We treat labor as a variable cost, since producing a greater quantity of a good or service typically requires more workers or more work hours. Performing a marginal cost analysis allows your company to maximize profits by ensuring you produce enough products to meet demand without overproducing. It also helps you price products high enough to cover your total cost of production. The marginal cost curve demonstrates that marginal cost is relatively high with low production levels, declines as production increases, reaches a minimum point, then rises again. However, the marginal cost of production can eventually start to increase as the business becomes less productive. You can get a visual representation of diseconomies of scale with a u-shaped curve known as the marginal cost curve.

An Example of the Marginal Cost Formula

Let us learn more about the marginal cost along with its formula in this article. Calculating marginal cost also provides an understanding of the behavior of total costs as output changes. This helps you understand how your costs evolve over different production levels. When the marginal cost is less than the average cost, the production of additional units will decrease the average cost. When the marginal cost is higher, producing more units will increase the average cost per unit. The purpose of analyzing marginal cost is to determine at what point an organization can achieve economies of scale to optimize production and overall operations.

Variable costs change with the level of output – for example, materials, hourly wages, and heating and energy bills. Such production creates a social cost curve that is below the private cost curve. In an equilibrium state, markets creating positive externalities of production will underproduce their good. As a result, the socially optimal production level would be greater than that observed. When the marginal social cost of production is less than that of the private cost function, there is a positive externality of production. Production of public goods is a textbook example of production that creates positive externalities.

Are marginal costs the same as variable costs?

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For example, a cereal maker in the food industry may shrink its box size or number of ounces to save costs and keep current product pricing. Marginal cost pricing is used to make some incremental sales with below-normal pricing. Marginal cost helps in identifying areas where production can be streamlined. These include how much to produce, how to price your products, and how to allocate resources efficiently.

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1. Variable costs are things that can change over time, such as costs for labor and raw materials.
2. These articles and related content is the property of The Sage Group plc or its contractors or its licensors (“Sage”).
3. A lower marginal cost would suggest that a company can profitably expand production, while a higher marginal cost might signal that it’s more cost-efficient to reduce output.
4. In combination with marginal cost analysis, businesses use variable and fixed costs for different types of financial analysis, trend monitoring, pricing, and decision-making.
5. Also, you don’t have to purchase additional equipment or move into a larger facility.
6. If the company makes 500 hats per month, then each hat incurs $2 of fixed costs ($1,000 total fixed costs ÷ 500 hats).

What we observe is that the cost increases as the firm produces higher quantities of output. This is pretty intuitive, since producing how to calculate marginal cost more output requires greater quantities of inputs, which cost more dollars to acquire. Instead of creating the table we did in the example above, we can calculate marginal cost of a unit directly using calculus.

Marginal Cost Helps You Figure Out if You Can Scale

Remember, the value of marginal cost is a crucial factor in deciding whether to increase or decrease production. A lower marginal cost would suggest that a company can profitably expand production, while a higher marginal cost might signal that it’s more cost-efficient to reduce output. If you want to calculate the additional cost of producing more units, simply enter your numbers into our Excel-based calculator, and you’ll immediately get the answer. From improving pricing strategies to optimizing production levels, marginal cost gives you a clearer picture of the true cost of growth. If production increases beyond this range, the marginal cost may change due to factors like overtime pay for workers or the need for additional machinery.