The marginal cost refers to the increase in production costs generated by the production of additional product units. It is also known as the marginal cost of production. Calculating the marginal cost allows companies to see how volume output influences cost and hence, ultimately, profits.
Example of marginal cost
Marginal cost is calculated by dividing the increase in production costs by the increase in unit output.
For example, a company starts by paying $100 to manufacture 100 product units. It then pays an extra $50 to manufacture an extra 100 product units. The initial production cost is $1 per unit. The marginal cost, however, is $0.50 per unit ($50/100).
It’s important to note that changes to production costs are not necessarily linear. For example, some companies may find that there are certain threshold points where costs change significantly. In between these points, however, changing output volume may have little to no effect.
Likewise, where industries have highly variable costs, any marginal cost calculation may only be accurate for a relatively short period. Companies would therefore have to balance the potential for economies of scale with the ability to produce the goods while the costing data used remained valid.
The mechanics of marginal costs
Most companies have to deal with two types of costs. Fixed costs typically relate to the running of the business itself. For example, rent, standard utility costs and core salaries need to be paid regardless of production volume.
Variable costs, by contrast, increase and decrease according to the level of production. In many cases, however, the increase in variable costs will be less than the increase in production output. In economics, this concept is referred to as the economies of scale.
In simple terms, it’s often easier for producers to fulfill a small number of large orders than a large number of small orders. As a result, producers often incentivize buyers to place the largest orders they can by offering more attractive prices on larger purchases.
This is why manufacturers often need a minimum production run just to reach a break-even point. After this, however, any increase in the production volume tends to increase variable costs at a lower rate.
The importance of marginal costing
Marginal costing is important for both accounting and everyday management. It provides a basis for optimizing production levels to minimize the cost of goods sold (COGS). This in turn minimizes operating expenses (OPEX).
When companies minimize their costs, they maximize their room to maneuver. For example, if they have debt, they can choose to repay it more quickly. This can reduce their interest expense and hence improve their profitability over the long run.
Alternatively, they may choose to reduce the selling price of their goods to make them more attractive in comparison with the competition. If this resulted in an improved sales volume, their overall level of profitability might stay the same (or improve).
Another option would be to increase their payments to company owners. For example, the company might choose to offer bonuses to directors (and employees) and/or increased dividends to shareholders.
The limits of marginal costs
In accounting and economics, the benefits of marginal costs may, theoretically, be infinite. In the real world, however, the benefits of economies of scale have to be balanced with the need to manage inventory.
Most products have an effective shelf life. They tend to have the highest value at the start of their life cycle and decrease in value (depreciate) as their life cycle draws to a close.
If a company increases its production volume to the extent that it produces more goods than it can sell, then it may end up needing to write off its inventory. It will then need to absorb the production costs at the expense of its overall profit.