When discussing what marginal cost is and its uses in business, there are some terms that need to be explained, particularly when plugging in the number to calculate the marginal cost value. In non-technical language, marginal cost is the added costs associated with producing additional numbers of a product or service. It is a simple calculation, arrived at by dividing the change in costs by the change in the number of additional units produced, as shown here:
Marginal Cost = Change in Costs / Change in Number of Additional Units Produced
The purpose of calculating the marginal cost is to increase the cash flow of a business by incorporating it into financial modeling. Now let’s define precisely what each of the terms mean in more detail, as they are essential to arriving at the most accurate number.
Change in Costs
The production cost of any product or service is directly connected to what is required to produce a single item. The number of factors that influence the cost largely depends on the complexity of the item. If hiring an additional person is needed to produce an additional unit, the cost of the employee is directly connected to the production of the item, and must be included in the calculation. If additional raw materials are required to produce an additional unit, then the costs of the material are to be included in the Change of Costs calculation.
To accurately reflect the effect of Change in Costs in marginal cost, the values must be calculated on a per batch basis. Batch 1 production costs need to be deducted from Batch 2 production costs when the output of the number of Batch 2 units is greater than that of Batch 1. However, the difference between the two batches must be significant enough to determine whether calculation marginal cost has any benefit. This value will be arrived at over time.
Change in Number of Additional Units Produced
This is a value determined by simply subtracting the produced units of Batch 1 from the produced units in Batch 2. It is highly unlikely that two batches will produced exactly the same number of units, so this calculation needs to be constantly done on a comparative basis.
While the marginal cost formula is relatively straightforward, the complexity lies in determining the variable costs of specific units. The most common variable costs will be:
- labor and materials
- estimated increases in fixed costs
- selling expenses
Let’s use an example to illustrate what has been discussed about the marginal cost calculation.
Marginal Cost Formula Example
Alpha Company produces 10,000 units of widgets every calendar year. The total cost of producing these 10,000 widgets is $5 million. Due to increased demand from lower prices, demand for the widgets increases dramatically. That demand has the company raising the total number of widgets produced from 10,000 per calendar year to 15,000. The additional cost of producing the widgets, including the purchase of more raw materials and the additional hiring of employees, raises the annual cost of production by $2.5 million to $7.5 million.
The marginal cost for the calendar year is calculated by:
Change in Costs ($2.5 million) / Change in Number of Additional Units Produced (5,000) = $500.
Practical Application of Marginal Cost
If your marginal cost is greater than the sale price on a per unit basis, the company will lose money. In the example, if it costs $500 to make a unit that is selling for $450 per unit, the company will lose $50 per unit. The reverse is true if the sale price is $550 with the same $500 marginal cost.
The Economy of Scale Factor
A simple way of looking at the impact of economy of scale is to think of a manufacturing business that has considerable warehouse space. That space can either be empty (wasted) or filled with product to ship (used for its intended purpose). The business will be paying for that space either way, so it makes business sense to occupy as much space in that warehouse as possible to maximize its benefit (provided the product will sell in a reasonable amount of time).
When analyzing marginal cost, this is one of many economy of scale factors that will drive the decision on future production quotas and planning. For example, if additional warehouse space is needed to be purchased or constructed to store the additional units produced, this will directly impact the marginal cost.