Marginal cost definition
/What is Marginal Cost?
Marginal cost is the cost of one additional unit of output. The concept is used to determine the optimum production quantity for a company, where it costs the least amount to produce additional units. It is calculated by dividing the change in manufacturing costs by the change in the quantity produced. If a company operates within this "sweet spot," it can maximize its profits. The concept is also used to determine product pricing when customers request the lowest possible price for certain orders.
When to Use Marginal Cost
The marginal cost concept is most useful in decision-making situations where management needs to evaluate the impact of producing one additional unit of a product or service. It is especially relevant when assessing short-term pricing strategies, such as accepting a special order below the normal selling price, as long as the price covers the marginal cost and contributes to fixed costs. Marginal cost analysis is also valuable when deciding whether to expand production, discontinue a product line, or make or buy a component, as it focuses only on the variable costs that change with the decision, ignoring fixed costs that remain unchanged. This approach helps businesses make efficient, profit-maximizing choices in dynamic or competitive environments.
Impact of Standardization on Marginal Cost
The marginal cost of customized goods tends to be quite high, whereas it is very low for highly standardized products that are manufactured in bulk. The reason for the difference is that the variable cost associated with a customized product tends to be higher than for a standardized product. A high level of standardization is usually achieved with more automation, so the variable cost per unit is low and the fixed cost of manufacturing equipment is high.
Accounting for Marginal Cost
Since marginal cost is only used for management decision making, there is no accounting entry for it. Instead, this concept is mostly used for pricing and production decisions.
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Example of Marginal Cost
As an example of marginal cost, a production line currently creates 10,000 widgets at a cost of $30,000, so that the average cost per unit is $3.00. However, if the production line creates 10,001 units, the total cost is $30,002, so that the marginal cost of the one additional unit is only $2. This is a common effect, because there is rarely any additional overhead cost associated with a single unit of output; the result is a lower marginal cost.
Impact of Step Costs on Marginal Cost
In rare cases, step costs may take effect, so that the marginal cost is actually much higher than the average cost. To use the same example, what if the company must start up a new production line on a second shift in order to create unit number 10,001? If so, the marginal cost of this additional unit might be vastly higher than $2 - it may be thousands of dollars, because the company had to start up an extra production line in order to create that single unit.
A more common situation lying between the preceding two alternatives is when a production facility operating near capacity simply pays overtime to its employees for them to work somewhat longer to manufacture that one additional unit. If so, the marginal cost will increase to include the cost of overtime, but not to the extent caused by a step cost.
Terms Similar to Marginal Cost
Marginal cost is the same as incremental cost.