Marginal Cost

Marginal cost represents the incremental costs incurred when producing additional units of
a good or service. It is calculated by taking the total change in the costs of producing more
goods and dividing that by the change in the quantity of good produced. The usual variable
costs included in the calculation are labour 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 modelling to optimise the generation of cash flow.

Definition:

The Marginal Cost refers to the change in the total cost as a result of the production of one
more unit of the product. In other words, the marginal cost is the increase or decrease in
the total cost due to the production of one additional unit of the product.

In simple terms,

"The cost that results from a one unit change in the production rate"

Below we will break down the various components of the marginal cost formula.

Formula:
Marginal Cost = Change in Total Cost = ΔTC
Change in Quantity ΔQ
The marginal cost includes any cost incurred in producing the next unit of the product and
hence is expressed as:

MC = ΔTC/ ΔQ
Where,
ΔTC = Change in Total Cost, ΔQ = Change in Quantity

The purpose of marginal cost is to determine the point where the firm reaches its
economies of scale. This can be shown in the figure given below:

The marginal cost curve is a U-shaped curve, which shows that cost starts at higher point
and declines with the increase in the production. The cost declines with the increase in the
level of output because of the economies of scale. When the cost is lower, the firm can hire
specialized labour, avail discount benefits on bulk purchase of raw materials, enjoy the full
utilization of machines and equipment, etc.

But after some time, the marginal costs starts rising, which shows, the cost increases with
the increase in the level of output. This is because the curve reaches the point where
diseconomies of scale persist. The costs rise because the resources from the current source
might have completely exhausted and the firm purchases raw materials from other sources
at a relatively higher price, hire more management, buy more machines and equipment, etc.

Till the price charged for the product is greater than the marginal cost, the revenue will be
greater than the added cost and the firm will continue its production. But, as soon as the
price charged is less than the marginal cost, the revenue declines, and it is not wise to
expand production.

What is “Change in Total 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 of goods
manufactured (COGM); 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.

How important is Marginal Cost in Business Operations?

When performing financial analysis, it is important for management to evaluate the price of
each good or service being offered to consumers, and marginal cost analysis is one factor to
consider.

If the selling price for a product is greater than the marginal cost, then earnings will still be
greater than the added cost – a valid reason to continue production. If, however, the price
tag is less than the marginal cost, losses will be incurred and therefore additional production
should not be pursued, or perhaps prices should be increased. This is an important piece of
analysis to consider for business operations.

Economies of Scale (or Not)

Businesses may experience lower costs of producing more goods if they have what’s known
as economies of scale. For a business with economies of scale, producing each additional
unit becomes cheaper and the company is incentivized to reach the point where marginal
revenue equals marginal cost. An example would be a production factory that has a lot of
space capacity and becomes more efficient as more volume is produced. In addition, this
business is able to negotiate lower material costs with suppliers at higher volumes, which
makes the variable costs lower over time.

For some businesses, costs actually rise as more good or services are produced. These
companies are said to have diseconomies of scale. Imagine a company that has reached its
maximum limit of production volume. If it wants to produce more units, the marginal cost
would be very high as major investments would be required to expand the factory’s capacity
or lease space from another factory at a high cost.

With this understanding, let us see an example.

For example, the total cost of producing one pen is $5 and the total cost of producing two
pens is $9, then the marginal cost of expanding output by one unit is $4 only (9 - 5 = 4).

The marginal cost of the second unit is the difference between the total cost of the second
unit and total cost of the first unit. The marginal cost of the 5th unit is $5. It is the difference
between the total cost of the 6th unit and the total cost of the, 5th unit and so forth.

Marginal Cost is governed only by variable cost which changes with changes in output.
Marginal cost which is really an incremental cost can be expressed in symbols.
The readers can easily understand from the table given below as to how the marginal cost is
computed:

Schedule:

Units of Output Total Cost (Rupees) Marginal Cost (Rupees)

1 5 5
2 9 4
3 12 3
4 16 4
5 21 5
6 29 8

Diagram:

MC curve, can also be plotted graphically. The marginal cost curve in fig. (13.8) decreases
sharply with smaller Q output and reaches a minimum. As production is expanded to a
higher level, it begins to rise at a rapid rate.

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.

Marginal cost will tend to fall at first, but quickly rise as marginal returns to the variable
factor inputs will start to diminish, which makes the marginal factors more expensive to
employ. This is referred to as the 'law of diminishing marginal returns'.

Marginal cost is significant in economic theory because a profit maximising firm will produce
up to the point where marginal cost (MC) equals marginal revenue (MR).

Also, a firm’s supply curve is effectively the part of the MC curve above average variable
costs (from point B upwards, on the diagram below). A firm will not supply below this point
as it will not be covering its opportunity cost. Point B is also known as shut-down point.
Point A represents break-even point.
Long-run Marginal Cost Curve:

The long run marginal cost curve like the long-run average cost curve is U-shaped. As
production expands, the marginal cost falls sharply in the beginning, reaches a minimum
and then rises sharply.

Relationship Between Log-run Average Cost and Marginal Cost:

The relationship between the long-run average total cost and long-run marginal cost can be
understood better with the help of following diagram:

It is clear from the diagram, that the long-run marginal cost curve and the long-run average
total cost curve show the same behaviour as the short-run marginal cost curve express with
the short-run average total cost curve. So long as the average cost curve is falling with the
increase in output, the marginal cost curve lies below the average cost curve.

When average total cost curve begins to rise, marginal cost curve also rises, passes through
the minimum point of the average cost and then rises. The only difference between the
short-run and long-run marginal cost and average cost is that in the short-run, the fall and
rise of curves LRMC is sharp. Whereas In the long-run, the cost curves falls and rises
steadily.