Marginal cost describes the additional cost incurred by producing additional units. It is a function of production efficiency, taking into account both fixed and varied costs. To produce these additional units, a business may need to hire more workers and use more raw materials, which are examples of variable costs. If the additional units require increased machine capacity, the business owner may choose to buy another machine, a fixed cost. As seen in the graph below, fixed costs commonly stay static over time, while variable costs will increase as production is increased. The total cost is the variable cost plus the fixed cost. A threshold will eventually be reached when fixed costs will rise (e.g. by purchase of a larger building, machinery, etc.) in order to facilitate expanded production.
Marginal cost is then determined by dividing the total change in the cost of producing additional units by the change in units produced. It is important to understand marginal cost, so a business can maximize its revenue while keeping costs low. It can help determine if expanding production capacity will have a positive or negative effect on the cost of goods sold. Marginal cost calculations can also help to predict different cost scenarios if demand for the company’s products were to increase or decrease.
This article will provide the Marginal Cost formula, how to calculate step by step, and give you examples on how it can be applied to different situations.
Marginal Cost Formula
Marginal Cost = Change in Total Cost / Change in Quantity
Marginal cost is calculated by adding together variable and fixed costs, noting the difference between current and future state, and then dividing this by change in quantity of units produced.
Marginal Cost Calculation Step by Step
- Determine the change in Total Cost. You can do this by adding the fixed and variable costs from production run 1 and production run 2 (when units have increased), then subtracting Cost (Production 2) from Cost (Production 1). This will give you your change in total cost.
- Determine the change in Quantity. Note the additional units that will be produced in the increased volume production run.
- Divide change in Total Cost by change in Total Quantity. This will produce the Marginal Cost result, given as a dollar figure.
A bakery currently produced 200 croissants a day at a cost of $100. They secure a contract to produce an additional 300 per day for a local restaurant. In order to fulfil their contract, they will need to order $15 more in ingredients, and hire an additional baker at $12/hr for 3 more hours a day.
To solve for Marginal Cost;
51300 = $0.17
Calculating Marginal Cost in Excel
To calculate Marginal Cost in Microsoft Excel, let’s take an example from a fictional business that manufactures tennis rackets.
The owner wants to calculate tfhe marginal cost of producing 1000 more tennis rackets per year over 5 years. The spreadsheet would be formatted as below:
First, calculate the total cost per year by entering the following formula in cell B9:
And copy the formula across to column F in the same row. This will give you the Total Cost for all years.
Next, calculate Marginal Cost by entering this formula in cell C10:
This will give you the Marginal Cost. For 1,000 additional units, there will be a marginal cost of 10 cents per unit.
Copy the formula across the row to Column F:
With the hire of an additional worker in Year 3, and an additional machine in Year 4, the marginal cost is increased significantly. It is not until Year 5 where the tennis racket manufacturer begins to see economies of scale, with the marginal cost dropping to 5 cents per additional unit.
Economies of Scale
When production becomes more efficient, a business may enjoy what is known as ‘economies of scale’. Economies of scale are cost advantages from increased production without an increase to fixed costs. The costs of production are spread over a larger number of units. Perhaps the business has unused warehouse space to expand or only needs to hire a minimal number of extra workers to accommodate increased production. Marginal cost can help calculate whether a business is achieving economies of scale; as marginal cost decreases, a business is usually more profitable.
Conversely, if marginal costs increase, businesses may undergo diseconomies of scale. Costs may increase to the point where they meet marginal revenue and suffer from negative cash flow. This may happen if a company becomes inefficient in production, whether it be from errors or breakdown of machinery, or lack of staff motivation for example. Prices to consumers must go up to compensate from the higher cost of production to keep a business profitable. The marginal cost calculation is therefore also critical to help determine product pricing.
The Bottom Line
It is imperative to have a sound understanding of marginal cost in order to increase efficiency and profitability for any business or manufacturer. Having a low cost per unit gives a business the potential to enjoy higher profits, and potentially higher net income, which can then be distributed to shareholders/owners or reinvested into the business.