Marginal Cost Of Production

What Is the Marginal Cost of Production?

In economics, the marginal cost of production is the change in total production cost that comes from making or producing one additional unit. To calculate marginal cost, divide the change in production costs by the change in quantity. The purpose of analyzing marginal cost is to determine at what point an organization can achieve economies of scale to optimize production and overall operations. If the marginal cost of producing one additional unit is lower than the per-unit price, the producer has the potential to gain a profit.

Understanding Marginal Cost of Production

The marginal cost of production is an economics and managerial accounting concept most often used among manufacturers as a means of isolating an optimum production level. Manufacturers often examine the cost of adding one more unit to their production schedules.

At a certain level of production, the benefit of producing one additional unit and generating revenue from that item will bring the overall cost of producing the product line down. The key to optimizing manufacturing costs is to find that point or level as quickly as possible.

Marginal cost of production includes all of the costs that vary with that level of production. For example, if a company needs to build an entirely new factory in order to produce more goods, the cost of building the factory is a marginal cost. The amount of marginal cost varies according to the volume of the good being produced.

Marginal cost is an important factor in economic theory because a company that is looking to maximize its profits will produce up to the point where marginal cost (MC) equals marginal revenue (MR). Beyond that point, the cost of producing an additional unit will exceed the revenue generated.

Important

Economic factors that may impact the marginal cost of production include information asymmetries, positive and negative externalities, transaction costs, and price discrimination.

Example of Marginal Cost of Production

Production costs consist of both fixed costs and variable costs. Fixed costs do not change with an increase or decrease in production levels, so the same value can be spread out over more units of output with increased production. Variable costs refer to costs that change with varying levels of output. Therefore, variable costs will increase when more units are produced.

For example, consider a company that makes hats. Each hat produced requires seventy-five cents of plastic and fabric. Plastic and fabric are variable costs. The hat factory also incurs $1,000 dollars of fixed costs per month.

If you make 500 hats per month, then each hat incurs $2 of fixed costs ($1,000 total fixed costs / 500 hats). In this simple example, the total cost per hat would be $2.75 ($2 fixed cost per unit + $0.75 variable costs).

If the company boosted production volume and produced 1,000 hats per month, then each hat would incur $1 dollar of fixed costs ($1,000 total fixed costs / 1,000 hats), because fixed costs are spread out over an increased number of units of output. The total cost per hat would then drop to $1.75 ($1 fixed cost per unit + $.75 variable costs). In this situation, increasing production volume causes marginal costs to go down.

If the hat factory was unable to handle any more units of production on the current machinery, the cost of adding an additional machine would need to be included in the marginal cost of production. Assume the machinery could only handle 1,499 units. The 1,500th unit would require purchasing an additional $500 machine. In this case, the cost of the new machine would also need to be considered in the marginal cost of production calculation as well.

Why is the marginal cost of production important?

The marginal cost of production is an economics concept that plays an important role in business management. It refers to the incremental cost of adding one more unit of production, such as producing one more product or delivering one more service to customers. It is generally associated with manufacturing businesses, although the concept can be applied to other types of businesses as well.

How is the marginal cost of production calculated?

The marginal cost of production is calculated by dividing the change in costs by the change in quantity. For example, suppose that a factory is currently producing 5,000 units and wishes to increase their production to 10,000 units. If the factory’s current cost of production is $100,000, and if increasing their production level would raise their costs to $150,000, then the marginal cost of production is $10, or ($150,000 - $100,000) / (10,000 - 5,000).

How can the marginal cost of production help businesses?

The marginal cost of production can help businesses optimize their production levels. Producing too much too quickly could negatively impact profitability, whereas producing too little can also lead to suboptimal results. Generally speaking, a company will reach optimal production levels when their marginal cost of production is equal to their marginal revenue.