What is the marginal cost of funds?

The marginal cost of funds can be defined as the addition of financing cost for a business. It‘s the result of adding one more dollar of new funding to a business portfolio. It plays a crucial role when a business needs to make future capital structure decisions as it is an incremental or differentiated cost. Hence, financial managers use the marginal cost of funds when selecting capital sources or financing types to isolate the sources of financing methods.

Marginal cost of funds formula

As the marginal cost of funds is referred to as the incremental cost of producing an additional unit, to calculate it, a business should divide the change in cost by the total change in production. Cost in this case is the amount of money the company requires to run its operations.

Let’s say a company manufactures 500 bags that cost a total of $2,000, the cost of producing one bag will be $4. The marginal cost is the change in total costs when an additional unit of the product is made by the company. So in case, the company makes 501 bags instead and the total cost of manufacturing comes to $2,050, the marginal cost will be $50 for the 501st bag, which is the marginal cost incurred by the company to make one extra bag.

Therefore, the marginal cost of funds represents the average amount it costs the company to add one more unit of debt or equity. Now, since this is an incremental cost, the marginal cost of funds is often referred to as the company’s incremental cost of capital.

For example: If a company is planning to build a new factory at the cost of $1.5m, the marginal cost of funds, in this case, would be calculated by translating to the rate of interest the company could have earned if the amount was to be invested rather than spending on the construction of the factory.

Another simple example of the marginal cost of funds is, banks paying interest to the savings account holder or simple investment vehicle owners. We can say that the lower the cost of funds, the better is the return and higher costs will have less-than-average returns.

In several instances, investors consider the marginal cost of funds as the funds borrowed from someone else, public or private funding. However, it is rather just the amount borrowed from oneself or from the company’s assets. It can also be considered as the opportunity cost by not investing the amount anywhere else.

Understanding difference between marginal cost of funds vs average cost of funds

The marginal cost of funds and the average cost of funds are often muddled, but there is an easy way of distinguishing between them. The marginal cost of funds is the incremental cost of producing an additional unit. The average cost of funds is calculated by computing a weighted average of all financing sources and their respective cost of funds.