Last Updated May 2, 2007 7:03 PM EDT
Much economic theory is based not on marginal analysis of totals but on analyzing the changes caused by increasing or decreasing those totals. Marginal cost is the increase in total costs resulting from a unit increase in production. It follows that if marginal revenue exceeds marginal cost, it will be profitable to increase production—to the point where both are equal. At that point, or when marginal cost exceeds marginal revenue, management may choose to outsource production or expand.
The possibility of expansion introduces another marginal measure: the weighted marginal cost of capital. This measure focuses on the point at which retained earnings used to finance expansion are exhausted, and it becomes necessary to issue more equity. Because retained earnings are a cheaper source of financing than issuing more equity, the weighted marginal cost of capital will rise.
The formula is:
If a company is charged $500,000 to produce 5,000 items, and $675,000 to produce 7,500 items, the change in cost would be:
The change in units produced would be:
The formula to calculate marginal cost is then applied:
Then, if the item in question is selling for, say, $99.95—more than $70—the feasibility of expansion could be determined.
- A marginal cost lower than the price at which items are sold indicates that it is not always necessary to cut prices to sell more.
- Using idle capacity to produce lower-margin items can still be beneficial, because these generate revenues that help cover fixed costs.
- Marginal cost studies can become complicated, because the basic formula does not always take into account variables that can affect cost and quantity. However, there are software programs available, many of which are industry-specific.
- At some point, marginal cost invariably begins to rise; typically, labor becomes less productive as a production run increases, while the time required also increases.
- Marginal cost alone may not justify expansion. It is best to determine also average costs, then chart the respective series of figures to find where marginal cost meets average cost, and thus determine optimum cost.
- Relying on marginal cost is not fail-safe; increasing production can drive down prices and cut margins. Furthermore, committing idle capacity to long-term production may tie up resources that could be better used in some other direction. An important, related principle is the consideration of the cash gained (or lost) from producing and selling an additional unit.
Marginal Cost: www.drexel.edu/top/prin/txt/Cost/cost6a.html