Definition: Marginal cost is the additional cost incurred for the production of an additional unit of output. The formula is calculated by dividing the change in the total cost by the change in the product output.
What Does Marginal Cost Mean?
What is the definition of marginal cost? MC indicates the rate at which the total cost of a product changes as the production increases by one unit. However, because fixed costs do not change based on the number of products produced, the marginal cost is influenced only by the variations in the variable costs.
MC is particularly important in the business decision-making process. Management has to make decisions on where to best allocate resources in the production process. For instance, when the management needs to decide whether to increase production or not, they have to compare the marginal cost with the marginal revenue that will be realized by an additional unit of output. Is it worth it to the company to produce more goods on the whole?
Let’s look at an example.
Example
Manufacturing company X manufactures heating systems. The factor’s outdated existing equipment does not meet the firm’s manufacturing needs and can’t keep up with the production schedule. The firm has to purchase or rent additional equipment to maintain its production at the same levels.
Thus, the accounting department needs to calculate the marginal cost of the heating systems that will be produced by the new equipment, including the cost of their acquisition.
Observations
1. The total cost increases as the quantity of the product increases because larger quantities of production factors are required.
2. The MC is reduced up to a certain level of production (Q=5), and then, it keeps on growing along with production.
3. The MC of producing an additional unit of heating systems at each level of production has to take into account a sudden increase in the raw materials. If the firm has to change its suppliers, the MC may increase due to longer distances and higher prices of raw materials.
Summary Definition
Define Marginal Cost: Marginal cost is the extra expense associated with producing one additional unit.
Marginal cost refers to the expense of creating one more item for sale. It is most commonly used in manufacturing, where it’s called the marginal cost of production.
The marginal cost tells a business precisely how much more they have to spend to create one more product, or deliver a service one more time.
It’s useful to know how much it costs to create more of the things you sell. The incremental costs are often quite small because the business has already paid for all the work tools and systems required to make the item or deliver the service.
When the marginal cost is relatively small, it means the business can affordably increase production and possibly revenue.
It’s common for the marginal cost of serving extra customers to be relatively low. The lower cost of production may allow you to make those extra sales at a higher profit. Or it may allow you to offer a better price to customers.
Learn more in our entry on how to calculate marginal cost.
While a business can often increase production by simply buying more raw materials, there will come a point at which capacity is maxed out. The business won’t be able to produce more unless it invests in a new workshop, more equipment, or additional employees.
These bigger investments are stepped costs. A business will typically need to sell a lot more products or services to pay back the investment involved in a stepped cost.
Marginal cost (calculation)
This glossary is for small business owners. The definitions are written with their requirements in mind. More detailed definitions can be found in accounting textbooks or from an accounting professional. Xero does not provide accounting, tax, business or legal advice.
Marginal costing in economics and managerial accounting refers to an increase or decrease in the total cost of production due to a change in the quantity of the desired output. It is variable, depending on the inclusion of resources required to produce or deliver additional unit(s) of a product or service.
Calculating marginal cost enables managers to make decisions on resource allocation, optimize the production and operation, control manufacturing costs, plan budget and profits, etc. It considers expenses incurred at each production stage, except for overhead pricing. The practice is common in manufacturing industries, allowing companies to achieve economies of scale.
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- Marginal costing is the increase or decrease in the overall cost of production due to changes in the quantity of desired output.
- Managers can use it to make resource allocation decisions, optimize production, streamline operations, control manufacturing costs, plan budgets and profits, and so on.
- In most cases, variable costs influence marginal costs. It can, however, consider fixed expenses in circumstances of increased output.
- When a company’s marginal cost equals its marginal income, it maximizes profits while setting the selling price of a product or service.
How Does Marginal Costing Work?
The marginal costing technique is crucial for any business aiming to optimize the production of goods or delivery of services. The concept technically means extra costs added to the production cost due to additional unit(s). It helps companies determine the selling price of a product or service. Furthermore, they can estimate the desired output by understanding marginal and sales costs. It simply works like this:
- Sale or Unit price > Marginal cost = More production = Profit
- Marginal cost > Sale or Unit price = Less production = Loss
Moreover, entities can calculate the price associated with resources needed to scale up the production of additionally ordered items. Also, it enables managers to estimate production expenses and budget, avoiding last-minute resource shortages.
Marginal costing varies with the production level and volume. Based on this, it can be either short-run (i.e., fixed costs for additional production in a short time) or long-run (i.e., variable inputs for extra output in more time).
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In the other context, it is an essential tool for companies to maximize profits and achieve economies of scaleEconomies of scale are the cost advantage a business achieves due to large-scale production and higher efficiency. read more. It happens by producing to the point where the marginal cost equals marginal revenue. Manufacturing and selling an additional unit of a product or service generates marginal or sales revenueSales revenue refers to the income generated by any business entity by selling its goods or providing its services during the normal course of its operations. It is reported annually, quarterly or monthly as the case may be in the business entity's income statement/profit & loss account.read more.
