How to calculate marginal costs for your small business

Published Tuesday 23 December 2025

Table of contents

• What is marginal cost?
• What are the main components of marginal cost?
• How to calculate marginal cost
• Marginal cost examples for small businesses
• Why marginal cost matters for your business decisions
• Marginal revenue vs marginal cost
• How to use marginal cost for production planning
• Track your costs with accounting software
• FAQs on marginal cost calculation

Key takeaways

• Calculate marginal cost by dividing the change in total costs by the change in quantity produced to determine whether increasing production will boost or reduce your profits.

• Compare marginal cost to average cost to make optimal production decisions—increase production when marginal cost is lower than average cost, and maintain current levels when marginal cost exceeds average cost.

• Apply the profit maximisation principle by finding the production level where marginal cost equals marginal revenue to achieve optimal profitability.

• Use marginal cost analysis for strategic business decisions including pricing strategy, production planning, cash flow management, and assessing whether growth opportunities are profitable.

What is marginal cost?

Marginal cost is the additional cost of producing one extra unit of a product or service. This calculation helps you determine optimal production levels and pricing strategies to maximise profits.

Marginal cost calculations help with key business decisions:

• Cash flow planning: Determine if you can afford increased production
• Pricing strategy: Set prices that maximise profit margins
• Production planning: Find the optimal number of units to produce
• Market expansion: Assess whether growth opportunities are profitable

What are the main components of marginal cost?

Marginal cost components include all expenses that change when you produce additional units. The two main cost categories are:

• Variable costs: expenses that increase with production volume, including materials, hourly wages, utilities and shipping costs
• Fixed costs: expenses that stay the same regardless of production volume, such as rent, equipment and salaried staff – higher production spreads these costs across more units, reducing cost per item

How to calculate marginal cost

Marginal cost calculation determines the exact cost of producing one additional unit. This helps you decide whether increasing production will boost or reduce your profits.

Marginal cost formula

The calculation involves two simple steps:

Step 1: Calculate the change in total costs when producing one extra unitStep 2: Divide this cost increase by the quantity increase (typically 1 unit)

Step-by-step calculation process

Follow these simple steps to find your marginal cost:

1. Determine your starting point: Note your current total production cost and the number of units you produce.
2. Calculate the change in cost: Figure out the new total cost for producing one or more additional units. Subtract the original total cost from this new total cost.
3. Calculate the change in quantity: This is the number of additional units you're producing.
4. Divide the change in cost by the change in quantity: This gives you the marginal cost per unit.

Use your marginal cost to make production decisions:

• Marginal cost < average cost: Increase production to boost profits
• Marginal cost > average cost: Maintain current production levels
• Marginal cost = average cost: You've reached optimal production efficiency

Marginal cost examples for small businesses

Let's say Mohammed wants to expand his bakery. He currently makes 100 cakes and wants to make one 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 = £5

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

Why marginal cost matters for your business decisions

Marginal cost helps you make critical business decisions by answering:

• Production volume: How many units should you produce?
• Growth timing: When is the right time to expand operations?
• Pricing strategy: What prices will maximise your profits?
• Resource allocation: Where should you invest your money and time?

Finding the right production level is crucial for profitability.

Too little production means you miss opportunities to spread fixed costs across more units. Too much production can cause costs to spiral faster than revenue increases.

For instance, one analysis showed that increasing production from 3,000 to 4,000 units generated only $40,000 in extra revenue for additional costs of $65,000, making the expansion unprofitable. Marginal cost calculations help you find the sweet spot that maximises profits.

Marginal revenue vs marginal cost

Marginal cost is the expense of producing one additional unit. Marginal revenue is the income from selling one additional unit. Together, these metrics help you maximise profits by finding the optimal production level.

The formula for marginal revenue is:

Profit maximisation occurs when marginal cost equals marginal revenue. This principle is used in economic models to find the profit-maximising quantity. For example, by setting the marginal cost of $65 equal to the marginal revenue equation, one model determined the optimal production level to be 2,875 units.

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 needs to work out how to bring her marginal cost in line with 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 can compare the extra revenue with the extra costs to see whether the extra sales are worth it.

How to use marginal cost for production planning

Accurate marginal cost calculations help you maximise profits through:

• Optimal pricing: Set prices that customers will pay while maximising revenue. For example, once an optimal production quantity is determined, it can be used to calculate the profit-maximizing selling price, such as arriving at a price of $122.50 based on a demand curve equation.
• Smart production decisions: Determine whether producing more units increases profitability
• Efficient resource allocation: Invest time and money in the most profitable products and services

Track your costs with Xero

You need clear numbers to run your business with confidence. Xero accounting software brings your key figures together in one place so you can make quick, informed decisions. Calculations update automatically, and reports give you a clear view of your revenue and costs.

Because Xero runs in the cloud, you and your accountant or bookkeeper can work from the same up-to-date data. No more jumping between different tools – just one place to manage your financial admin.

Try Xero for free to get started.

FAQs on marginal cost calculation

Implementing marginal cost analysis can raise questions. Here are some of the most frequently asked questions to help you use this concept in your business.

What causes marginal cost to increase?

Marginal cost increases occur due to:

• Labour costs: Overtime pay and additional staffing requirements
• Supply chain issues: Higher material costs or expensive suppliers
• Capacity constraints: Need for new equipment, facilities, or staff
• Production inefficiencies: Quality issues or process bottlenecks

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 margin?

Contribution margin measures profitability by subtracting variable costs from sales revenue. When marginal cost is lower than contribution margin, increasing production boosts profits.

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, use this formula:

Cont margin = net sales revenue – variable costs

As with your marginal cost equation, you can use the contribution margin percentage (also called the contribution margin ratio) to compare products. It helps you decide which products to focus on and how much of each to produce.

The contribution margin percentage formula is:

(Net sales revenue – variable costs) / sales revenue

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 can use the contribution margin ratio to compare different products. This shows you which lines contribute more to profit, and where it may make sense to increase production.