**Guide**

# Why marginal cost is crucial to your business plans

Knowing your marginal cost helps you figure out your production levels and pricing, so you can maximize your profits.

## What is a marginal cost?

A marginal cost is the incremental cost to a business of producing one extra unit of a product or service. It’s an important concept in cost accounting and financial management because it allows a business to understand the risks and opportunities of increasing production.

Perhaps you’re thinking about expanding your business’s operations. There’s the short-term impact on cash flow – can you spare the extra money right now? You’ll need to look at all changes to your costs and expenses, and more complex long-term considerations like market demand and pricing strategies.

Working out your marginal cost is an important first step in shaping a business plan.

## What are the main components of marginal cost?

To work out marginal cost, you need to account for all the costs involved in production. There are two main cost categories:

**Variable costs** change with the level of output – for example, materials, hourly wages, and heating and energy bills. When you produce more units, these costs increase.

**Fixed costs** do not change as output goes up or down – for example, machinery, building rent, and salaries remain the same regardless of your production level. Increasing your production spreads these costs further, bringing down the cost per unit you produce.

## Why is marginal cost important to grasp?

Knowing your marginal cost helps you make fundamental decisions for your business: how much to produce, and when.

You want to grow your business – but should you? If so, how quickly? What about changes in prices? Most businesses that want to maximize their revenue will grapple with these questions.

Grow by too little and you won’t fully benefit from spreading your fixed costs and bringing down your price per unit. But grow too much and your costs might spiral without enough of an uptick in production and sales.

Your marginal cost therefore helps you figure out a pricing strategy to boost your sales.

## What is the formula for marginal cost?

The aim of the marginal cost calculation is to determine how your total costs are affected if you increase production by a single unit.

It’s a simple formula:

You first need to know how much your total costs will rise if you increase your production by a single unit (for example, this might be one more computer, or one more hour of work if you’re providing a service). You divide this figure by the increase in your production – in this case, by 1.0.

### The benefits of calculating marginal cost

Once you’ve calculated your marginal cost, you can put it into the larger context of your business’s financials.

- If your marginal cost is lower than your average cost of production (your total costs divided by your number of units produced) then there’s extra revenue to be squeezed.
- If that marginal cost is higher than your average cost of production, you’ll probably want to keep production levels the same.

### Marginal cost example

Let’s say Mohammed wants to expand his bakery. He currently makes 100 cakes and wants to make 1 more. His usual production costs are $1000 ($10 per cake); these costs increase to $1005 if he makes that additional cake.

First, he works out the change in total cost: $1005 – $1000 = $5

Second, he works out the marginal cost: $5 / 1.0 = $5

This marginal cost of $5 is lower than the usual cost to Mohammed of making cakes ($10). He therefore could increase his profit by expanding production by 1.0 unit.

## Marginal revenue vs marginal cost

While marginal cost is the cost of selling one extra unit of production, marginal revenue is the income you receive by selling that extra unit. Marginal revenue therefore focuses on how much your income changes when you increase your production, rather than your costs.

The formula for marginal revenue is:

To maximize your profits, you generally want your marginal cost to equal your marginal revenue. This is because at a certain point, your increases in production will result in diminishing returns. Why? Too much supply dampens demand and, therefore, your viable price per unit.

### Example of marginal revenue

Let’s say Alison sells wallets at a market stall for $30 each. If she can’t sell all her stock, she could supply the surplus wallets to another vendor across town at a rate of $20. But is this worth it? How many wallets does she need to sell to increase her profits or just to break even?

From the image above, we see her marginal revenue would be $20 for the sale of one extra wallet. If her marginal cost is higher than this – say, $22 – then she would not make a profit on this single-unit transaction.

From here, she must work out how to make her marginal cost equal her marginal revenue.

She has a few options:

- Perhaps she can negotiate a higher unit price for a larger wholesale order? By selling more wallets she would decrease their cost per unit.
- She might sell to a vendor nearer to where she is and is therefore cheaper to get to.
- She might find a less expensive way to travel.

Alison would benefit from analyzing her revenue to cost ratios.

## Why you should calculate your marginal cost accurately

Knowing your true marginal cost helps you maximize your profits because it helps you:

**Make optimal pricing decisions**: Your marginal cost helps you find the sweet spot where you can charge prices your customers will pay while maximizing your revenue.**Make better production decisions**: Higher production doesn’t always lead to higher profits. An accurate calculation of your marginal cost shows you whether producing one extra unit would cause a large increase in your average costs. For example:**Allocate resources efficiently**: How do you know which products to make? When to buy machinery or lease larger premises? Understanding your fixed costs and their capacities – and how these affect your profitability per unit – helps you decide where to allocate your time, energy, and other resources.

For more guidance on managing your business, check out this government resource.

## Frequently asked questions about marginal cost

### What causes marginal cost to increase?

Your marginal cost can rise due to things like rising labour costs (overtime pay, for example) or inefficiencies in production, such as buying materials from a more expensive source. And if a business reaches its capacity limits, producing more units may require new investments in equipment, premises, staff and wages.

### How does marginal cost relate to supply and demand?

There’s a fundamental relationship between marginal cost and supply and demand. If the marginal cost of producing an extra unit is lower than the price it can be sold for, a business is incentivised to increase production. But if the marginal cost exceeds the selling price, the business may reduce output to avoid losses. As part of your profit margin analysis, you should work out your gross profit margins.

### What’s the relationship between marginal cost and contribution cost?

These related yet distinct terms are both used in profit analysis and pricing decisions.

You work out your contribution costs by subtracting your variable costs from your sales revenue. In general, when marginal cost is less than contribution cost, producing more units is profitable.

### How do you calculate contribution margin per unit?

This helps you figure out the point at which you break even with your production.

To calculate the contribution margin (cont margin), use this formula:

Cont margin = net sales revenue – variable costs

As with your marginal cost equation, the contribution margin percentage formula (also known as the contribution margin ratio) can then determine which products you might produce for maximum profits, and how much to produce.

The cont margin percentage formula is:

Net sales revenue – variable costs / sales venue

Here’s a contribution margin ratio example. Let’s say you sell jeans for $50 with variable costs of $20 per unit. The contribution margin is $50 – $20 = $30. To then figure out the contribution margin ratio, you divide $30 by the revenue, which equals 60% ($30 is 60% of $50).

You could use the contribution margin ratio formula several times to compare the relative contribution margins of different products to see where to increase your production.

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## Disclaimer

Xero does not provide accounting, tax, business or legal advice. This guide has been provided for information purposes only. You should consult your own professional advisors for advice directly relating to your business or before taking action in relation to any of the content provided.

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