Marginal costs are a critical economic concept describing the cost of producing one extra unit of a good or service.
This concept is essential for businesses, as it helps to determine the optimal output level for maximum profitability.
In economic and business analysis, producing an extra unit of a product or service comes with additional costs known as marginal costs. This cost is measured by observing how much more it would take to make one more item than initially projected.
Marginal cost is essential for managerial accounting, as it facilitates an organization in maximizing its productivity through economies of scale.
Businesses can decide on the most profitable output level and its corresponding pricing structure by calculating marginal cost.
Marginal Costs Definition
In economics, the marginal cost reflects the change in total cost that arises when producing one extra unit of a good or service. It is the incremental cost of producing an extra unit, which is usually not fixed.
According to Soni and Nema (2021), marginal cost is:
“the change in the total cost that comes from making one additional item or producing one ton extra (i.e., increased output)”(Soni & Nema, p. 65)
Marginal costs involve all the expenses that vary with production volume, including raw materials, labor fees, and overhead costs. By evaluating this information accurately, businesses can strategically plan for greater success (Bragg, 2019).
Suppose a business needs to erect a new factory to manufacture more goods. This cost is identified as marginal cost, which varies with the product quantity.
So, in simple terms, marginal cost is an additional cost associated with producing one extra unit of a good or service. This indicator helps to understand better how output levels influence their expenses and thus increase earnings.
10 Examples of Marginal Costs
- The expense of building a new factory: For example, if a company needs to build a brand new factory to produce more goods. This cost would be considered a marginal cost because it is an extra investment required to increase output.
- Cost of increasing raw materials: If a business intends to increase an item’s production, it must acquire additional raw materials to do so. This expenditure is referred to as marginal cost.
- Expenditure of hiring new workers: When an organization wants to produce one additional product unit, it may need to hire more workers to complete the task. The cost of hiring new employees is marginal.
- Cost of installing new machines: Introducing the latest types of machinery, such as robots or computers, to upsurge production may come with extra expenses due to their need for investment in new technology. These costs are considered marginal costs.
- The expense of increasing energy consumption: All energy consumed for production, whether it be electricity or fuel, is considered an extra cost of manufacture. So, if a factory produces one additional product unit, the energy needed to do so would be a marginal cost.
- Cost of increasing factory maintenance: To maximize production efficiency and ensure longevity in its operations, a business must make an effort to maintain its internal systems. It may come with a marginal cost, yet it is necessary for success.
- Expenditure of increasing advertising: To reach more potential customers, businesses may increase their advertising budget. As a result, they need to invest more resources and incur additional marginal costs.
- Cost of increasing research and development: When companies are trying to develop new products or improve existing ones, they need to allocate additional resources and incur associated costs such as workforce, software, etc. These are all considered marginal costs.
- The expense of increasing inventory: When a business seeks to bolster its inventory to meet growing customer demand, there is an inevitable cost increase associated with storing and managing the additional products. So each additional unit produced incurs a marginal cost in the form of additional inventory.
- Cost of increasing transportation: If a business is producing one additional unit of a good, it will need to hire extra vehicles or transportation services to move the product from its source to its destination. This cost is considered a marginal cost of production.
How to Calculate Marginal Cost
Marginal cost is calculated as the amount of money that must be spent to produce a single extra unit. It can be done by dividing the change in total cost (ΔTC) by the change in output (ΔQ) (Mankiw, 2016).
The formula for calculating marginal cost is as follows:
Marginal Cost = Change in Total Cost/Change in Quantity.
Production costs can fluctuate based on the production level and how much output needs to be created.
For example, suppose a company must hire additional labor and buy more raw materials for an increased production volume. In that case, it will inevitably result in a total cost change.
Unavoidably, the amount of production will either increase or decrease according to its level. Therefore, dividing the change in total cost by the change in output allows for an accurate marginal cost calculation (Mankiw, 2016).
