Growth is a key objective for most small businesses, and that may mean increasing production to sell more products and services to your customers. But just how much growth is best?
Marginal cost is a way to calculate the cost of delivering an additional product or service. It’s an important metric that helps business owners assess whether a new product will increase profits.
Understanding marginal cost
Any new cost associated with producing one additional product or service is a marginal cost, explains Stephanie Marshall, host of the finance podcast The 3 Bz. “If you’re making pencils then you have a good idea of the cost of goods sold (COGS), but marginal cost is the additional cost involved in making just one more item,” she explains.
Short-term production increases can allow businesses to meet spikes in customer demand and take advantage of new business opportunities. But it’s important to know what impact this increase in production can have on profitability - which is exactly what marginal cost enables you to do.
The marginal cost formula
To calculate the marginal cost of increasing production, you must divide the change in your total costs by the change in the total quantity of products or services that your business delivers. The marginal cost formula is as follows:
Marginal Cost = Change in Total Cost / Change in Quantity
To calculate the change in total cost, compare the total production costs at two different output levels. Determine the total cost at each production level, and subtract the initial level's cost from the final level's cost. This difference signifies the change in total cost.
For the change in quantity, compare the quantity of goods or services produced in two periods. Subtract the initial quantity from the final quantity to find the difference.
The marginal cost curve
Using the marginal cost curve, you can plot on a graph the point at which a new product or service becomes profitable.
“When you’re delivering an additional service or product, there will be additional costs around things like material and labour, but there will also be a point where you benefit from bulk buying of materials, or the cost of the materials doesn’t increase further if it’s something like a software licence,” says Marshall. “The marginal cost curve can be used to track that journey and identify the point at which profit can be realised.”
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At Vineyards, a Dorset-based wine merchant and distillery, marginal costs are critical. “We’re producing gin, amaretto and liqueurs in small volumes, so we need to pay attention to the cost of increasing production to ensure it’s profitable,” explains Hannah Wilkins, the company’s managing director.
Increasing gin production by one bottle doesn’t impact on the cost of running the still to produce the alcohol, and costs such as duty remain constant as output increases. However, variable costs such as shipping and raw materials will change at certain levels of output, explains Wilkins. “We get a volume discount on bottles, so if we increase production by several hundred bottles, the price per bottle falls, and our cost of shipping materials from France falls as output increases because we pay for shipping per pallet, and we can simply stack materials higher on one pallet if we buy more.”
Marginal cost and economies of scale
Knowing your marginal costs allows you to understand at what point your business can achieve economies of scale. This is where a business starts to feel the cost advantage of scaled production. In many cases, companies will benefit from economies of scale as they buy more of things like raw materials or labour.
For example, using the example of the graph above, economies of scale are achieved when output (in units) is at two. This is the point at which the plotted line starts to curve and increase.
What is an example of a marginal cost?
A classroom furniture company spends £1,000 to manufacture 100 chairs for a school. The marginal cost would refer to any additional expense incurred by producing one more chair beyond the initial 100.
While the average cost of these 100 chairs is £10, this average is unlikely to be evenly distributed due to the cost curve and economies of scale. For example, the first 10 chairs might cost £12 per chair, while chairs 90-100 might cost £8 each to produce. So it may be that the marginal cost of additional materials and labour for one extra chair amounts to £8.
To make it easier to absorb increases in production costs, the American Express® Business Gold Card, gives you up to 54 days to clear your Card balance¹. This gives you greater flexibility in your cash flow as you increase your orders to suppliers.
What are the different types of marginal costs?
Marginal costs can be divided into fixed or variable costs, and which category an expense falls into will sometimes depend on the nature of your business.
Fixed marginal costs
Fixed marginal costs include any costs that don’t change with short-term fluctuations in production. They can include rent, salaries and insurance payments, which will remain constant even if production increases for a period.
Variable marginal costs
Variable marginal costs are different and will vary based on output. For example, a business might increase spending on freelance labour, raw materials or packaging depending on the volume of a product being made.
Understanding marginal costs helps business owners to make more informed business decisions. “Making business decisions based on unit costs isn’t realistic, but by knowing marginal costs, you can work out if it’s more financially beneficial to produce 100 more products or 10,000,” says Marshall.
1. The maximum payment period on purchases is 54 calendar days and is obtained only if you spend on the first day of the new statement period and repay the balance in full on the due date. If you'd prefer a Card with no annual fee, rewards or other features, an alternative option is available – the Business Basic Card.
