Marginal Cost is simply the change in total production cost that is a direct result from making or producing one additional unit. The sole purpose of analyzing marginal cost is to determine at what point an organization can achieve economies of scale to optimize production and overall operations. If the marginal cost of producing one additional unit is lower than the per-unit price, then the producer may likely gain some profit.
Marginal Cost Definition – What is Marginal Cost?
Marginal cost can simply be defined as the increase or decrease in the total cost of a production process in order to produce one additional unit of item. They are variable costs that consist of labor and material costs, plus an estimated portion of fixed costs like administration overheads and selling expenses.
Marginal cost is computed in cases where the breakeven point has been reached: the fixed costs have already been absorbed by the already produced items and only the direct (variable) costs are to be accounted for.
How Marginal Cost of Production Works
The marginal cost of production is an economics and managerial accounting term that is mostly used amongst manufacturers in a bid to isolate an optimum production level.
Manufacturers most times examine the cost of adding one more unit to their production schedules and at a certain level of production, the benefit of producing one additional unit and generating revenue from that item will bring the overall cost of producing the product line down.
Thus, the key to optimizing manufacturing costs is to discover that point or level as fast as possible.
The marginal cost of production covers all of the costs that vary with that level of production, and the amount of marginal cost differs according to the volume of the product being manufactured.
Marginal cost is a vital factor in economic theory. This is because a company that is looking to maximize its profits will produce up to the point where marginal cost is equal to the marginal revenue. But beyond that point, the cost of producing an additional unit exceeds the revenue being generated.
Marginal Cost Formula – Formula For Marginal Cost
The formula for calculating marginal cost is:
Marginal Cost = (Change in Costs) / (Change in Quantity)
Importance of Marginal Cost in Business Operations
The marginal cost is a factor to consider when carrying out financial analysis. This is important as management evaluates the price of each good or service being offered to consumers.
If at any point, the selling price for a product is greater than the marginal cost, then earnings we still are greater than the added cost, which is a valid reason to keep up with production. If on the other hand, the price is less than the marginal cost, losses will be incurred and therefore is an indicator that additional production should not be pursued, or perhaps prices should be increased. This becomes an essential piece of analysis to consider for business operations.
What Field of Jobs Use the Marginal Cost Formula?
Marginal cost is used by professionals working in a wide range of corporate finance roles to calculate the incremental cost of production as part of routine financial analysis.
It is also used by accountants working in the valuations group, who may perform this exercise calculation for a client.
An analyst who is in investment banking may include it also as part of the output in their financial model.