What is Marginal Cost?
The marginal cost is the cost increase as a result of making one more unit.The concept is often used in production costing to decide whether production should be increased or not.
All things being equal, if the marginal cost is less than the selling price of a product then it is worth increasing production, as this will generate additional contribution towards overheads. On the other hand, if the marginal cost is greater than the selling price of the product, then production should not be increased.
Marginal Cost Formula
The formula for marginal cost is as follows:
By increasing production by a given number of units and measuring the change in cost, using the equation above, it is possible to calculate the change in cost for an additional unit.
Marginal Costing Example
As an example of, suppose a business currently produces 1500 units at a cost of 120,000, and are considering changing production levels to make 1700 units. They work out that additional material, labor, and machine costs will mean that the total cost for the 1700 units will be 134,000.
The equation for marginal cost shows that.
Marginal cost = Change in cost / Change in units. Marginal cost = (134,000 - 120,000) / (1700 - 1500) Marginal cost = 14,000 / 200 = 70.00 per unit
This marginal costing analysis shows that providing the selling price of the additional units is greater than 70.00, then the increase in production should take place. Suppose the selling price was 100.00, then each additional unit sold would generate a contribution margin of 100 – 70 = 30.
Marginal Revenue Equals Marginal Cost
Now lets look at other examples of marginal cost. Suppose in the above example, the total estimated cost of production had increased to 140,000. To calculate marginal costing we again use the formula.
Marginal cost = Change in cost / Change in units. Marginal cost = (140,000 - 120,000) / (1700 - 1500) Marginal cost = 20,000 / 200 = 100.00 per unit
In this instance it would not be worth the business increasing production capacity as the marginal cost of producing the additional units is the same as the selling price. To put it another way marginal revenue and marginal cost are the same.
Marginal Cost is Greater than Selling Price
As a further example, if the costs of increasing production levels went to 143,000, the marginal costing calculation shows.
Marginal cost = Change in cost / Change in units. Marginal cost = (143,000 - 120,000) / (1700 - 1500) Marginal cost = 23,000 / 200 = 115.00 per unit
The increasing marginal cost now exceeds the selling price, and the business would make a loss of 115 – 100 = 15 for each unit produced and sold.
Calculating the marginal costing is only one factor in deciding whether or not to increase production levels; the market for the product must also be considered. The contribution is only made if the product can be sold at the current price, increasing production can cause supply to outstrip demand resulting in prices falling.
In addition utilizing the idle capacity of the production plant to maximize the supply of one product can reduce the businesses capacity to invest in and produce new products, which may be more profitable.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Double Entry Bookkeeping. He has worked as an accountant and consultant for more than 25 years in all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a BSc from Loughborough University.