Marginal Cost: Meaning, Formula, and Examples

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28 NOVEMBER, 2024

Business owners must understand their company's cost structure to keep up with the competition. Marginal Cost lets managers make better product mix, pricing, and profitability decisions. Calculate the Marginal Costing by subtracting variable costing from fixed costing. Learning how to calculate Marginal Cost explains the impact of changing production volumes on a business’s bottom line. Accordingly, business owners can optimise their operations to maximise profits.

Read on to understand Marginal Cost meaning, definition, and examples.

What is Marginal Cost?

As the Marginal Cost definition indicates, companies use a cost accounting technique to determine their production cost for each additional product or service unit. The costs are calculated based on variable costs like raw materials and direct labour. According to the Marginal Costing concept, fixed costs like rent and salaries come under period costs. They are not directly associated with a specific unit’s production.

Business owners calculate the Marginal Cost to determine their profitability with additional production. This helps them decide how to achieve economies of scale, optimise production, and streamline operations. If the cost of the extra output is less than the per-unit price, the company has a higher chance of gaining a profit.

What are the Advantages of Marginal Costing?

Marginal Cost offers several benefits to a business. Some of the key advantages include the following:

Clear Analysis of Cost-Volume-Profit: Marginal Costing explains the relationship between a product’s cost, volume, and profit. Separating fixed costs from variable costs determines a company’s breakeven point and assesses its profitability from different product or service lines.
Effective Decision Making: Marginal Costing provides insights into business revenues and incremental costs, assessing profitability. After evaluating a new project's profitability, managers can make better decisions.
Simpler Costing: Since the process considers variable costs, it simplifies the costing process while eliminating the complexities of fixed overheads.
Cost Control: It facilitates cost control by identifying controllable variable costs.
Evaluate Performance: Managers can evaluate performance at different levels while assessing their profitability. Accordingly, they can identify underperforming products and take corrective actions.

What are the Benefits of Marginal Cost?

After understanding what Marginal Cost is, it’s also essential to understand its benefits. These include the following:

A company can reduce production costs by producing extra units and generating revenue.
Finding the breakeven point is a significant part of improving the production costs.
After understanding the Marginal Cost and revenue for various production lines, a company can focus its resources on things with the most significant
A company can maximise its returns by producing new units rather than investing in under-performing product lines.
If the marginal cost is too high, the additional production can be unprofitable. Based on the calculations, business owners can make informed decisions.

What is the Importance of Marginal Cost?

Those who understand Marginal Cost meaning know that it is a concept of managerial accounting that manufacturers often use to isolate their optimum production level. They can optimise their manufacturing costs by calculating the cost of producing more units to achieve a breakeven point.

When learning how to calculate Marginal Cost, one must include all the variable costs associated with the production level. For instance, if a company builds a new factory to manufacture more goods, it will consider the cost of building as a Marginal Cost. This cost varies according to the volume of goods to be produced.

All in all, Marginal Costing is a crucial factor in economic theory. A company looking for maximum profitability will increase its production until the Marginal Costs equal the marginal revenue. Beyond that level, the additional production costs will exceed the revenue generation.

Types of Costs Involved in Marginal Cost Calculation

The Marginal Cost calculation involves two main parameters:

Change in Costs: The production costs may decrease or increase with changing output volumes. For instance, if a company requires two more machines to increase production, their costs will also increase.
Change in Quantity: Production quantity decreases or increases at different points. The amount should be enough to evaluate the significant cost changes.

The formula to calculate the Marginal Costs is as follows:

Marginal Cost = Change in total costs / Change in quantity of output

For instance, if a company produces 1000 pens with an initial total cost of Rs. 50,000, its new total cost will be Rs. 54,000 if it starts producing 100 more units.

What are the Limitations of Marginal Cost Analysis?

Although Marginal Costing offers various advantages, it also has some limitations. These are the most important ones:

Does Not Consider All Costs: Calculating the Marginal Costs does not consider fixed costs like salaries and rent, leading to an incomplete image of a company’s expenses and profits.
Misleading: Sometimes, the calculation can be misleading, especially where production is low and fixed costs are high.
Non-Allocation of Fixed Costs: The costing method needs to allocate fixed costs to the produced units, making it harder to estimate the cost of each unit accurately.
Inappropriate for Long-Term Planning: In the longer term, fixed costs may vary and affect profitability. Therefore, it is appropriate for short-term planning rather than for the long-term.
Does Not Consider Inventory Valuation: The method does not consider the inventory value, leading to inaccurate profitability figures.

Read Also : What is a Cancelled Cheque: How to Write it & Cancelled Cheque?

Conclusion

Understanding the Marginal Cost definition helps identify areas where a company can improve efficiency and reduce costs. By analysing the production process, a business can minimise its production cost per unit, increasing the cash flow and making its products more competitive.