How to Calculate Marginal Cost and Marginal Revenue

Marginal cost and marginal revenue are fundamental concepts in economic and business analysis. They represent the change in total cost or total revenue that results from producing or selling one additional unit of output. Understanding these metrics allows businesses to assess the profitability of producing more goods or services.

Calculating Marginal Cost

Marginal cost is the additional expense incurred when a business produces one more unit of a good or service. The calculation focuses on the change in total production costs as output increases incrementally.

To determine marginal cost, the formula used is the change in total cost divided by the change in quantity. For instance, if a company’s total production cost rises from $10,000 to $10,050 when output increases from 100 units to 101 units, the marginal cost of that 101st unit is $50. This change in total cost primarily reflects variable costs, such as raw materials and direct labor, associated with the extra unit. Fixed costs, like rent or administrative salaries, generally remain constant regardless of minor production changes.

Consider a small custom furniture maker who produces wooden chairs. If producing 10 chairs costs $2,000 in total, encompassing materials, labor, and a portion of overhead. When they decide to produce an 11th chair, their total cost might rise to $2,180.

Using the formula, the change in total cost is $2,180 minus $2,000, which equals $180. The change in quantity is 11 chairs minus 10 chairs, resulting in 1 unit. Therefore, the marginal cost for the 11th chair is $180 divided by 1, yielding $180 per chair.

Calculating Marginal Revenue

Marginal revenue represents the additional income a business generates from selling one more unit of its product or service. This financial metric helps understand how each incremental sale contributes to a company’s overall earnings.

The formula for calculating marginal revenue is the change in total revenue divided by the change in quantity sold. For example, if a company’s total revenue increases from $5,000 to $5,095 when sales grow from 50 units to 51 units, the marginal revenue from that 51st unit is $95. Total revenue itself is determined by multiplying the price per unit by the quantity of units sold.

Imagine the same custom furniture maker, who sells their wooden chairs. If they sell 10 chairs at $300 each, their total revenue is $3,000. When they sell an 11th chair, also for $300, their total revenue increases to $3,300. This additional $300 is the direct revenue gained from that single extra sale.

Applying the formula, the change in total revenue is $3,300 minus $3,000, which is $300. The change in quantity is 11 chairs minus 10 chairs, equaling 1 unit. Consequently, the marginal revenue for the 11th chair is $300 divided by 1, resulting in $300 per chair. This calculation demonstrates the direct revenue impact of an incremental sale, which businesses can track through their sales transaction records.

Using Marginal Analysis for Decision Making

Comparing marginal cost and marginal revenue is a fundamental approach to making informed business decisions about production levels. This analytical process, known as marginal analysis, helps companies determine the optimal output quantity to maximize profitability. Businesses utilize these calculated figures to assess the financial viability of increasing or decreasing production.

When marginal revenue exceeds marginal cost, producing and selling an additional unit will increase the company’s total profit. This indicates that the income generated from the extra unit is greater than the cost incurred to produce it, contributing positively to the bottom line. Conversely, if marginal cost surpasses marginal revenue, producing that extra unit would lead to a decrease in overall profit. In such a scenario, the expense of creating the unit outweighs the revenue it brings in, making further production unprofitable.

For instance, if the furniture maker finds their marginal cost for an 11th chair is $180 and their marginal revenue is $300, producing that chair is financially beneficial. The $120 difference between revenue and cost ($300 – $180) adds directly to the company’s profit. However, if rising material costs caused the marginal cost to jump to $350 while revenue remained $300, producing that 11th chair would result in a $50 loss for that unit, signaling that production should not increase beyond 10 chairs under those conditions. Businesses continuously monitor these relationships, adjusting production schedules and resource allocation based on real-time cost and revenue data to maintain profitability.