How to Calculate Marginal Cost: A Step-by-Step Guide
The concept of marginal cost can be difficult for business owners to understand. However, understanding how to calculate marginal cost is essential to good forecasting and business management. With that in mind, we’ve created a step-by-step guide detailing everything from the importance of marginal costs and formula examples.
Below, we’ll examine critical concepts involving the use of marginal cost. Highlights include the relation between variable and fixed costs, the related concept of marginal revenue, and how these are used to determine the optimal point at which a business can make the most profit. In addition, we’ll show you a formula that demonstrates how to find the marginal cost of goods.
The Importance of Marginal Cost
Knowing how to calculate marginal cost is important because every business should strive to expand to a point where marginal cost is equal to marginal value. So, let’s start by exploring what marginal cost is and how to find the marginal costs associated with your business.
Marginal cost is the added cost to produce an additional good. For example, say that to make 100 car tires, it costs $100. To make one more tire would cost $80. This is then the marginal cost: how much it costs to create one additional unit of a good or service.
The costs of production determine the marginal cost. These include fixed and variable costs. Fixed costs are things like monthly rent and utilities. Variable costs are things that can change over time, such as costs for labor and raw materials.
A good example is if demand for running shoes for a footwear company increases more machinery may be needed to expand production and is a one-off expense. However, it does need to be accounted for at the point the purchase takes place. Usually, marginal costs include all costs that vary with increases in production.
A U-shaped short-run Average Cost (AC) curve. AVC is the Average Variable Cost, AFC the Average Fixed Cost, and MC the marginal cost curve crossing the minimum of both the Average Variable Cost curve and the Average Cost curve.
The Marginal Cost Curve
The marginal cost curve is the relation of the change between the marginal cost of producing a run of a product, and the amount of the product produced. In classical economics, the marginal cost of production is expected to increase until there is a point where producing more units would increase the per-unit production cost. Calculating marginal cost and understanding its curve is essential to determine if a business activity is profitable.
The Marginal Cost Formula
How do you find the marginal cost? There’s a mathematical formula that expresses the change in the total cost of a good or product that comes from one additional unit of that product. Knowing this formula is essential in learning how to calculate marginal cost. It is called the marginal cost equation or marginal cost formula.
Marginal Cost = (Changes in Costs)/(Changes in Quantity)
This is an important formula for cost projections and determining whether or not a business activity is profitable.
- Change in Total Cost is the usual net fixed and variable costs that go into the production of goods. Variable costs include labor, raw materials, and so on.
- Change in Quantity refers to an obvious increase in the number of goods produced.
A Marginal Cost Formula Example
Here is an example of how to calculate marginal cost:
Big Dynamo is a toy company that produces robot toys. Every month, they produce 2,000 robot toys for a total cost of $200,000. They expect to produce 4,000 robot toys next month for $250,000.
Current production amount
Current production cost
Future production amount
Future cost of production
Marginal Cost Formula
Since we know that Marginal Cost = (Change in Total Cost)/ (Change in Quantity), we have:
Change in total cost = (250,000-$200,000) = $50,000
Change in total units = (4000-2000) = 2000
So, the marginal cost equals $50,000/2000 = $25
Note that the marginal cost represents the change in the cost of a good, not the total cost of the good itself. This $25 represents the margin change.
Marginal Cost Pricing
Marginal cost pricing is a strategy that some businesses use to either regain market share or to increase cash flow. This where a company will lower the price on a product so that what is earned from a sale is what a product costs to produce, with no profit. Companies can do this for an enormous number of reasons, some of them actually rather shrewd, such as:
- Generating cash to pay off an upcoming debt payment.
- Lowering prices on a popular product so as to increase market share and win a larger portion of a market, with plans to slowly increase prices back to prior levels, or even increase them as the company approaches monopoly status.
- Get rid of old stock and clear their distribution chain for new products. This can help a company by reducing transportation and inventory storage expenses.
- Increase demand for a poorly performing product.
- When used in conjunction with skilled planning and marketing, margin cost pricing can be an excellent tool to use in sales, increasing liquidity, and so on.
In addition to marginal cost pricing, it’s vital you create a competitive cash flow analysis. Doing so will allow you to forecast, and prepare for, a variety of financial scenarios for your business.
Synario has Your Solutions
Finance teams can run into trouble when forecasting marginal cost into the future. As your organization changes, your marginal cost formula may have to change with it. Updating that formula over time based on the completion or implementation of capital projects and initiatives can be a daunting task in a spreadsheet-based financial model.
Fortunately, Synario solves this challenging problem for CFOs and their finance teams. Custom formulas and ratios (like marginal cost) can be updated based on different factors or changed across different scenarios.
Synario’s proven suite of financial modeling tools can help you make intelligent business planning decisions. Contact us to discuss how our tools can help you more clearly understand the factors which comprise your business.