Marginal Cost Definition, Formula, Example and Importance
Table of Contents
Marginal Cost Definition
Marginal cost is the additional cost spent in producing any additional unit of goods.
Marginal Cost Formula
Marginal Cost = Change in Total Cost (ΔTC)÷Change in Quantity(ΔQ)
Marginal Cost Example
An example is; that it costs $20 to produce 10 bars, and to produce any other chocolate bar would cost $0.2. The $0.2 is the marginal cost in this case. To calculate marginal costs, divide the change in the cost of production by the change in the number of goods produced.
Marginal cost is inclusive of both fixed and variable costs. However, they are only calculated in fixed costs when required to expand production. Marginal cost automatically includes variable costs.
Importance of Marginal Costs
1. Facilitates estimating profits
Since marginal benefits are the extra profits from the additional production units, businesses can forecast the profits to earn over time.
2. Enables business to stop at optimal production
Once a company reaches its optimal production level, then the production of an additional unit will increase the cost of production. Therefore, businesses can measure their optimal point of production by managing when to stop producing additional units.
3. Used to leverage from specialization and division of labor
Marginal costs help to measure the change in the cost of production from an additional extra unit. Businesses get the chance to take advantage of division of labor and specialization, which lowers the cost of production of additional units.
4. Creates more value for customers’ money
Customers also benefit from marginal costs as they can purchase an additional unit or service at will. Businesses will create deals like lowering the cost of a unit if one buys an extra unit. Often customers will be willing to pay for an extra unit if the price is lower.
5. Enhances Cost-benefit analysis
Marginal costs are crucial in decision-making. It follows a cost-benefit analysis. Determining that marginal cost does not exceed the sale price justifies the production of an extra unit.
How Do Fixed Costs Affect Marginal Cost
Total cost comprises the sum of fixed costs and variable costs. The fixed costs can only affect the marginal costs when variable costs exist. Fixed costs are expenditures that remain constant regardless of the number of units produced.
Examples of fixed costs are salaries and wages, rent, and insurance. Fixed costs are payable regardless of whether the production has increased or decreased.
In other words, the fixed cost will remain constant regardless of whether the business decides to produce an extra unit. Therefore, if the production of goods and services only affects the fixed costs, then the marginal costs will always be zero. It assumes no variable costs exist.
How Do Variable Costs Affect Marginal Cost
Unlike fixed costs, variable costs vary depending on production volume. The more the production volume, the higher the variable costs will be. It means that if a business decides to produce extra units, the variable costs will increase in the same proportion.
If the business has a higher variable cost than fixed costs, it will result in a very constituent gross margin, operating margin, and profit margin.
How Do Economies of Scale Affect Marginal Cost
Economies of scale refer to an economic situation where businesses increase output volume while simultaneously cutting down costs.
Businesses get an advantage because the higher the production of units, the lower the cost. It means that a business incurs lowers fixed costs per unit of production. The lower the fixed cost per unit, the lower the marginal cost.
How Do Diseconomies of Scale Affect Marginal Cost
Diseconomies of scale refer to the economic situation where an increase in the production of units increases the cost per unit. It happens when the economies of scale no longer function or a firm, whereby there is a steady cost increase as the output increases.
In that situation, the company has grown, so managing it becomes challenging, resulting in unnecessary costs for the company. Diseconomies of scale result in to increase in fixed costs per unit of production hence an increase in marginal costs.