What is Marginal Cost? Definition and Calculation

Marginal cost is a concept commonly used in business. It is used to determine the best production quantity that adds the least cost to producing extra units. Calculating marginal costs is a vital aspect to doing business.

Using this method can help companies to maximize their profits. It can also be used to determine the pricing of products. For example, a customer may ask for the lowest price we can offer them for certain orders. Knowing our marginal cost can help us make more realistic decisions.

What Does Marginal Cost Mean?

Marginal costing is used to illustrate extra costs incurred by the production of additional units of goods or services.

To calculate this you would first take the total change in the cost of producing the extra goods. Then you would divide it by the change in the number of goods actually produced.

Variable costs added to the calculation would be:

  • Labor
  • Materials
  • An estimate of increases in fixed costs i.e. administration, overheads and expenses incurred with selling

Using the marginal cost formula can help to optimize the generation of cash into your business.

marginal cost analyzing

Marginal Cost Formula

The actual formula for marginal cost is:

Marginal cost = (change in cost) / (change in quantity)

Let’s look closely at the elements we need to include in this calculation: change in cost and change in quantity.

Change in Costs

Each stage of production can result in costs either decreasing or increasing. The costs may also be affected by the time of year that production occurs. This may be especially evident when an unexpected need arises for a change in production volume.

To increase your production output you may need to use more workers. Or the cost of purchasing raw materials may have increased. These will result in a change in your production costs.

To determine these changes in cost you need to do a simple calculation. Subtract the costs of the first production from that of the second with the additional output. The result is your change in costs.

Change in Quantity

As expected the volume of output will either increase or decrease with each cycle of production. Thus, the amounts involved are important for assess the marginal cost.

Increases and decreases in the quantities of the goods produced contribute to the marginal costs. Again, to determine this change, you subtract the quantity of the first production from the second.

Example Using Marginal Cost Formula

Let’s say a computer company makes 10,000 laptops each year which costs them $5 million in production costs. The next year sees the demand for laptops increase so the company will need to produce more.

To meet this need they buy more manpower, parts and raw materials.

The increased demands that year results in production costs of $7.5 million. This is for an output of 15,000 laptops.

When analyzing the figures using the above formula, you observed that the marginal cost is $500 per unit. This is what it would take to make each additional laptop.

black and white graph

Is Marginal Cost Important in Business?

Analyzing financial viability is important. It includes appraising the cost of each product or service you offer. Marginal cost is a superb way of doing that.

For example, should the price you sell the product at be greater than the marginal cost? This would mean revenue will be greater than the additional costs. Knowing this helps to justify your decision to expand the production.

On the flip side, if the return is less than the marginal cost then the sales would incur losses. You would then need to either drop extra production or increase prices.

So you can see how it is a valuable tool which can be used to effectively analyze business efficiency.

When to Use the Marginal Cost Formula?

Marginal costing is a great tool to use when evaluating some business decisions. It can offer great benefits to different areas of business. Below are some of the areas that can benefit from using marginal costing.

Investing in Automation

Many companies look at the possibility of using machines over manpower to complete work. Using marginal cost calculations could help them decide if this is a viable decision or not.

The key costs they would consider are the cost of purchasing the new equipment and the maintenance costs. Then they would compare this to the cost of labor. This is specifically regarding employees they would terminate in place of the new machines.

Variable Costs

Marginal costing is a useful way of having better control over variable costs. You can create reports that show a variance in the analysis. This would compare the actual cost of the variable to the their costs in the original production.

Profit and Volume

Marginal costing can be used to help decide which customers offer value to your business. You can determine which customers make the productions changes profitable based on the pricing and volume of their purchases.

As volume levels change, so do sales profits. Using marginal costing can be useful to help you plot these changes.

This can be presented in a visually easy to read chart, table or graph. The table would show volume levels that indicates where extra marginal costs appear. This aids management to approximate the amount of profit they will see at each level of production activity.

revenue

Redistribution

This is another area where marginal costing can aid in decision making. It is a valuable tool when considering the redistribution of manufacture. It can help you decide if it’s more cost effective to do the work yourself or outsource it to another company.

Benefits of Using Marginal Cost Formula

We now know what marginal cost is. We also know how the formula works and when it is best to use it. So what we need to know now is when is it most beneficial to use.

Maximum Returns

By using marginal costing it is easier to assess and acknowledge the effects of alternative production schedules. This helps to ensure that decisions taken will generate the most benefit and maximize the return on spending.

 gold coin as representation

Controlling Costs

Marginal costing helps to better establish and control the trues costs of production.

You do this by avoiding inconsistent appropriation of fixed business costs. Management is then able to achieve and maintain uniform costs.

Short-Term Planning

Marginal costing is a great way to demonstrate short-term profit planning. It is something easily demonstrated with profit graphs and break-even charts.

This makes assessing profitability easy. It provides a great way of bringing it to the attention of management. They can then use it for decision-making purposes.

Ease of Use

Marginal costing is a simple method to use and understand. It can be used in combination with other costing methods such as budgetary and standard costing.

solving income

Disadvantages of Using Marginal Cost Formula

Many business processes have both an upside and a downside. Using the marginal cost formula is no different. Here are some of the disadvantages you might encounter when using marginal costing.

Profit Representation

Marginal costing could give shareholders a misleading view of profits. Using marginal costs alone means closing stock prices reflect variable costs. These may then ignore the actual fixed costs.

We know that the fixed costs could be quite a considerable amount. This would be a disadvantage for shareholders, as they may not be seeing the full picture.

coin and cash for profit representation

Categorizing Costs

The separation of costs into fixed and variable can sometimes prove difficult. Most costs will be variable at some point.

Marginal costing runs the risk of blurring the line between fixed and variable costs. This is why classification could result in misleading results.

A company that produces a large varieties of products may find less benefit in applying marginal costing.

Cost Increases

Marginal costing is based on historical information. This can sometimes result in an inaccurate picture in the presence of increases in cost and production.

External Reports

You cannot use marginal costing in external reports. These must include a full picture of business costs and indirect costs.

Recovering Overheads

The use of marginal costing can cause the problem of over or under-recovery of business costs. This is due to variable costs being chosen on an estimated assumption rather than actual value.

Costs Which Are Semi-Variable

Semi-variable costs could lead to misinterpretations through exclusion or incorrect analysis.


Summary

Marginal costing is not as difficult to calculate as you had imagined. We have tried to provide you with all you need to know. You now have a better understanding of what marginal costing is, and the formula you need to use to calculate results.

This article has given you advice on what areas of business it is helpful to. It has also shown where it will offer no advantage at all. It also contains an example of marginal costing.

With your new -found knowledge of what marginal cost is, you could benefit your business by using it. Take a close look at your business’ production costs.

It might very well be the case that using marginal costing has the potential to boost your profitability.