Marginal revenue (MR) refers to the incremental change that occurs in the revenue or income of a company as a result of the sale of an additional unit of product or service. It determines the quantity of output and the price that each unit of a product should be sold to maximize profits.
Revenue is simply the amount of money a company can make from selling its products and services. Being able to analyze and calculate marginal revenue is important. It will help to determine the revenue that is generated by a company by the production of one additional unit of its products or services. To get the monetary value of marginal revenue, two important things need to be considered. The difference in the total advantage a firm got from the goods and services produced previously and presently with one extra unit increase will have to be calculated.
Marginal Revenue makes it possible for a business aiming at maximizing profit to know when to halt further production. For instance, if the marginal revenue exceeds the marginal cost, the business will experience a net loss. This is because the amount of money the firm is spending in the production of an additional unit of the product is higher than what it will get when it is sold. The implication of this is that the firm loses money each time it tries to produce an extra unit of the product.
Marginal revenue usually respects the law of diminishing returns. This law states that a unit increase in the quantity produced will result in a smaller increase in output. When this occurs, it simply means the business has exceeded its optimal level. Each additional production and sale has a cost implication on the business. To ensure profitability, the business should therefore ensure that marginal revenue is above marginal cost.
Formula for calculating Marginal Revenue
The formula for calculating Marginal Revenue is change in total revenue/ change in quantity sold. The formula below is used to denote this:
MR = ΔTR / ΔQ
MR = Marginal revenue;
ΔTR = Change in total revenue; and
ΔQ = Change in quantity
How to find the Marginal Revenue, step by step
Let’s take the example of a business that produces cookies. For this company, the quantity of cookies being produced initially equals 1000 boxes and the cost of production for the 1000 boxes is $30,000. To get the unit cost of producing each box of chocolate, divide the production cost by the total quantity produced.
Unit cost = $30,000 ÷ 1000 = $30.
So, it cost $30 to produce each box of cookies.
The business was able to sell these 1000 boxes of Cookies and made a revenue of $50,000. To get the price of each box of Cookies, divide the total amount of revenue by the total quantity of cookies produced.
Unit price = $50,000 ÷ 1000 = $50
So each box of Cookie was sold for $50
Going further, calculate the profit made on the boxes of cookies:
Profit = $50,000 – $30,000 = $20,000.
The next month, the business decided to add 400 boxes extra to the quantity produced in the previous month. The total quantity produced therefore is 1400 boxes of chocolates. The change in quantity produced in the current month in comparison with the previous month is 400 boxes. It cost the business $35,000 to produce 1400 boxes of chocolate. To calculate the unit cost of production, divide the total production cost by the quantity produced.
Unit cost = $35,000 ÷ 1400 = $25
Invariably, it cost $25 to produce each box of cookies.
From the sale of this quantity, the business made $84,000. To get the profit made on each box of cookies sold, divide the revenue by the quantity sold.
Profit per unit = $84,000 ÷ 1400 = $60
Taking this a little further, calculate the profit made on the sale of 1400 boxes of cookies. This is gotten by subtracting the cost of production from the sales revenue.
Profit = $84,000 – $35,000 = $49,000
Compared with the profit for the previous month ($20,000) the business made a profit of $49,000 by increasing its production quantity by 400 boxes. The additional profit made from the production of extra 400 boxes therefore is:
$49,000 – $20,000 = $19,000
To calculate the Marginal revenue using the formula, you have:
MR = ΔTR / ΔQ
MR = $19,000 ÷ 400
MR = $47.5
Relationship between marginal revenue and total revenue
Total revenue tries to measure the amount of revenue that has accrued to the business from its efforts. The goal of every business is to grow its profit and this affects its total revenue. To achieve this, the difference between their total revenue and total cost has to be maximized. Marginal revenue on the other hand measures the increase in revenue as a result of selling more products and services.
Financial/Managerial applications of Marginal Revenue
Though marginal revenue could be said to be an economic term, it also has so many financial and managerial applications. The following are some of the decisions that management uses marginal revenue to analyze and make.
- Analysis of the overall demand for the product in the market. Businesses go into production and offer services to sell to the customers and make a profit. If a business misjudges the preference of the consumer two things are bound to happen. First, it may result in surplus production which will lead to excess production cost.
- Setting Price of Product. One way of influencing the production schedule and changing the level of demand is fixing of price. The relationship between price and demand is such that a higher price moat times equates to lower demand. This is because every rational consumer wants to get more quantity of the product at a cheaper price. If the price is high, however, the business will make more profit. If the competition sells at a lower price, consumers will switch to competitors and the sales for the business will drop. Knowing the marginal revenue will therefore help the business to fix the right price to maximize profit.
- Plan production schedules. Through marginal revenue, the business can easily determine the demand rate. This will help in planning the production schedule.