Marginal cost

Published Wednesday 12 August 2026

Table of contents

• What is marginal cost?
• Why marginal cost matters
• The marginal cost formula and how to calculate it
• Marginal cost vs average cost
• Marginal cost vs marginal revenue
• The marginal cost curve
• Using marginal cost to set prices
• Marginal costs versus stepped costs
• Manage your production costs with Xero
• FAQs on marginal cost
• Related terms
• Learn more about marginal cost

Key takeaways

• Marginal cost is the additional expense of producing one more unit of a product or service, calculated by dividing the change in total cost by the change in quantity.
• Comparing marginal cost to marginal revenue helps you find the point where profit is maximised and guides decisions about how much to produce.
• Marginal cost typically falls at first as fixed costs spread over more units, then rises as you approach capacity and face diminishing returns.
• Understanding marginal cost supports smarter pricing, better resource allocation, and clearer insight into when expansion makes financial sense.

What is marginal cost?

Marginal cost is the cost of producing one more unit of a product or service. In manufacturing, it's often called the marginal cost of production.

You calculate marginal cost by dividing the change in total cost by the change in quantity. This figure tells you how much your expenses increase each time you produce an additional unit, helping you decide whether ramping up output makes financial sense.

Why marginal cost matters

Knowing your marginal cost gives you a clearer picture of your true production expenses. This insight helps you measure profitability and make informed decisions about your business.

• Pricing: set prices that cover costs and protect your profit margins
• Production decisions: determine whether increasing output adds to your bottom line or eats into profits
• Resource allocation: direct materials, labour, and capital where they generate the best return
• Expansion planning: assess whether scaling up is financially worthwhile before committing to growth

The marginal cost formula and how to calculate it

The marginal cost formula is straightforward: marginal cost equals the change in total costs divided by the change in quantity. For a detailed breakdown, see this guide on calculating marginal cost.

Here's how to work it out in three steps:

1. Work out the change in total cost by subtracting your original total cost from your new total cost after increasing production.
2. Work out the change in quantity by subtracting your original number of units from your new number of units.
3. Divide the change in cost by the change in quantity to get the marginal cost per unit.

Consider a furniture maker who currently produces 50 wooden tables at a total cost of R60,000. Producing 10 more tables raises total costs to R64,000. The change in cost is R4,000 (R64,000 minus R60,000) and the change in quantity is 10 tables. Dividing R4,000 by 10 gives a marginal cost of R400 per table. This means each additional table beyond the first 50 costs R400 to produce. Tracking variable expenses like materials is easier when you understand your cost of sales calculation.

Marginal cost vs average cost

While marginal cost focuses on the expense of one extra unit, average cost looks at total spending across all units. Average cost equals total cost divided by the total number of units produced.

Using the furniture maker example, the average cost is R60,000 divided by 50 tables, which equals R1,200 per table. Compare this to the R400 marginal cost: because producing more tables costs less per unit than the current average, making additional tables pulls down the overall average cost. This relationship helps you understand when scaling up improves efficiency.

Marginal cost vs marginal revenue

Marginal revenue is the extra income you earn from selling one more unit. Comparing it to marginal cost reveals whether producing that unit adds to your profit.

Profit is maximised at the point where marginal cost equals marginal revenue. Beyond that point, each additional unit you produce adds less profit than the one before. When marginal cost exceeds marginal revenue, making more actually reduces your overall profit. Keeping these two figures in balance helps you find the optimal production level.

The marginal cost curve

The shape of the marginal cost curve depends on how your costs behave as output changes. Understanding the difference between fixed and variable costs is essential here.

Fixed costs stay the same regardless of how many units you produce. Examples include rent, machinery, and insurance. You can learn more about these expenses in the guide to overheads. Variable costs change with output, such as raw materials and hourly wages.

Marginal cost typically falls at first because fixed costs spread over more units, creating economies of scale. Once the business approaches capacity, that advantage reverses and the cost per extra unit climbs again, a shift known as diseconomies of scale. At this point, diminishing returns set in: equipment runs at maximum, workers put in overtime, and each additional unit requires proportionally more resources. This pattern of falling then rising marginal costs is common across most production environments.

Using marginal cost to set prices

Your marginal cost directly influences how you price products. When marginal cost is low, you can sell extra units at a healthy profit or offer competitive pricing to attract more customers.

Any selling price above marginal cost means the extra unit adds to profit. A price below marginal cost means you're losing money on that unit. Understanding your gross profit margin helps you set prices that cover production costs while leaving room for profit.

Marginal costs versus stepped costs

Marginal cost assumes you can increase output gradually, but real-world production often hits capacity limits. Once you've maxed out your current setup, producing more requires bigger investments.

These stepped costs include expenses like a new workshop, additional equipment, or extra employees. Unlike marginal costs that change smoothly with each unit, stepped costs jump suddenly when you cross a capacity threshold. They take a lot more sales to pay back, so it's important to plan carefully before committing to that level of expansion.

Manage your production costs with Xero

Tracking marginal costs and other production expenses is simpler when your financial data is organised in one place. Xero accounting software helps small businesses monitor costs, generate real-time reports, and make pricing decisions with confidence. You can see exactly where your money goes and spot opportunities to improve margins, and you can get one month free when you try Xero.

FAQs on marginal cost

Here are answers to common questions about marginal cost.

How do you calculate marginal cost?

Subtract your original total cost from your new total cost after increasing production, then divide by the number of additional units produced. The result is your marginal cost per unit.

What is the marginal cost formula?

Marginal cost equals the change in total costs divided by the change in quantity. This formula works for any product or service where you can measure both cost and output.

What is the difference between marginal cost and average cost?

Marginal cost is the expense of producing one additional unit, while average cost is total cost divided by the total number of units. Marginal cost shows incremental spending; average cost shows overall spending per unit.

What is the difference between marginal cost and marginal revenue?

Marginal cost is what you spend to produce one more unit, while marginal revenue is what you earn from selling that unit. Comparing them tells you whether the extra unit adds to or subtracts from profit.

Why does marginal cost matter for pricing?

Setting prices above marginal cost ensures each additional sale contributes to profit. If you price below marginal cost, you lose money on every extra unit sold.

Related terms

• Direct costs
• Fixed costs
• Variable costs
• Gross profit

Learn more about marginal cost

• What is profit margin?
• Profitability ratios
• Margin of safety formula
• Increase profits