Marginal Costs & Profit Maximization

A business' profitability is determined by the net result of its inflows (revenues) and outflows (costs) also known as marginal revenues (MR) and marginal costs (MC) respectively. It is however more common for people to refer to this concept in terms of marginal costs. Other common terms for marginal costs include incremental costs, differential costs, contribution costs, direct costs and choice costs. Marginal costing is a method of cost accounting for internal reporting and decision-making.


Common Uses & Benefits of Marginal Costing

• To inform management of optimal resource allocation. For instance, it helps management to establish the optimal production quantities (that maximize profitability) and the 'shut down' point, ie the point from which increasing production further will translate into doing so at a loss.
• To establish volumes for wholesale buyers.

To calculate marginal costs, you will need to know the following.

• Current number of units being produced
• Cost of producing each unit 
• Maximum production capacity (based on current [production circumstances. For instance, if you have 2 employees, calculate the maximum that they can produce before you will need to hire additional labor.)
• Cost for additional variable costs per unit. (For instance, the cost of additional labor).

Marginal Costs (MC)

Marginal costing is a form of cost accounting that attaches only costs associated with producing each additional unit, ie marginal costs (MC) to cost units of production (while isolating fixed costs as a lump sum apart).

Marginal costs are the incremental costs incurred when producing additional units of a product. The key term is ADDITIONAL units. This is the equation.

MC = Change in costs / Change in quantity

Example:

• Current number of cakes produced = 1
• Cost of baking a wedding cake = $ 10.00
• Maximum Production capacity (based on current cost structure) = 3 cakes
• Cost for additional variable costs per unit (like labor and cooking gas) after the capacity (of 3 cakes) = $1.50 per unit

MC for 

• 2 additional cakes (ie 3 cakes in total) = 
• ($20 additional cost - $10 current)  /  (2 additional cakes - 1 cake currently) = 
• $10 / 1 =
• $10
• 3 additional cakes (ie 4 cakes in total) = 
• ($30 additional cost - $10 current)  /  (3 additional cakes - 1 cake currently) = 
• $20 / 2 =
• $20
• 4 additional cakes (ie 5 cakes in total) = 
• (($40+1.5) additional cost - $10 current)  /  (4 additional cakes - 1 cake currently) = 
• $31.50 / 3 =
• $10.5

• 6 additional cakes (ie 7 cakes in total) = 
• ($60+(3*1.5) additional cost - $10 current)  /  (6 additional cakes - 1 cake currently) = 
• $64.50 / 5 =
• $12.9

When comparing scenarios, a lower marginal cost may suggest better economies of scale.

Marginal Revenue (MR)

Marginal revenue is the incremental revenue earned when producing additional units of a product. It has a similar equation.

Marginal revenue = Change in revenue / Change in quantity

Point of Profit Maximization

A business' profit can be maximized when MC = MR.

Consequently, a business should know this profit maximizing production quantity. After that point, its managers may consider a temporary operational 'shut down' to avoid the financial loss.

The following table illustrates a very simple means of determining the optimal production volume, even without calculating the MC.

demand    (qty)	price	revenue (q x price)	cost	profit (R-C)
0		0	4	-4
1	18	18	6	12
2	15	30	10	20
3	12	36	16	20
4	9	36	24	12
5	6	30	34	-4
6	3	18	46	-28

Observations

• This business' profit rises and then falls.
• After a point, the business actually incurs a loss.
• Using only these simple calculations can already provide an answer regarding the most profitable production levels, in this case between 2 and 3 units. 

The following table confirms the findings of the table above, ie that maximum profitability indeed occurs when MC = MR.

demand     (qty)	price	revenue (q x price)	cost	profit (R-C)	MR	MC
0		0	4	-4
					18	2
1	18	18	6	12
					12	4
2	15	30	10	20
					6	6
3	12	36	16	20
					0	8
4	9	36	24	12
					-6	10
5	6	30	34	-4
					-12	12
6	3	18	46	-28

Observations

• The MC and MR are the same when the profitability is highest.
• If you can not produce to the ideal level, know that it is safe to produce when MR is greater than MC. The profit is increasing with quantity.
• When MR is lower than MC, the revenue is in decline with quantity. Great care must be taken as production may be occurring at a loss, or will get to that point if the quantity continues to increase.

CONTENT RELATED TO MARGINAL COST

• Consider marginal costing for volume pricing for retail customers and tier pricing for wholesale customers.

• Learn more about why raising prices for product decommoditization is necessary.
• Breakeven analysis