What Is Marginal Cost, Its Formula, And How To Calculate It?

Farwah Jafri | January 26 2023

Small and medium businesses long for ways to win a competitive edge and beat the market. Economies of scale enable them to do the same and help them target a mark at which mass production turns profitable. However, to use economies of scale for your benefit, you must first know how to calculate marginal costs.

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What is Marginal Cost?

In simple terms, the increase or decrease in production cost needed to produce one more unit refers to marginal cost. Calculating marginal costs help businesses pinpoint the exact number at which they can use economies of scale to optimize their business for better returns. The mark at which the production cost for the new unit drops below the unit price is where profit begins.

What is the Marginal Cost Formula?

Calculating marginal costs is simple once you know the right formula. In plain words, all you need to do is divide the difference in production cost by the change in product count. The answer gets you the added cost involved in producing the extra unit, which helps you find the ratio to target to hit break even and go beyond.

Marginal Cost Formula = Change in Total Expenses
                                                     Number of New Units

Marginal costs tell the difference between the cost of manufacturing products in the original quantity and the added cost incurred to produce more units. More so, it is a must to know the formula requires feeding in the change in expenses, not the total. For instance, if the current process costs $1,000,000 and increased production costs $1,075,000, the numerator would be $75,000.

Moreover, the denominator often entails one as it helps find the per-unit marginal cost required to raise production.

How Do Economies of Scale Work?

Economies of scale are the added advantages and better profits you make by scaling production levels up or by producing products in bulk quantity. Generally, from a certain point, the profits made from production begin to outweigh the expenses needed to raise unit counts. The trick lies in finding the mark at which bulk production will help a business turn over more, and you need to calculate marginal costs to do that.

The sooner a business owner learns to leverage economies of scale, the better it is, as it helps you make profits without raising costs. How? By getting max value from business expenses under the bracket of fixed costs.

Types of Production Costs

Two types of production costs are involved in a business; fixed and variable. The former remains fixed with the change in production levels, while the latter increases with every unit addition. The purpose behind the marginal costs is to help businesses get maximum value from fixed ones, like the factory rent, the machinery cost, and the like.

Consider a chocolate factory. Each bar requires ingredients worth $0.50, while the machine that can produce 10,000 chocolate bars costs $10,000. If the factory owner makes only 5,000 chocolates, the average cost would be high as the fixed costs will get divided by 5,000. In other words, the cost of producing a single bar would be (10,000/5,000 + 0.50 = $2.50).

If the bar retails for two dollars, the factory will incur a loss with each sale. Imagine the owner taking production up to match the machine’s limit, 10,000. Now, the cost of producing a single bar would drop, and a new price would be (10,000/10,000 + 0.50 = $1.50). A profit!

Here’s how increasing production volumes helps drop marginal costs and make better profits. It’s about setting up your business to leverage the maximum from fixed costs. At times, reaching peak product count from a single piece of machinery is not enough, and new machines are required to raise production levels. Here, the cost of each new piece of equipment will add to fixed costs.

Why is Marginal Cost Important?

Marginal costs help businesses use finances to outperform their competition by finding the ideal production level to target for better margins. Better quality is the only factor more important than the cost for average consumers. Businesses with streamlined finances can precisely calculate marginal costs and use economies of scale to leave the competition behind.

Though the concept is mostly for manufacturers and factories, the principle also works for other businesses seeking new ways to one-up their competition and be the best. Better finances can give you an advantage unlike anything else. The question is can you hear what your numbers say?

See Also: What Is Cash Disbursements Journal In Accounting?

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Author Bio

Farwah is the Product Owner of Monily. She has an MBA from Alliance Manchester Business School, UK. She is passionate about helping businesses overcome challenges that hamper their growth, which is why she is working at Monily to facilitate entrepreneurs to efficiently manage business finances and stay focused on growth.