Marginal Costing Factors
In the production process, some resources remain constant regardless of how many extra orders the business receives. Such resources involve fixed costsFixed Cost refers to the cost or expense that is not affected by any decrease or increase in the number of units produced or sold over a short-term horizon. It is the type of cost which is not dependent on the business activity.read more that do not change with the production quantity, resulting in increased output. These mainly include overhead, administration, and sales costs.
On the other hand, the company may require a few resources to enhance the production speed for additional orders. Buying and maintaining these resources involve variable costs that keep changing with the output volume, increasing expenses. These usually include raw materialsRaw materials refer to unfinished substances or unrefined natural resources used to manufacture finished goods.read more and labor costsCost of labor is the remuneration paid in the form of wages and salaries to the employees. The allowances are sub-divided broadly into two categories- direct labor involved in the manufacturing process and indirect labor pertaining to all other processes.read more.
For example, baker Maria, on regular occasions, bakes 20 cakes per day. Hence, she has a small plant, 2 baking machines, and 7 employees to handle daily orders. However, during the Christmas season, Maria receives the order of 50 cakes per day for as long as the New Year hangover continues. To speed up the process, she employs 8 more employees, who she needs to pay for the season, along with buying 3 more machines, which involves another significant investment from her side, while her plant does not change.
In this example, adding new staff and machines involves variable costs. It eventually adds to the total cost of production, contributing to Maria’s marginal cost. The cost of the plant, on the other hand, remains fixed without affecting the overall manufacturing cost.
Marginal costing typically considers variable costs in its calculation. However, it can include fixed expenses in the cases of enhanced production.
Equation Of Marginal Costing
Marginal costing signifies the change in the overall production cost due to a variation in the desired quantity of goods or services. Companies perform financial modelingFinancial modeling refers to the use of excel-based models to reflect a company's projected financial performance. Such models represent the financial situation by taking into account risks and future assumptions, which are critical for making significant decisions in the future, such as raising capital or valuing a business, and interpreting their impact.read more to maximize cash flow generation using the following equations:
Marginal Cost (MC) = (Change in Total Costs) / (Change in Quantity)
Or,
MC = ΔTC/ ΔQ ——————————— Equation (I)
Where,
- TC = Total cost
- Q = Quantity
- Δ = Incremental change of producing one additional unit
The total cost of production is the sum of both fixed and variable costs, depending on the desired output. Marginal cost is directly proportional to the variable cost occurring at every production level. So, let us have a look at another equation to check out the interrelation between both:
TC = FC + (Q x VC) —————————— Equation (II)
Where,
- FC = Fixed cost
- VC = Variable cost
Combining both equations I and II together, we get:
- MC = ΔTC/ ΔQ = VC ————————— Equation (III)
Equation III shows how TC is directly proportional to VC. It means the total cost will automatically increase if the variable cost increases and vice-versa.
Calculation Example
Calculating marginal cost involves dividing the change in production costsProduction Cost is the total capital amount that a Company spends in producing finished goods or offering specific services. You can calculate it by adding Direct Material cost, Direct Labor Cost, & Manufacturing Overhead Cost. read more by the variation in the desired output. Here is a marginal costing example with the step-by-step calculation:
Sam owns an automobile company. He manufactured 10 four-wheelers worth $400,000 in the first year of business. The total cost involved in the making of those sedans was $180,000. In the second year, he sold 20 vehicles worth $800,000. This time, the total cost he incurred in manufacturing them was $360,000.
Here, the change in the total cost of production:
- = $360,000 – $180,000
- = 180,000
The change in quantity:
Using the marginal costing equation,
MC = ΔTC/ ΔQ
We get,
- MC = $180,000/10
- = $18,000
Therefore, $18,000 is the MC per sedan.
Advantages And Disadvantages
Correct marginal costs estimation can help managers develop budget and profit plans for the next production cycle. It means an inaccurate calculation can lead to massive losses to manufacturing units. Thus, it has both pros and cons, which are as follows:
| Classifies costs as fixed and variable | Efficiency of resources and other factors could also affect the marginal cost |
| No overhead pricing included | Does not consider time as a factor |
| Easy cost ascertainment | Not suitable for all sectors |
| Helps in effective decision-making, whether it is to replace a machine or discontinue a product or service | |
| Cost comparison becomes easy |
Frequently Asked Questions (FAQs)
What is marginal costing?
Marginal costing calculates the change in the overall production cost owing to variation in the volume of the targeted output. The price varies depending on the number of products. Marginal costs include expenses incurred at each production stage due to changes in resources needed to create the required additional quantity of products or services.
What is marginal costing in accounting?
In accounting, marginal costing is a variable expense applied to the unit cost. The quantity produced by removing marginal cost from the product’s selling price is referred to as a contribution. In this situation, the contribution completely offsets the fixed cost.
What is the difference between marginal costing and absorption costing?
The marginal costing technique considers variable costs as the actual production cost. In contrast, absorption costing is the method that considers both variable and fixed costs as part of the production cost.
Recommended Articles
This has been a guide to what is Marginal Costing and its definition. Here we discuss how it works along with its formula and example. You can learn more from the following articles –
- Marginal Cost of Capital
- Average Cost
- Conversion Cost