Just about every entrepreneur wants to see their business grow. But product-based businesses can't simply produce as many additional units as they wish and hope they'll sell.
Producing goods costs money, so you don't want to overproduce and not see a return on the investment.
Keeping an eye on your marginal cost formula is important because it helps you find the sweet spot—producing enough units to meet customer demand without losing money.
What Is Marginal Cost?
Marginal cost is the increase or decrease in the cost of producing one additional unit of output. In other words, if your business is currently making 100 units of a product, then the cost to create the 101st unit would be the marginal cost of that particular product. It is also known as your incremental cost.
Marginal costs are based on variable costs, which change based on how much the business produces or sells. Examples of variable costs include raw materials, wages for production line workers, shipping costs, commissions, etc.
Marginal costs don't typically include fixed costs, which are the same no matter how many units are produced. Examples of fixed costs include rent, management salaries, commercial insurance, and property taxes. Fixed costs, however, can be included in marginal costs if they're required for additional production. For example, if you need to move into a larger facility to produce additional goods, you would factor that expense in.
To illustrate, say you own a millwork company that produces wood doors, molding, paneling and cabinets. Your overall cost to manufacture 20 doors is $2,000, including raw materials and direct labor. If you're considering producing another 10 units, you need to know the marginal cost projection first.
Doubling your production won't necessarily double your production costs. If you can negotiate a discount from your materials supplier on a larger order, your per unit cost might go down. On the other hand, if you need to move into a larger facility or purchase new equipment to produce additional goods, your average cost per unit might go up.
Why Is the Marginal Cost Equation Important?
The marginal cost formula is essential because it tells you if increasing production volume is a good idea.
If you can sell an item for more than it costs you to produce, you stand to see increased profits. However, if the selling price is less than that item's total production costs, your business will lose money.
Marginal Cost Formula
The marginal cost formula tells you how much it costs to make one additional unit of your product.
The marginal cost equation is:
Marginal Cost = Change in Costs / Change in Quantity
Let's break down the two parts of that equation.
- Change in costs: Production costs for your next batch minus production costs from the previous batch
- Change in quantity: The number of units produced in your next batch minus the quantity produced in the previous production run
Marginal Cost Example
Returning to our millwork company example above, say you normally produce 240 doors per year at a cost of $24,000. However, you've discovered that market demand for your doors is significantly higher, and you want to produce an additional 100 doors next year.
To produce those extra doors, you must account for the additional cost of purchasing more raw materials and supplies and hiring more employees. However, you can get a slightly better deal on the raw materials and supplies when you place a larger order with your vendors. Also, you don't have to purchase additional equipment or move into a larger facility.
You calculate the total cost to produce 340 doors next year (the original 240 doors plus the 100 additional units) will be $33,500. In other words:
First batch cost: $24,000
Number of units: 240
Second batch cost: $33,500
Number of units: 340
So, you calculate your marginal cost formula as follows:
Marginal Cost = Change in Costs / Change in Quantity
Marginal Cost = ($33,500 - $24,000) / (340 - 240)
= $9,500 / 100
= $95
So each extra unit you produce past the initial run of 240 doors will cost you $95.
If you know you can sell those doors for $250 each, then producing the additional units makes a lot of sense. You’ll increase your profits by $15,500—that’s $25,000 in revenue from the extra 100 doors minus the $9,500 cost of producing them.
On the other hand, what if they don’t sell? What if they sit in your inventory, collecting dust and taking up space, and you eventually have to discount them to $75 each to get rid of them? Then you’d lose $20 on an extra door you produced.
Calculating your marginal costs helps you decide whether producing extra units is worth it or whether you might need to scale down. One way to make this calculation easier? See your labor costs in real-time with Hourly's platform. You'll have all the info you need for one of your biggest expenses, which will help make your marginal cost calculations super accurate.
What Is the Marginal Cost Curve?
Marginal costs typically decrease as companies benefit from economies of scale—the cost advantages experienced by a business when it increases its output level. For example, a company might reduce the price per unit by buying supplies in bulk or negotiating with suppliers for volume discounts.
However, the marginal cost of production can eventually start to increase as the business becomes less productive. This is known as diseconomies of scale. You can get a visual representation of diseconomies of scale with a u-shaped curve known as the marginal cost curve.
Diseconomies of scale can happen for several reasons. As a company grows, communication breakdowns can make people less productive. Employees might feel less connected to the organization and its mission, and be less motivated to do their best work. The company might need to move into a larger facility, relocate to a higher cost of living area to find talent, or hire more supervisors, which drives up costs.
The marginal cost curve demonstrates that marginal cost is relatively high with low production levels, declines as production increases, reaches a minimum point, then rises again.
General FAQs on Marginal Costs
How do you calculate marginal cost?
You perform a marginal cost calculation by dividing the change in total cost by the change in quantity.
Marginal Cost = Change in Costs / Change in Quantity
What is marginal revenue?
Marginal revenue is the total revenue gained by producing one additional unit of a good or service. You calculate marginal revenue by dividing the total change in revenue by the change in quantity.
Marginal Revenue = Change in Revenue / Change in Quantity
As long as marginal revenues are higher than your marginal costs, then you’re making money. When marginal costs equal marginal revenue, then you’ve maximized the profits you can earn on that product. To sell more, you’d need to lower your price, which would mean losing money on each sale.
What does the marginal cost formula tell you?
Performing a marginal cost analysis allows your company to maximize profits by ensuring you produce enough products to meet demand without overproducing. It also helps you price products high enough to cover your total cost of production.
Are marginal costs the same as variable costs?
The terms marginal cost and variable cost are not interchangeable. Marginal costs are the increase or decrease in total costs resulting from one extra unit of production, and they can include both fixed and variable costs.
Variable costs are costs that change based on production output. For example, a manufacturer spends more money on raw materials, labor, and supplies when they produce a greater number of goods.
Marginal Cost Helps You Figure Out if You Can Scale
In every business, there comes a point where it doesn't make sense to produce additional units. Calculating your marginal cost helps you find this level of production and ensure you don't lose money producing goods that won't sell or cost more than you can sell them for. So now that you know everything there is to know about marginal cost, all that’s left to do? Get that calculator out and figure out if you can grow!
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