Marginal cost is the increase or decrease in the cost of producing one more unit or serving one more customer. It is also known as incremental cost.
It’s calculated when enough items have been produced to cover the fixed costs and production is at a break-even point. That’s where the only expenses going forward are variable or direct costs.
Knowing marginal cost helps you maximize pricing and improve profitability for your store.
Learn the basics of marginal cost and figuring out yours, so you can create a more profitable business.
What is marginal cost?
Marginal cost is the change in total production cost that comes from making or producing one more unit. It’s calculated by dividing the change in production costs by the change in quantity.
You can use marginal cost to determine your optimal production volume and pricing. It includes both fixed and variable costs. Investors also use it to help forecast the profit growth of a company as it increases in scale.
Key takeaways
- Marginal cost refers to the additional cost incurred to produce one more unit of a product or service.
- Analyzing marginal cost helps you assess profitability and make informed decisions related to the product, including pricing.
- Marginal cost is shown on a graph through a curve that typically takes a U-shape. Initially, as production increases, marginal costs decrease due to efficiencies gained.
- A company maximizing profits will produce up to the point where marginal cost equals marginal revenue (MC=MR).
- When marginal cost falls, it means a company can produce more of its product or service without a significant increase in cost.
Marginal cost formula
Marginal cost can be calculated as follows:
Marginal cost = Change in total cost / Change in total quantity
The formula for calculating marginal cost is MC = ΔTC/ΔQ, where:
- MC represents marginal cost
- ΔTC represents change in total cost
- ΔQ represents change in total quantity
How to calculate marginal cost
Suppose you run an ecommerce business selling handmade jewelry. Initially, you’re making 100 bracelets a day, and your total cost (materials, labor, etc.) is $500.
You decide to produce an extra bracelet, making the total 101 bracelets. This increases your total cost to $505. The increase in cost ($5) is the marginal cost.
But how do you figure that out?
Here are the steps to calculate marginal cost:
1. Identify the change in quantity
Figure out the change in the quantity of your product. This is typically one unit, but could be any number depending on the amount of products you are adding.
2. Figure out the change in total cost
Determine the change in your total cost when your output changes. Subtract the initial total cost from the new total cost after the change in production.
3. Calculate the marginal cost
Once you have these two figures, you can run a marginal cost calculation by dividing the change in cost by the change in quantity.
Using our example above, the full calculation is:
- Change in quantity = 101 bracelets - 100 bracelets = 1 bracelet
- Change in total cost = $505 - $500 = $5
- Marginal cost = $5 / 1 = $5
The marginal cost of making one additional bracelet is $5.
If the marginal cost is lower than the price you can sell the additional product for, it may make sense to increase the level of output.
But if the marginal cost is higher, it might be better to maintain or decrease the quantity of output. You can also consider raising your prices if you plan to increase production.
Marginal cost example
Say you run an ecommerce business that sells handmade leather jackets. Currently, you’re producing 50 jackets per week, and it costs you $2,000.
You decide to increase production by 10 jackets a week, to a total of 60 jackets. Your total cost rises to $2,450.
The marginal cost of producing 10 additional leather jackets would be:
- Change in quantity = 60 jackets - 50 jackets = 10 jackets.
- Change in total cost = $2,450 - $2,000 = $450.
- Marginal cost = $450 / 10 = $45.
The marginal cost of producing one additional leather jacket (in batches of 10) is $45.
Given the marginal cost of producing an additional leather jacket is $45, you can price the jackets at a higher value to ensure profitability.
For example, if you price each jacket at $90, you’d make a profit of $45 per jacket. By producing and selling 10 more jackets, you would increase profits by $450.
Marginal cost curve
When charted on a graph, the marginal cost of producing different amounts of products tends to follow a U shape. Costs start out high until production hits the break-even point when fixed costs are covered.
It stays at that low point for a period, then starts to creep up as increased production requires spending money for more employees, equipment, and so on.
Here’s an example:
To make your own marginal cost curve, you’ll need to:
- Identify cost drivers: First, you need to understand what factors impact your costs, such as labor, raw materials, shipping, etc. These will influence your marginal cost of production.
- Calculate the marginal cost of different levels of production: You would then calculate the marginal cost of producing different quantities of your product.
- Plot the curve: Once you have these numbers, you can plot them on a graph. The x-axis represents the quantity of products, and the y-axis represents the cost per number of units.
- Analyze the curve: Now you can analyze the curve to make strategic decisions. If you’re seeing economies of scale (falling marginal costs), you could increase production. If you’re seeing diseconomies of scale (rising marginal costs), you might want to reconsider expanding production further, or look for ways to improve efficiency.
Generally, the price of your product should be above the marginal cost to ensure profitability. If it’s not, you might need to adjust your pricing strategy, or find ways to lower your costs.
Marginal cost and marginal revenue
Marginal cost and marginal revenue work together to help you maximize production. The ideal production level occurs when marginal cost equals marginal revenue (MC=MR).
These two concepts, however, are different. Let’s look at the definitions:
- Marginal cost: The additional cost a business incurs by producing one more unit of a product or service.
- Marginal revenue: The additional revenue a company earns from selling one additional unit of a product or service.
In the graph below, marginal revenue is shown by the lower pink line. The quantity where marginal revenue and marginal cost intersect is the optimal quantity to sell.
The marginal revenue varies based on market conditions. It can slope down due to diminishing returns, or, it can be a horizontal line in the case of perfect competition.
At the end of the day, if the marginal revenue is greater than the marginal cost, the business can increase its profits by selling more units.
Nail your next production run
Understanding marginal cost can help you identify areas to reduce costs and improve efficiency. By analyzing your production processes, you can reduce the cost per unit, which can increase cash flow and make your product more competitive in the market.