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Marginal cost refers to the expense you (or your business) incur when producing additional units of a product or service. It is often referred to as the 'cost of the last unit.' Understanding marginal cost is essential for maximizing profits. To calculate it, divide the change in total cost by the change in the quantity of output.
Steps
Determine the Change in Output Quantity
Identify the production level where fixed costs will change. To calculate marginal cost, you need to know the total cost of producing one additional unit of output. Fixed costs remain constant during cost analysis, so you must identify the output level at which fixed costs increase.
- For example, if you own a cupcake bakery, your oven is a fixed cost. If your oven can bake 1,000 cupcakes a day, then 1,000 is the maximum quantity you’ll use for cost analysis. If you produce more than 1,000 cupcakes, your fixed costs will change because you’ll need to purchase additional ovens.
Determine the interval you want to evaluate. You might want to calculate the marginal cost for each unit of output. However, this approach is generally useful only if your product or service has a relatively low daily output. Otherwise, you may need to consider changes in quantity in intervals of 10, 50, or even 100 units.
- For example, suppose you own a spa offering massage services with 3-5 sessions per day, and you want to calculate the marginal cost of adding one more session. In this case, 1 unit is a reasonable interval.
- If you run a manufacturing business, you might need to consider larger output intervals. For instance, if your company produces 500 products daily, you may want to calculate the marginal cost of producing an additional 100, then 200 products, and so on.
Tip: If you struggle to determine the interval for evaluation, start with a smaller range. If the marginal cost you calculate is extremely small, you can recalculate using a larger interval.
Subtract the number of units in the previous batch from the number of units in the next batch. Each interval represents a production batch. To find the change in output, simply subtract the old output from the new output.
- For example, if your company produces 500 products daily and you want to calculate the marginal cost of producing 600 products daily, your change in output will be 100.
Determine the Change in Cost
Calculate the total production cost. Total cost includes both fixed and variable costs for a specific quantity of output. Fixed costs remain unchanged during the evaluation period, while variable costs can fluctuate depending on the situation.
- Capital investments, such as equipment, are typically fixed costs. Monthly rent payments are also fixed costs.
- Variable costs include utilities, employee wages, and materials used to produce the product or service. These costs are variable because they usually increase as production levels rise.
- Calculate variable costs for each output level or production interval. Add variable costs to fixed costs to determine the total cost.
Tip: The total cost for each output level or production interval is the only figure you need to calculate marginal cost. While knowing the proportion of fixed and variable costs isn't necessary for this calculation, it can be useful in other contexts.
Calculate the average cost per unit. Once you have the total cost, you can determine the average cost per unit of output. For each production level or interval, simply divide the total cost by the number of units.
- For example, if the total cost to produce 500 products is $500, the average cost per unit would be $1. However, if the total cost to produce 600 products is $550, the average cost per unit for that quantity would be $0.92.
- You can also calculate the average fixed cost and average variable cost.
Tip: Although average cost figures aren't used to calculate marginal cost, they can help you determine the optimal production level to maximize profits for your product or service.
Subtract the old cost from the new cost to find the change in cost. The change in cost is calculated similarly to the change in quantity. Subtract the cost of the smaller production level from the cost of the larger one. This figure represents the change in cost for that specific interval.
- For example, if the cost to produce 500 products is $500 and the cost to produce 600 products is $550, your change in cost would be $50.
Find the Marginal Cost
Divide the change in cost by the change in output. The formula for marginal cost involves dividing the change in cost by the change in quantity. Once you’ve determined the total change in cost and the change in output, you can use these figures to calculate marginal cost quickly and easily.
- For example, if you want to calculate the marginal cost of increasing production from 500 to 600 units per day, and the change in cost is $50 while the change in output is 100, the marginal cost would be $0.50.
Repeat the calculation for additional intervals. Marginal cost can increase or decrease as you continue to scale production. Your ultimate goal is to produce goods or services at the lowest possible marginal cost.
- For instance, the marginal cost of producing 600 units instead of 500 might be $0.50. However, the marginal cost of producing an additional 100 units (700 units) could drop to $0.32. This means producing 700 units is more cost-effective than producing 500 units.
- Marginal cost doesn’t always decrease. Eventually, it will rise. For example, if hiring an additional worker is necessary to produce 800 units, the marginal cost might increase to $0.52.
Input the data into a spreadsheet to create a cost curve. By entering your data into a spreadsheet, you can generate a graph that illustrates the marginal cost for each production interval or output level. The marginal cost curve typically takes a U-shape, starting high at the beginning of the graph where additional units incur higher costs.
- Plotting this data allows you to identify the most cost-efficient production level for your business.
Tip: If you’ve calculated average total cost and average variable cost, you can also plot these on a graph. These curves will also form a U-shape, though they will appear later on the axis compared to the marginal cost curve.
