What is Marginal Cost?
In economics, marginal cost represents the change in total production cost that arises from making or producing one additional unit. To calculate marginal cost, divide the change in production costs by the change in quantity produced. Analyzing marginal cost is pivotal to achieving economies of scale to optimize production efficiency and overall operations. When the marginal cost of producing an additional unit is lower than the unit price, businesses can potentially gain profit.
Key Takeaways
- Optimization Tool: Marginal cost is crucial in managerial accounting to enable an organization to optimize its production levels through economies of scale.
- Profit Maximization: A company can maximize its profits by producing up to the point where marginal cost (MC) equals marginal revenue (MR).
- Cost Dynamics: Fixed costs remain constant regardless of production levels, which means higher production equates to a lower fixed cost per unit. Variable costs fluctuate based on production levels.
- Step Costs Consideration: Companies must consider step costs when increased production necessitates additional resources, such as new machinery.
Marginal Cost Formula
Marginal cost quantifies the total expenses required to manufacture one additional good. It is measured by analyzing changes in expenses for any given additional unit.
Marginal Cost = Change in Total Expenses / Change in Quantity of Units Produced
For instance, if the production cost increases from $1,000,000 to $1,050,000 when one more unit is produced, the change in total expenses is $50,000. If a company increases production from 24 units to 25 units, the change in quantity of units produced is one.
Understanding Marginal Cost
Marginal cost is widely used in economic and managerial accounting to isolate optimum production levels. Manufacturers specifically analyze the cost of adding one more unit to their schedules.
Additional costs, like constructing a new factory to scale up production, can significantly impact marginal cost. It helps businesses produce until MC equals MR to avoid inefficiencies.
Important:
Factors like information asymmetries, externalities, transaction costs, and price discrimination can also impact marginal cost.
Benefits of Marginal Cost
- Resource Allocation: Knowing marginal cost and revenue informs better investment and production decisions.
- Profit Analysis: Deciding on additional or custom orders is streamlined by the marginal cost.
- Strategic Investment: Helps determine when scaling production makes sense financially.
Example of Marginal Cost
Production costs comprise fixed and variable costs. Fixed costs are static, spreading over more units with increased production, while variable costs rise with higher output.
Imagine a company producing hats that incur $1,000 in fixed costs per month and $0.75 in plastic per hat. Making 500 hats monthly means each hat has $2 fixed and $0.75 variable costs, totaling $2.75 per hat. Raising production to 1,000 hats drops the fixed cost per hat to $1, totaling $1.75 per hat. If additional machinery is required beyond 1,499 units, this added expense impacts the marginal cost. Additional costs in new machinery at the 1,500th unit must be included in marginal cost calculations.
Special Considerations
- Graphical Representation: Marginal cost vs. marginal revenue often depicts a
Related Terms: marginal revenue, average cost, fixed cost, variable cost, economies of scale, manufacturing costs.
References
- Lumen Learning. “Average Costs and Curves”.
- Alfred E. Kahn. “The Economics of Regulation”, The MIT Press, 1988.
- Alfred E. Kahn. “The Economics of Regulation”, Pages 16-17. The MIT Press, 1988.
- International Monetary Fund. “Supply and Demand: Why Markets Tick”.
