How to Calculate Marginal Cost in Finance: Definition, Formula and Examples
Marginal Cost Definition
Marginal cost is the additional cost a company incurs to produce one more unit of a product or service.
Calculating marginal cost helps businesses understand how changes in production levels affect their total costs.
For example, imagine a manufacturing company that decides to increase its production of widgets.
The company needs to calculate the cost of producing one more widget to understand how this will impact overall profitability.
If the marginal cost is low, it may be beneficial to increase production.
However, if marginal cost is high, producing more may not be cost-effective.
By looking at marginal cost, the company can determine whether increasing production will lead to higher profits or if it should focus on reducing production costs to maximise profit margins.
Marginal Cost Formula
Calculating marginal cost uses the formula:
Marginal Cost = Change in Total Cost / Change in Quantity
Where:
- Change in Total Cost = Change in the total cost incurred after an increase in the number of units produced
- Change in Quantity = Change in the number of units produced
Calculating Marginal Cost Step-by-Step
Let’s walk through how to calculate marginal cost step-by-step:
Step 1: Calculate Total Cost
Total cost is the sum of fixed costs and variable costs.
Fixed costs do not change with production volume (ie rent, salaries),
Variable costs change with production volumes (ie materials, labour).
Total Cost = Fixed Costs + Variable Costs
Step 2: Calculate Change in Total Cost
To find the change in total cost, we calculate the difference in total cost before and after an increase in the number of units produced:
Change in Total Cost = Total Cost at New Quantity − Total Cost at Previous Quantity
Step 3: Calculate the Change in Quantity
The change in quantity is the difference between the new and previous quantities produced:
Change in Quantity = New Quantity − Previous Quantity
Step 4: Calculate Marginal Cost
Using the marginal cost formula:
Marginal Cost = Change in Total Cost / Change in Quantity
Example Marginal Cost Calculation
Let’s now look at a real-world example of the marginal cost calculation.
Imagine a factory that produces handmade leather bags. The company decides to increase production from 100 bags to 101 bags.
Initial Total Cost | 100 bags at £15.00 each |
New Total Cost | 101 bags at £14.90 each |
Step 1: Calculate Total Cost
Total Cost (100 bags): 100 x £15 = £1,500
Total Cost (101 bags): 101 x £14.90 = £1,505
Step 2: Calculate Change in Total Cost
Change in Total Cost = £1,505 − £1,500 = £5
Step 3: Calculate Change in Quantity
Change in Quantity = 101 − 100 = 1
Step 4: Calculate Marginal Cost
Marginal Cost = £5 / 1 = £5
This means the marginal cost of producing the 101st bag is £5.
Key Points to Remember
Marginal Cost Can Be Negative
Marginal cost can be negative when producing an additional unit reduces total costs.
This can happen due to economies of scale or bulk purchasing discounts.
Marginal Cost Can Be Zero
Marginal cost could be zero in situations where producing additional units does not change total costs.
This is typical in sectors like software or digital products, where after the initial development, distributing extra units has no additional cost.
In these cases, businesses can scale with minimal added expenses, leading to potential higher profits.
Integration with Marginal Revenue
Marginal cost is most useful when analysed alongside marginal revenue.
Marginal revenue is the additional revenue a company earns from selling one more unit of a product.
Profit is maximized when marginal revenue equals marginal cost (MR = MC).
This is because it is the point where the revenue from selling one additional unit matches the cost of producing it.
If marginal revenue is greater than marginal cost, the company can increase its profit by producing more.
However, if marginal cost exceeds marginal revenue, it would be better to reduce production, as each additional unit costs more to produce than it generates in revenue.