For each entrepreneur (manufacturer), the main goal is to obtain profit (net income). In the modern world, the manufacturer faces many difficulties, one of which is production costs. Without appropriate knowledge about them, it is quite difficult to successfully conduct business. The manufacturer spends tremendous efforts to reduce production costs and get maximum profit.
Along with average, total, and other types of costs, it is worth considering marginal costs. This type of cost represents how much a manufacturer will have to spend per unit of goods if it increases its output (or saves with a reduction in production).
To give an example, if Johnson Company makes 301 units instead of 300, then the extra amount of money it has to spend to make 301 units is the marginal cost. Simply put, it is the increment in total costs when releasing one more unit of output.
Role in business
Marginal costs occupy a special place in economic analysis. They are important because economic decisions usually involve a marginal analysis of the available alternatives. Since fixed costs do not affect the increment in total costs, the marginal costs can also be considered as an increment in variable costs when a company evaluates the effect of a decision to produce one more bottle, car, cereal box, or anything else.
Marginal costs can vary significantly, so they are one of the key indicators that must be taken into account when deciding how much and what kind of product to produce. Many companies strive to balance costs and benefits, although in some cases, it may be acceptable that the costs exceed the benefits obtained, which is compensated by other factors.
At first glance, it seems the marginal cost remains fixed, but this is not the case:
- In a graphical representation, marginal costs create a curve, not a straight line.
- With a relatively small amount of production, these are usually high, but as production increases, they decline.
- After passing a certain point, a further increase in production leads to an increase in marginal costs.
Therefore, deciding on the volume of production involves finding the point at which the costs correspond to the benefits obtained.
The marginal cost is very useful in project implementation because, from a financial point of view, the optimal point is between the cost of production and the sale price, so an appropriate sales price is calculated at which the company does not lose money and does not take advantage of the customer. It is very important to know this information to find out the final amount of money necessary to make these units, with which we can accurately determine the sales price so the project objectives are achieved and maintained. But how do you find the marginal cost?
Marginal cost formula
Businesses calculate the marginal cost for various output quantities using the simple marginal cost formula below until they find an optimal production quantity or can evaluate the associated spendings vs benefits when increasing or decreasing production.
Marginal Cost = (Change in Cost) / (Change in Quantity)
The formula produces a dollar amount for each additional unit of a product manufactured, which greatly simplifies decision-making.
Example of calculation
Let’s calculate the marginal cost with the following data.
So, if the total cost of making 0 units is $15 and the total for 1 unit is $30, then the marginal cost when producing the first unit is $15. If it chooses to produce the second unit the marginal cost equals $42 less $30 divided by 1 or $12. You would use the same marginal cost formula and process to calculate this value for the next unit being produced.
The company might also want to calculate how much it would need to spend to go from 1 unit being produced to let’s say 4 units on a per-unit basis. Once again, you would turn to the formula. The change in costs equals $70 less $30 or $40. The change in quantity is 4 less 1 or 3. Now, if we input these numbers into the equation, we get $40 divided by 3 or $13. This means it would need to spend on average $13 per unit to go from 1 to 4 units.