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

Retail Volume Pricing

Retail volume pricing refers to offering price discounts for larger quantity purchases of a product. Consequently, the more that a customer buys at once, the larger the discount.  As illustrated in the examples below, volume pricing is most commonly presented through differences in product size and number of units bought at once.

Example

Small plate: $1.00

Medium plate: $1.15

Large plate with unlimited extra helpings: $1.43

Example

1 unit of shampoo X: $1,00

3 units of shampoo X: $2.85

Benefits of volume pricing

• Larger orders. Larger orders provide customers with the reward of a lower price and possibly lower shipping costs.
• Creating new customers. First-time customers can have a lower price to try the product before getting the standard price for the second order.
• Compensates consumers for  their perceived diminishing marginal product value. one theory posits that as someone consumes a product, the initial wow effect diminishes over time. The lower price helps to compensate for this.
• Frees up human and other resources. This is a matter of working more efficiently. 

Beware. Volume pricing is NOT a panacea as it applies favorably in only some cases.

'DOs & DON'Ts' and Considerations

• Customers expect a discount, even though there are often no or very negligible differences.
• Customers are considerably more likely to buy volume priced products if the products are non-perishable or has an extended shelf life.
• Price sensitive customers report taking out a calculator at stores to verify the level of saving.
• Proceed ONLY IF volume pricing still generates more sales and a profit. For instance, personal care commodity product savings are likely to range from roughly 4% to 14%, with the higher priced products having the higher discounts. When asked, some low resources individuals said they will not buy the discounted product if the saving is on the much lower end, especially since they must pay out more initially. Ironically, this is the segment that seeks savings more but less likely to get it with the products that target them. Respondents suggested that they are more likely to buy with discounts like '2 for the price of 1' (ie 50% off) or '3 for the price of 2' (ie 33% off). You may consider ways other than price discounts as a means of increasing sales. Interestingly however, higher discounts on higher end products can help to target lower resources individuals.
• Establish prices around customer perception and not simply a markup on manufacturing costs. On this basis, price discounts may be inappropriate for products needing to use higher prices to signal higher quality. For such high end products, volume pricing may be inappropriate for retail. Tier pricing (mentioned below) might be more suitable for wholesale customers. 
• Know your customers' buying patterns as they relate to volume. For instance, if your customers usually buy small volumes, volume pricing is worthwhile. Otherwise, if they already buy in high volume, do NOT proceed as the discount will be un-necessary.
• This point has 2 messages; 1) Investigate to understand the reason for lower sales and 2) Segment your market to price accordingly. Slow sales may have nothing at all to do with prices. For instance, there are case studies of products being priced between 2 segments without adequately capturing the demand of either. Prices for such products need not be discounted. Rather, the opposite, ie raising the price has worked to better target a market that strongly believes that higher price suggests higher value.
• Initial price of $1,000 perceived as too high for consumers
• Initial price of $1,000 perceived as not sufficiently serious by professionals
• Solution that worked: Raised the price by 63% and targeted professionals. Sales soared with the professional segment.
• Higher margin products are best suited to volume pricing.
• If your customers like small volume sales, ensure they still have that option when applying volume pricing.
• Like other forms of price discounting strategies, volume pricing can negatively impact customer perceived value of the brand. Consequently, stress the benefit of higher volumes versus stressing the obvious economic saving. For instance, 'buy for the whole family', 'stock up on travel size units for the upcoming travel season', 'Share the joy! Give one to a friend', etc  
• If you decide to implement volume pricing, allocate someone to analyze whether volume pricing is worthwhile regarding raising sales and profitability.

CONTENT RELATED TO VOLUME PRICING

• Volume pricing ought not be confused with tier pricing. Tier pricing establishes unit price tiers and is often used in wholesale pricing, an area in which sale volumes are considerably larger (than retail). Notice the volume ranges in the example immediately below.

• You may be selling retail now. However, you never know if the future will present opportunities for wholesale, as crazy as it currently seems. Consider wholesale pricing as part of the process of calculating your retail prices (for the volume offers). Ensure that all parties can reap some financial benefit, especially yourself.
• Wholesale payment terms
• Learn more about why raising prices for product decommoditization is sensible