What is marginal cost?

Marginal cost (definition)

Marginal cost refers to the expense of creating one more item for sale. It is most commonly used in manufacturing, where it’s called the marginal cost of production.

The marginal cost tells a business precisely how much more they have to spend to create one more product, or deliver a service one more time.

Why marginal cost matters

It’s useful to know how much it costs to create more of the things you sell. The incremental costs are often quite small because the business has already paid for all the work tools and systems required to make the item or deliver the service.

When the marginal cost is relatively small, it means the business can affordably increase production and possibly revenue.

Marginal cost in action

It’s common for the marginal cost of serving extra customers to be relatively low. The lower cost of production may allow you to make those extra sales at a higher profit. Or it may allow you to offer a better price to customers.

Marginal costs versus stepped costs

While a business can often increase production by simply buying more raw materials, there will come a point at which capacity is maxed out. The business won’t be able to produce more unless it invests in a new workshop, more equipment, or additional employees.

These bigger investments are stepped costs. A business will typically need to sell a lot more products or services to pay back the investment involved in a stepped cost.

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This glossary is for small business owners. The definitions are written with their requirements in mind. More detailed definitions can be found in accounting textbooks or from an accounting professional. Xero does not provide accounting, tax, business or legal advice.