Marginal cost is referred to as incremental cost and is defined as the increase or decrease in the cost of production of more units or serving just one more customer. As there is no change in the fixed costs, the only factor to influence the marginal cost is the variations in the variable cost.
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What is marginal cost?
The marginal cost is calculated when the break-even point is reached and when the produced goods absorb the fixed cost and the variable costs are yet to be accounted for. In the calculation, the general variable costs are materials and labor, along with an increase in fixed costs like selling expenses, overhead, and administration.
The marginal cost formula is beneficial for an organization as it is used to increase the generation of cash flow. It is mostly used by accountants who work in valuations group for a client and analysts who work in investment banking in the financial model.
When the average cost in an organization is constant, then both the average and marginal costs are nearly equal. If massive capital investment is required in an industry (airlines and automobiles) and it shows high average costs, then the marginal cost will be meager.
Marginal cost is also an essential factor in resource allocation. It helps the management in making decisions about the allotment of resources in the production process to achieve optimal results.
The management takes the help of marginal cost to evaluate the price of each unit of goods and services that is offered to its consumers. In case the selling price is more than the marginal cost of the product, then it signifies that the revenues will be more than the additional cost.
The organization can then continue with increased production. In case the selling price is less than the marginal cost of a product, it signifies that the revenues will be less than the additional cost, and the organization should not continue with the additional production.
How to calculate the marginal cost
Marginal cost can easily be calculated with the help of the given formula
Marginal cost = change in cost/ change in quantity
XYZ Company is producing 1000 units at 10,000 dollars. It had to increase its production to 1500 units, and the total cost of production also increased to 15,000 dollars.
The marginal cost will be
Marginal cost = change in cost/ change in quantity
Marginal cost = 15000 – 10000 / 1500 – 1000
Marginal cost = 5000 / 500
Marginal cost = 10
It shows that the marginal cost of increasing the output by a single unit is 10 dollars
CD Limited produces 100 face masks daily, and the cost of production is estimated at 1000 dollars. Because of high demand, the company decided to increase its production to 150 units daily. Their cost of production was now 1700 dollars.
The company wanted to know whether to continue with the production or not. So, they decided to get an estimate of its marginal cost.
The marginal cost will be
Marginal cost = change in cost/ change in quantity
Marginal cost = 1700 – 1000 / 150 – 100
Marginal cost = 700 / 50
Marginal cost = 14
It shows that the marginal cost of increasing the output by a single unit is 14 dollars. Earlier their cost of production was only 10 dollars, but an increase in the prices of variable costs has increased the marginal cost to 14 dollars.
Steps in calculating marginal cost
It is easy to calculate the marginal cost by following these steps
1. Calculate the change in cost
The first step in calculating the marginal cost is calculating the change in cost. Costs of production include both variables as well as fixed costs. Change in costs is the level of output that determines an increase or decrease in cost because when the output is high, it will lead to high costs, and vice versa, lower outputs mean lower costs.
One simple reason for this is the presence of variable costs that are linked directly to the production volume and which decreases or increases accordingly. Sometimes step fixed costs are also the reason for the costs.
If you are looking for ways to calculate the change in cost, then take the total cost that was before the output change and subtract it from the new cost or the total cost that has incurred after the change. The formula is
Change in total cost = new cost – old cost
For example, Mahendra and Sons are producing 10 motorcycles at the cost of 1500 dollars each. The total cost of motorcycles is 10*1500 = 15000 dollars. It increases its production capacity to 15, and now the cost price has also increased to 25000 dollars. The difference in the total cost is
Change in total cost = new cost – old cost
Change in total cost = 25000 – 15000
Change in total cost = 10000 dollars
2. Calculate the change in quantity
The next step in calculating the marginal cost is determining the change in quantity. It is the level of output that determines the quantity and a change in it is reflected through a change in quantity.
As soon as there is an increase in the level of production, the quantity will increase and vice-versa a decrease in production level will lead to lower quantity.
If you are looking for ways to calculate the change in quantity, then take the total quantity that was before the output change and subtract it from the new quantity or the total quantity that has incurred after the change. The formula is
Change in quantity = new quantity – old quantity
In the example mentioned above, the change in quantity will be
Change in quantity = new quantity – old quantity
Change in quantity = 15 – 10
Change in quantity = 5 units
3. Divide change in cost by change in quantity
The final step in calculating the marginal cost is by dividing the change in cost by the change in quantity.
Remember, marginal cost is the cost that incurs by producing one additional output unit, and this is a per-unit increase in the total cost. It will vary as the level of output changes. It now becomes easy to calculate marginal cost through this formula
Marginal cost = change in cost/ change in quantity
In the example mentioned above, the marginal cost will be
Marginal cost = change in cost/ change in quantity
Marginal cost = 10000 / 5
Marginal cost = 2000
The cost of every additional unit is now at 2000 dollars, whereas earlier it was at 1500 dollars.
Advantages of marginal cost
The advantages of marginal cost are as follows-
- Marginal cost aids in making useful decisions regarding the allocation of resources in the production process.
- The marginal cost allows an organization to understand at what point the production will help them to achieve economies of scale
- The marginal cost helps the management in deciding whether they should continue to increase production or stop it for now
- The marginal cost helps in the calculation of incremental cost in the process of production
- Marginal cost is used in financial modeling to boost cash flow
Conclusion
Marginal cost is considered one of the best concepts in managerial accounting as it helps to determine at which point a company can achieve economies of scale so that it can boost production as well as overall operations.
