If you’re an investor or business owner, you likely have encountered the term “marginal cost” and wondered what it means. To find out, Bottom Line Personal turned to Eric Amzalag, CEO of Peak Financial Planning.
What Is Marginal Cost?
Every unit that a company produces or manufactures incurs material, labor and other costs. Marginal cost is how much money a company would have to pay to generate one additional unit beyond current production levels. Example: If a company is currently making 10,000 pairs of socks annually, how much would it cost to produce one more pair of socks—10,001 pairs—annually? That’s the marginal cost.
How to Calculate Marginal Cost
The marginal cost formula is fairly simple once you’ve gathered all the data about expenditures. It is the change in variable costs divided by the change in the quantity of units produced (variable costs are those required to produce the extra units). Example: If it costs $300 more to begin producing more items, and the company is producing only one more item, then the marginal cost is $300 divided by 1, so $300.
What Is Marginal Revenue?
Marginal cost is most meaningful when viewed alongside marginal revenue. Marginal revenue is how much money one additional unit produced will bring in. Example: You work for a company that makes lawnmowers and sells each lawnmower for $3,200. You may wonder, Why don’t we manufacture more mowers to bring in more revenue? The answer requires knowledge of both how much it would cost to manufacture one more lawnmower (marginal cost) and how much more revenue one more lawnmower would bring (marginal revenue). If the marginal cost is $5,000 and marginal revenue is $3,200, then it would be a mistake to manufacture more lawnmowers.
What About Diminishing Returns?
The key to understanding marginal cost is operational efficiency.
Example: You want to start a business manufacturing computers. The costs of making your very first machine will be astronomical—you’ll have to buy real estate, hire workers, source materials, bring on executives…the works. So then making that first computer might cost $30 million. But the cost per unit goes down with each additional machine you make, since you need to purchase all that overhead only once. At a certain point, your operation will be humming along at maximum efficiency. Just before you reach that point, your operational cost will approach zero—in other words, it would cost you almost nothing to make one more machine. Viewed against marginal revenue, it would be profitable to keep making more machines until you surpass optimal efficiency. That’s when you hit an obstacle—building one more machine means opening another facility, hiring hundreds more workers and so on.
Why Marginal Cost Matters
If you’re a small-business owner, you might not be able to track your business quite this scientifically. But knowing how to find marginal cost can help you stay cognizant of efficiencies and make smart decisions about scaling your business.
