost equals marginal revenue. Beyond that point, the cost of manufacturing an extra unit of product will exceed the profits generated.

If the marginal cost exceeds the marginal revenue of a product, it means a company is producing too much and should cut down its quantity until marginal cost equalizes with marginal revenue.

Marginal cost includes both variable and fixed costs. Variable costs are those that change with varying levels of output, such as payroll, equipment and materials. Thus, variable costs will increase when more units of a good are produced. Fixed costs, on the other hand, usually do not depend on the number of goods or services produced, therefore, do not change with a decrease or increase in production levels. Fixed costs include administration, overhead and selling expenses.

What is the marginal cost formula?

Let’s see an example of how it works. A company consistently manufactures 1,000 units of chairs each year, incurring production costs of $10,000. The following year, the market demand for chairs increases significantly, requiring the production of additional units. This, in turn, encourages the firm’s management to purchase more raw materials and equipment, as well as hire more workers.

This demand results in overall production costs of $25,000 to produce 1,500 units in that year. In this scenario, the marginal cost of $30 is accounted for each additional chair produced.

Understanding a product’s marginal cost allows a business to evaluate its profitability and make rational decisions related to the product, such as setting its pricing.