Marginal cost is a unique concept. The calculation is used to determine the cost of output for additional units in production. This extends past the initial cost of production for a set number and considers the additional units to produce.
The formula used to calculate the marginal cost is the change in total cost divided by the change in quantity. This formula will include fixed costs as well as variable costs for production.
Understanding how to calculate the marginal cost and how these costs will affect production is significant. Businesses should use these calculations to make an educated decision on production. Read more to learn all the tips for calculating marginal cost and more.
How To Calculate Marginal Cost
The intent behind the marginal cost formula is to determine what it will cost to expand production. This can help a business determine whether or not expanding production is worth it for their business. The goal is to understand the financial impact of expanding production.
The business in question can use calculated marginal cost to determine how much they can expand production or if it is a bad idea altogether. When you use the formula, understanding the costs that should be used is critical.
For example, you will use both fixed and variable costs. However, not all fixed costs will be included. In terms of fixed costs, you will only include certain items and those are only costs that are directly associated with the cost of expanded production.
Here is another look at the marginal cost formula that is used for the calculation.
Marginal Cost = Change in Total Cost
Change in Quantity
There may be some footwork that needs to be completed before plugging in numbers to the formula. You will need to determine just what the costs are that should be included and then determine a total for those costs.
This will look different for every business and will depend on the production processes as well as any equipment needed to increase production. If you need to purchase a new machine to accommodate that increase, this should be included in your total cost number.
The formula itself can be simple to understand but determining just what numbers are part of each distinct element of the formula could be challenging. Consider things like labor, raw materials, and the cost of materials. Will you need to hire more employees or make other investments to accommodate the change?
Likewise, if you are considering decreasing production, you will think about how this could save you money rather than cost you money.
The number for change in quantity is much easier to come up with. This is truly the difference in the increase or decrease of the quantity of units you are considering adjusting your production to.
Let's break down this formula more.
How To Find Marginal Cost
As you strive to determine the marginal cost for adjusting production numbers, considering the elements of the formula will be important. Calculating marginal cost will do you no good if you don't get the numbers right for your calculation.
The next sections of our guide walk you through determining your change in total cost and the change in total quantity so that you can plug those numbers into the provided formula.
Change In Total Cost
The change in total cost is the first step in the formula but what does that mean? If standard production is 10 units but you want to consider expanding to 15 units, the total cost is going to look at the difference from 10 to 15 units. In this case, there is an excess of 5 units.
For this number, you will need to figure out what the total cost is for 10 units and the total cost for 15 units. You will then subtract the cost of 10 units from the cost of 15 units. This is your change in total cost.
Here is an example. If a single unit costs $100 to create, your cost for 10 units is $1,000. With the same costs, we assume that 15 units will be $1,500.
So, $1,500 – $1,000 = $500. This makes your change in total cost $500.
We are using nice even numbers for this formula but it might be important to consider that sometimes as more units are produced, the cost per unit could go down based on bulk supply orders.
However, with this example, we will stick to the standard cost across the board. This makes the top part of our equation $500.
Change In Quantity
Now, we need to create a change in quantity for the formula. This number is not as confusing to get to. It is exactly as it sounds. If you use the same numbers from our total cost, you currently produce 10 units but want to produce 15.
You will simply subtract 10 from 15 to determine the change in quantity. It's the difference between your ending number and your starting number.
This translates to 15 – 10 units = 5 units. That means your change in quantity is 5 units.
When you put your change in cost and change in quantity into the formula with this example, you should get the following.
Marginal Cost = $500
5 = $100
This makes your marginal cost $100 per additional unit.
How To Calculate Marginal Opportunity Cost
Marginal opportunity cost takes the marginal cost one step further. Rather than just determining the difference in the costs and quantity, you're also going to consider the cost of opportunity.
You might be wondering how you can possibly figure out the cost of opportunity but it's not as challenging as it sounds. Here, you will consider the cost of increase for your additional production, just as we did with marginal cost.
However, you are also going to add into the formula the potential lost opportunity for making any changes to accommodate the adjustments. Let's say you are considering reducing one item to sell more of another item.
In this case, your lost opportunity would be the item that you consider reducing or stopping completely. Your goal is to compare whether the increase of the other product will make this lost opportunity worth it.
Here, you are going to do more than one calculation to determine the marginal opportunity cost.
- Determine the marginal cost. This formula is the total change in cost divided by the total change in quantity as outlined above.
- Determine the opportunity or lost opportunity and what this cost will be.
- Determine opportunity cost. To do so, take the anticipated return on the new investment and subtract the other investment number.
Marginal opportunity cost helps you to determine the cost of increasing the production of a specific item while also determining what it may cost you if you have to adjust another item in order to necessitate the increase.
How To Calculate Profit With Marginal Cost
Profit with marginal cost can also be referred to as marginal profit. This number is used to determine what your profit will be on each additional unit that you decide to produce should you expand production.
Here is the formula for calculating marginal profit.
Marginal Profit = Marginal Revenue – Marginal Cost
In this formula, you will determine the revenue for each additional unit that you intend to produce. You can do this as a group number but we recommend breaking it down to cost per unit and revenue per unit.
Once you understand how much revenue each additional unit can provide, you need to determine what each additional unit will cost. The good news is that you already determined marginal cost so you can plug that number in here for quick results.
Once you complete the steps to these formulas, you can have a clear picture of what your marginal profit will be. You can then utilize that information to help you determine whether increasing production or making changes in production will be financially beneficial.
The goal is to be able to make a fully-informed decision before moving forward with increasing or changing production. The fact of the matter is that increasing production may not always be profitable to your business and this is a great way to fully understand the ramifications of this decision before moving forward.
Determining the marginal cost of your production numbers is the first step to making an informed decision when adjusting production plans. Understanding the true costs of adjusting your production numbers may help you to make the right choice.
These are just calculations based on real numbers. Choosing to increase production will also require increased sales in order to achieve profit from the change. However, if you feel as though there is demand and the numbers work out in your favor, you can reach for the stars.
This can also be beneficial for determining whether there is a certain production number that makes the costs more advantageous for your business. Always be fully informed of the effects on your bottom line before making a final decision on the numbers.
Shawn Manaher is a former financial advisor, has founded 5 online businesses, and is a coach, speaker, podcast host, and author. He's been featured on Forbes, The Consults Corner on TAE Radio, The Writing Biz, What's Your Story, and more.