What is Marginal Cost?
Marginal cost is the variable costs incurred when producing additional units of a goods or services. It is calculated when a breakeven point has been reached – fixed costs are incorporated in the finished product and only the direct variable costs have yet to be accounted for. The usual variable costs included are labor and materials, plus the estimated increases in fixed costs (if any), such as: administration, overhead, and selling expenses. The marginal cost formula can be used in financial modeling to optimize the generation of cash flow.
Below we will break down the various components of the marginal cost formula.
What is the Formula for Marginal Cost?
Here is the Marginal Cost Formula:
Marginal Cost = (Change in Costs) / (Change in Quantity)
What is Change in Costs?
At each level of production and during each time period, costs of production may increase or decrease, especially when the need arises to produce more or less volume of output. If manufacturing additional units requires hiring one or two workers and increases the purchase cost of raw materials, then a change in the overall production cost will result. To determine the change in costs, simply deduct the production costs incurred at during the first output run from the production costs in the next batch when output has increased.
What is Change in Quantity?
Since it’s inevitable that the volume of output will increase or decrease with each level of production. Thus, the quantities involved are significant enough to evaluate the changes made. An increase or decrease in the volume of goods produced translates to costs; therefore, it is important to know the difference. To determine the changes in quantity, the number of goods made in the first production run is deducted from the volume of output made in the following production run.
An Example of the Marginal Cost Formula
Obama Tires, a public company, consistently manufactures 10,000 units of truck tires each year, incurring production costs of $5 million. The following year, the market demand for tires increases significantly, requiring the additional production of units, which prompts management to purchase more raw materials and spare parts as well as hire more manpower. This demand results in overall production costs of $7.5 million to produce 15,000 units in that year. As a financial analyst, you determined the marginal cost of $500 is accounted counted for each additional unit produced.