Marginal Cost: Definition, Formula, and Examples

Starting a new business and keeping track of important financial metrics is no easy task. As your company grows, you may want to produce additional units of your product or merchandise. You don’t want to risk running out of inventory. But you also won’t want to fall into overproduction and have your goods sit on shelves for too long. Situations like these are where marginal cost (MC) comes into play. So, what is this metric exactly? Keep reading to learn the marginal cost definition, basics, why it’s an important metric to understand, and how to calculate marginal cost.

What is marginal cost?

Marginal cost refers to the increase in production expenses associated with the production of additional product units. In other words, it is how much money it runs your business to produce one additional unit of your product. Businesses use MC to optimize production volume and pricing. This metric can also be sued to forecast profit growth as your company increases in scale.

Marginal cost formula

As mentioned above, marginal cost is calculated as the total expense required to produce one additional unit. The formula represents the change in cost, divided by the change in quantity.

MC = (Change in Cost) / (Change in Quantity)

How to calculate marginal cost step-by-step

Now that you know the marginal cost formula, lets break it down step-by-step. But first, an important concept to understand is fixed vs variable costs. The costs of operating a company can be categorized in two ways:

• Fixed costs: These costs remain the same regardless of production volume or sales performance. Fixed costs include things like rent, utilities, etc. They are generally difficult to change in the short-term.
• Variable costs: These costs fluctuate depending on the production volume or sales performance. Variable costs include things like raw materials, direct labor, etc. Usually, you have more control over variable costs in the short term, at least compared to fixed costs. Read more about variable cost.

Note that if changes in the quantity produced result in total costs changing, it’s most likely due to variable costs. The sum of your variable costs and fixed costs will give you your total cost of production.

Here’s how to find marginal cost step-by-step:

Step 1: Calculate the change in cost

To find the MC, you first need to figure out how much the total expense has changed. Costs of production may increase or decrease at different levels of production and during different time periods. So, if for example, manufacturing additional units requires hiring a few additional workers and increases the cost of raw materials, there will be a change in the overall production cost.

To calculate the change in total costs, you’ll simply subtract the original cost from the new cost:

Change in Cost = New cost – Original cost

Step 2: Calculate the change in quantity

Next, calculate the change in total quantity. The volume of your business’ output will increase or decrease as levels of production vary. Similarly, the change in quantity is calculated by subtracting the original quantity from the new quantity:

Change = New quantity – Original quantity

Step 3: Utilize the marginal cost formula – divide expenses by quantity

The last step is to plug the numbers from above into our original formula:

MC =  (Change in costs) / (Change in quantity)

Marginal cost example calculation

To fully understand the marginal cost formula and its calculation steps, here’s a simplified example of the formula in action.

Let’s say you own a coffee mug company and you want to determine the marginal cost of producing additional mugs. Here are the current numbers for your company:

• It currently costs your company $200 to produce 20 mugs
• If you produce 30 more mugs it will cost $400
• You want to know the MC of producing the mugs.

Let’s plug these numbers into our original formulas:

1. Calculate the change in cost
   • Change in cost = $400 – $200 = $200. The change in cost for your mug company is $200.
2. Calculate the change in quantity:
   • Change in quantity = 50 mugs – 20 mugs = 30 mugs. The change in quantity for your mug company is 30 mugs.
3. Divide the change in cost by the change in quantity: MC = (change in costs) / (change in quantity). So for the mug company the formula would be as follows:

                        Marginal cost = ($200) / (30 mugs) = $6.67 per mug

Based on this calculation, your mug company has a marginal cost of $6.67 per additional mug if they produce a total of 50 mugs rather than 20 mugs (an increase of 30 mugs). As you can see, in this example it costs less money to produce more mugs. If you believe you have the demand to sell the additional inventory, it may make sense for to produce these additional mugs to seize the opportunity to make more profit due to savings from the overall lower MC.

The marginal cost curve

The marginal cost will often be depicted graphically as a relationship between marginal revenue and average cost (more on these metrics below). The marginal cost curve, or marginal slope cost will vary depending on your company and product. Often it’s a U-shaped curve that initially decreases. Usually, producing additional units becomes cheaper due to specialization and efficient use of resources. This phenomenom is sometimes called “economies of scale.”

Marginal cost vs marginal revenue: What’s the difference?

Marginal revenue and marginal cost work together to determine a business’s max profitability. The ideal level of production to maximize profit occurs when marginal cost (MC) equals marginal revenue (MR).

Marginal revenue is the revenue or income you gain by producing additional units. The formula for marginal revenue is the change in revenue divided by the change in quantity. If your marginal costs are greater than marginal revenue, your business isn’t making a sustainable profit. Each additional unit you sell is costing you more and more, eroding your overall margins. You may want to consider scaling back production.

Marginal cost vs average cost

Average cost (AC) is the total cost of manufacturing divided by the total units produced. It’s easy to confuse marginal cost and average cost. However, average cost is different from the marginal cost. MC is not consistent from one unit to the next, whereas AC reflects all units produced.

Overall importance and benefits of marginal cost

Marginal cost is a very important economic concept as it can aid in strategic business decisions. Marginal costing can help prevent your company from losing money from overproduction or shortages. It helps you determine when it becomes no longer profitable to manufacture any additional product. Again, when MC exceeds MR, you’ll know it’s no longer profitable for your company to make the additional unit. This is because the cost of a single unit exceeds the revenue you will collect from it. Marginal cost also helps you determine how many products you’ll need in order to satisfy customer demand. These are important metrics for profit forecasting and planning.

Get help with marginal cost and more

Focusing on the most important financial metrics, like marginal cost, marginal revenue, and more, can help you stay on top of your finances as a small business owner. Analyzing MC vs MR can help you assess profitability and make important short and long-term business decisions.

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This article is for informational purposes only. The content may not constitute the most up-to-date information and should not be construed as legal advice.