For example, suppose the total cost of manufacturing 10 units of a product is $20, and the total cost of producing 11 units of that product is $25. In that case, the marginal cost of producing an additional unit is calculated as follows:
Marginal Cost = (25-20)/(11-10) = $5/1 = $5.
It means that the cost of production of an additional product unit is $5.
The formula mentioned is the perfect choice when multiple units are being produced. Nonetheless, managers should be aware of varying marginal costs between different production groupings.
Marginal Costs vs. Average Costs
While marginal cost focuses on the change in total costs due to an increase or decrease in production, average cost compares the overall costs of production to the overall output.
Marginal costs are the expenses associated with generating one more product unit.
When operations become more efficient, or economies of scale are achieved, marginal costs often decrease over time. Nevertheless, there may come a moment when it becomes pricier to create an additional item (Pindyck & Rubinfeld, 2018).
On the other hand, average costs are calculated by dividing the total cost of production of specific goods by the number of units produced.
Average cost may contrast with marginal cost, as the latter will rarely remain stable across each unit. Marginal cost encompasses only one unit’s cost, whereas average expense typically indicates all units produced (Pindyck & Rubinfeld, 2018).
The Significance of Marginal Costs Calculation
Calculating marginal costs is essential for organizations and businesses that rely on production. It allows managers to identify possible cost savings in their operations and make more informed decisions regarding allocating resources.
Managerial accounting is vital for businesses to maximize production through economies of scale, and marginal cost plays a crucial role in that process.
Here are some of the reasons why calculating the marginal cost is so important:
- Monitor production costs: Marginal cost outlines the amount spent to produce an additional unit. This indicator is crucial for businesses to measure their production costs and ensure they remain within budget (Bragg, 2019).
- Understand the effect of production on costs: Companies must be able to figure out the marginal cost of each unit produced to measure how changes in output levels might affect the overall costs.
- Make decisions about pricing: A marginal cost is a handy tool for companies to set prices for their goods and services. By taking into account marginal and average costs, firms can establish prices that will cover their expenses and generate profits (Bragg, 2019).
- Evaluate potential production facilities: Marginal cost calculations allow managers to evaluate which production facilities are most suitable for their needs. For example, suppose the marginal cost is higher in one facility than in another. In that case, investing resources in the latter option may be wise.
- Maximize profits: Companies can maximize their profits by using marginal cost to identify the optimal production level. If a company produces too little, it may not be able to realize the economies of scale (Mankiw, 2016). In contrast, if it produces too much, it may incur higher costs due to overproduction. By focusing on marginal cost, businesses can generate the maximum profits possible.
Other Types of Costs in Economics
- Mixed Costs: Mixed costs, also known as semi-variable costs, are business expenses that have both fixed and variable components. In simpler terms, it’s a cost that fluctuates according to the amount of production.
- Sunk Costs: Sunk costs are defined as expenses that have already been incurred and cannot be reversed or recovered.
- Implicit Costs: Implicit costs are economic costs incurred by a business that do not directly involve monetary expenditures.
- Opportunity Costs: Opportunity cost is the cost of giving up one opportunity in order to take another one.
Marginal costs are the additional costs associated with producing one more unit. This calculation is essential for managers to understand how changes in output levels can affect overall costs and to make decisions about pricing, production facilities, and profits.
For example, the cost of building a new factory is marginal since it is an extra cost associated with producing one more unit.
Marginal costs can be easily calculated by dividing the change in total cost by the difference in the quantity of output.
Calculating marginal costs is a critical practice for businesses that rely on production. In such a way, managers can identify possible cost-saving opportunities and make strategic decisions regarding allocating resources to get maximum profit.
Bragg, S. M. (2019). Cost accounting fundamentals: Essential concepts and examples. Accounting Tools Inc.
Mankiw, N. G. (2016). Principles of microeconomics. Cengage Learning.
Pindyck, R. S., & Rubinfeld, D. L. (2018). Microeconomics (9th ed.). Pearson.
Soni, A. K., & Nema, P. (2021). Limestone mining in India. Springer Nature.