Formula For Marginal Cost

By Sean Stevenson – Latest Revision February 28th, 2021

What Is A Marginal Cost Formula?

Marginal cost is the relative cost of producing an additional good or service.  The formula for marginal cost reveals this incremental trend in greater detail.

Example

It may cost $20 to produce 10 sweet cakes.  However, producing an additional sweet cake would cost $1.60.  This additional cost would be the marginal cost that occurred after the initial 10 sweet cakes had already been produced.

Marginal costs consist of both variable and fixed costs.  Fixed costs remain the same, no matter the circumstances.  However, variable costs tend to rise as marginal costs increase in turn.

Formula For Marginal Cost

Note that the fixed costs remain the same, whereas the variable costs tend to rise alongside marginal costs (as the quantity produced increases). 

Why Marginal Cost Is Important

Marginal costs allow a business to better understand its own expenditures.  This gives an enterprise a great utility in working to maximize a business model’s efficiency. 

When marginal costs are minimized, a business can maximize its profitability.  Ideally, a company will strive to lower its marginal costs while increasing its marginal revenue.

If a company’s marginal costs equal its marginal revenue, then the business is not profitable.  In fact, it would not be making any money.  This is often referred to as profit maximization.  It tends to herald a very troubling situation for a business.

Example

In the graph below we can see both the marginal revenue and the marginal cost.

As the company benefits from a prosperous economy, the marginal revenue increased, while marginal costs decreased.

However, as the company grew stagnant and less productive over time, we can see an inverse of these trends.  When the marginal costs have met the marginal revenue, a dire inefficiency has occurred.  This could be due to managerial failure, a shift in the economy, or a demotivated workforce.

Regardless of the cause, in the event of the marginal cost equalling the marginal revenue, production will have to be halted. 

Formula For Marginal Cost

Note the intersecting point between the marginal cost and the marginal revenue.  At this point, when the marginal cost equals the marginal revenue, there is no longer any profitability in continuing the enterprise.  Production will typically be halted at this point.

Using The Marginal Cost Formula

Marginal cost can be calculated by using the following formula:

Formula For Marginal Cost

Example

If a business is producing 100 items for $50 total, then that initial production would represent a base amount for us to go by. 

Once this same business wishes to produce 100 additional units at $45 total, the change in total cost would now be $45.  This would then be divided by the change in quantity, which is still 100 more units. 

In this instance, the formula would therefore be:

Formula For Marginal Cost

After we divide our numbers we get our answer.  In this instance, there will be an additional marginal cost of $0.45 for each unit produced.

1. What is “Change in Total Costs”?

As the production cycle continues, there may be periods of time where the production costs incurred can increase or decrease.  This can often be attributed to varying levels of demand in the market.  

Example

During peak demand, more production is required.  Conversely, during slower periods, a lowered level of productivity may be more ideal.

To keep up with demand, a factory has hired several new workers.  While the productive output will increase overall as a result, so too will the associated costs.

Formula

In order to determine a change in costs, subtract the initial production cycle costs incurred from the next batch of production costs. 

The formula would look something like this:

Formula For Marginal Cost

After we subtract our initial production costs from the first cycle with the second production costs from the following cycle, we get our answer.

2. What is “Change in Quantity”?

As its name would imply, a change in quantity refers to the varied levels of production that naturally produce a higher or lower overall output.  As more goods or services are produced, we are seeing an increase in the change in quantity.  Conversely, as less goods or services are produced, we would be seeing a decrease in the change in quantity.

A shift in general output will inevitably impact the marginal costs as well.

Example

As more goods are being manufactured, the factory sees an increase in its output.  This would represent an increase in the change in quantity.

Formula

To understand the trend of the change in quantity, subtract the output of the first production cycle from the output of the second production cycle.  This will give you the relative increase or decrease that has occurred.

The formula will look something like this:

Formula For Marginal Cost

Marginal Cost Formula Example

Bohan Pharmaceuticals are producing vaccinations at a break-neck pace.  The reality is, they simply cannot keep up with demand in the market.

Currently, they manufacture over 200,000 of a particular vaccine, which costs them $10,000 per annum.

In order to keep up with demand, the company decides to purchase more machinery, and hire more employees.

Overall, their efforts result in 300,000 units being manufactured in total, at the cost of $15,000 per annum. 

Analyzing this trend, you can easily distinguish the additional cost per unit produced using this formula:

Formula For Marginal Cost
Formula For Marginal Cost

Above, dividing the new amount by the new associated cost, we reach the additional cost per unit.

Who Uses The Marginal Cost Formula?

Many professionals working in corporate finance would be constantly analyzing the costs associated with their production process.  Regardless of whether they produce goods or services, the marginal cost would be something that they would inevitably hope to improve upon.

However, finding ways of improving a business model is not easy.  It takes continuous cycles of improvement and route financial analysis to discover better ways of moving forward.

An accountant working for a large corporation would be constantly vigilant towards increasing or decreasing marginal costs.  They may make suggestions or offer insights as to why marginal costs are fluctuating (or remaining steady).

An investment banker may include marginal costs as part of their financial models.  This can grant a deeper insight into the nature of a company’s overall process and productive output.

In general, there are many ways the marginal cost formula can be used.  Marginal costs themselves are something every active business hopes to minimize, so as to maximize profits.

How Important Are Marginal Costs In Business?

In a word, crucial.

The marginal cost is a key indicator of how profitable a business model can ultimately become.  If the marginal costs are too high, then a business will never thrive.  Conversely, if a well-managed and minimized marginal cost would indicate that a business could potentially prosper.

It is imperative for management to constantly evaluate the potential revenues of their goods and services as they are offered to the consumer.  At the same time, they must also consider the best ways to approach the related marginal costs associated with their production process.

Example

In the event where the sales price for a good or service is higher than the marginal cost, then the earnings will be positive.  The added costs will not surmount the earnings, and there will be cause to continue production within the business model.

However, if the sales price for a good or service is lower than the marginal cost, then the earnings will be negative or neutralized.  The added costs will equal or surmount the earnings, and there will be no cause to continue production within the business model.

Key Takeaways

  • The dire nature of marginal costs should illustrate its importance in a business setting!
  • If the marginal costs are too high, the business will fail.
  • If the marginal costs can be managed and kept low, the business will ensure its own profitability over time.

History of Marginal Cost

The marginal cost doctrine was predicated upon the attainment of economical efficiency by accurately understanding price signals within the greater economy.

For a business to thrive, it needs to understand its own model and associated marginal costs indefinitely.  These can then be compared to the active market, which will associate pricing for the goods or services the business wishes to sell to consumers.

Professor Alfred E Kahn’s magnum opus and two volume book, The Economics of Regulation (1970 and 1971 respectively), encouraged this efficiency.  Kahn postulated that marginal cost pricing was the key to allowing any business model to efficiently service their market.  It allowed a more proactive approach to responding to the needs of consumers and the seasonality of industry.

From a practical perspective, marginal cost formulae also offer a better way to use limited resources.  Since labour and productive capacities are always limited, it is best for a company to use them as wisely as possible.  This means making effective use of all available resources while navigating a highly competitive marketplace.

If consumers purchase less of a good or service, then they are effectively voting for the economy to put less resources into their production.  However, if they are buying more of something, then they clearly wish for more of that particular product to be produced.  This also means directing more resources towards that poplar products productive process.

Ideally, the price would be as fair as possible, given the marginal costs in producing said product or service.

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