In economics, marginal cost is the increase or decrease of the cost of producing one more unit of a good or serving one more customer. It is also referred to as an incremental cost. Marginal costs help businesses define achievement in economies of scale.
To demonstrate how marginal cost is calculated, let us look at an example involving the production of books. The total cost of production of one book is $6, whereas the total cost of production of two books is $10. Therefore, the marginal cost of output expansion by one unit can be calculated as follows: $10 – $6 = $4.
According to the leading financial content source Investopedia, marginal costs are a function of the total cost of production, which includes fixed or variable costs. Fixed costs are regular, steady, and do not vary according to changes in production. Rent and property payments, taxes, and salaries are all examples of fixed costs. Variable costs change depending on production output, meaning the production of more units will lead to an increase in variable costs. Typical variable costs include calculations concerning labor, materials, and equipment.
Calculating marginal costs is crucial for companies trying to maximize their profits, as it helps them determine the point where the quantity of items produced will increase the average cost per unit. Here is how marginal cost is calculated:
In the formula above, Δ refers to an incremental change of one unit.
The marginal cost formula is used in financial modeling to manage the company’s capital and cash flow. Understanding marginal cost helps a business evaluate its profitability and decide on production and pricing policies.