Marginal Cost: How to Use It to Protect Your Bottom Line

Marginal cost is the additional expense of producing one more unit of a product. It’s a way to determine whether you should double down on your manufacturing efforts or scale back and lower your output.

If you’re planning on expanding your business, it’s important to remember that more production doesn’t always equal more profitability. As output scales, your cost of production can rise due to capacity constraints and workplace inefficiencies.

This is where calculating your marginal cost can make a big impact on your business. It helps you find the tipping point where making extra units costs more than they’re worth. In this guide, we’ll explain how marginal cost works, how you can calculate it, and the ways you can use it to maximise your profitability. Let’s dive in.

• What is marginal cost?
• Marginal cost formula
• How to calculate marginal cost (with examples)
• Marginal cost vs. marginal revenue
• The marginal cost curve
• Source: Synario
• Source: Pareto Labs
• Why is marginal cost important for businesses?
• Ready to put your marginal cost analysis to work?
• FAQs

Marginal cost (also known as incremental cost) is an economic term that refers to the extra cost of producing one additional unit of a product or service.

Marginal cost factors in the variable costs of production, such as materials, labour and product packaging. It can also (but not always) include fixed costs if they’ll change as your production increases. For instance, if creating more units requires you to invest in new machines and hire a new team member, you’ll need to factor these additional expenses into the equation.

Evaluating marginal costs is fundamental if you’re looking to optimise your production efforts, fine-tune your pricing strategy, make smarter decisions and keep your profitability high. We’ll show you how it works and give you some examples.

In the most basic terms, marginal cost will tell you how much your total cost changes when you produce one additional unit. Here’s how to calculate it:

Marginal cost = Change in total cost / Change in quantity produced

Or, broken down to its formula: MC = ΔTC / ΔQ

• MC: marginal cost
• ΔTC: change in total cost
• ΔQ: change in quantity produced

With these pieces in place, you’re ready to start applying the marginal cost formula to real scenarios. Let’s take a look at how to do that with some examples.

Now that you understand the formula, let’s talk through how to gather each of the elements to calculate it accurately. Here’s how you can calculate marginal cost for your own business.

This is the easy part. How many more units are you producing? In most cases, this will be one unit, though you can opt for any figure based on how many units you’d like to add.

For this example, let’s assume you currently produce 200 units and would like to add one unit, making 201 units.

Now you need to determine how much your total cost of production has changed since your output increased.

Variable costs should be easy to calculate. However, you’ll have to factor in additional costs, such as the need to hire a new worker, an additional machine or a larger space to handle the increased production. Also, you’ll need to consider how inefficiencies (like equipment strain and slower workflows) can quietly increase costs as you increase production capacity.

These variables can be hard to predict. With that in mind, the simplest way to identify the change in total cost is to trial-run the increased quantity and then assess the change. For instance, let’s assume you can produce 200 items for $1,000 and 201 units for $1,007.

All that’s left to do is to calculate the marginal cost. As we mentioned above, you can do this by dividing the change in total cost by the change in quantity produced. So:

• Change in quantity produced: 201 - 200 = 1 unit
• Change in total cost: $1,007 - $1,000 = $7
• Marginal cost: $7 / 1 = $7

This means that the marginal cost of making a single additional product is $7.

You can then compare this to your selling price. If you can sell your product for more than $7, it’s a good idea to make more.

However, if your marginal cost increases beyond your selling price, this isn’t sustainable. You’ll either need to decrease your output or raise your prices to avoid a hit to your profit margin.

Let’s say you run a bakery that has a total cost of $3,000 to produce 1,000 cakes a week. You’re looking to increase your output to 1,200 total cakes. After a test run, you find this will cost you $3,800 a week.

Let’s calculate the marginal cost for this business:

• Change in quantity produced: 1,200 cakes - 1,000 cakes = 200 cakes
• Change in total cost: $3,800 - $3,000 = $800
• Marginal cost: $800 / 200 = $4

This means the cost of producing one additional cake would be $4.

If you sell your cakes at $8 each, it’s a good idea to increase your output, as you’ll still be making a profit of $4 per cake.

However, if your cakes only sell for $3.50 each, you have a decision to make. You could either scale back your production to your previous levels or look to increase your prices to stay profitable.

Imagine you run a T-shirt printing business. It currently costs you $5,000 every month to make 500 T-shirts.

Your current operational goal is to increase production to 650 T-shirts per month due to increased demand.

You test the increase in production and find that your production costs will increase to $8,000 as your factory struggles to cope with the increased output.

Let’s calculate the marginal cost:

• Change in quantity produced: 650 T-shirts - 500 T-shirts = 150 T-shirts
• Change in total cost: $8,000 - $5,000 = $3,000
• Marginal cost: $3,000 / 150 = $20

In this instance, you’re paying $20 for each additional shirt you produce.

This is a dramatic increase. While it could still be viable if you sell each shirt for $25, the rapid rise in marginal cost is indicative of a wider problem. You’ll likely need to scale back output and look for ways to increase your efficiency before you ramp up production.

Marginal revenue refers to the additional revenue you earn from selling one extra unit of your product or service. Marginal cost calculates the expense of producing that extra unit.

You’ll often see these calculations used in tandem. There are two rules to keep in mind:

• If marginal revenue is higher than marginal cost, producing and selling one more unit will add to your profits.
• If marginal cost is higher than marginal revenue, it’s time to rethink, as producing more units will eat into profits.

The sweet spot is the output level where marginal revenue and marginal cost are equal (MR = MC). This is the profit-maximising point. Beyond it, the extra cost of each unit is higher than the extra revenue it brings in, so your overall profits will start to fall.

Let’s say you sell a product for a fixed price of $50 per unit. To keep things simple, let’s assume this means your marginal revenue is $50 for each additional unit you sell.

Your marginal cost, however, changes as you produce more. Ramping up output means paying for additional labour, sourcing materials from a new supplier and using less-efficient equipment to meet demand. Ultimately, each additional unit will be more expensive to make than the last:

• Unit 1: MC = $10
• Unit 2: MC = $15
• Unit 3: MC = $30
• Unit 4: MC = $50
• Unit 5: MC = $75

We can use this information to find the exact point where your business should stop producing additional units. Here’s what the data shows:

• Up to the third unit, your marginal revenue ($50) is higher than your marginal cost; each additional unit increases your profit.
• Once you reach the fourth unit, MC and MR are equal. This is the profit-maximising point, where the extra revenue from the unit exactly matches the extra cost.
• At the fifth unit, your marginal cost is higher than your marginal revenue, so producing that extra unit will reduce your profits.

This means your optimal output is four units, where MC and MR are equal. Businesses can use this information to find the exact output level that maximises total profitability.

Visualising marginal cost on a graph is one of the simplest ways to see how your costs behave as output changes. On a standard chart, quantity runs on the horizontal axis and marginal cost on the vertical axis. The shape of the resulting curve tells you the point at which you can keep increasing output and when rising costs will start to eat into your margins.

Here’s an example to show how this works. AVC refers to the average variable cost of each unit produced, while MC indicates the cost of producing one additional unit.

As you can see, the curve on the marginal cost graph typically follows a U-shape. At a low level of production, costs per extra unit tend to be high because you’re still dealing with equipment setup, unused capacity and inefficiencies that you’ll need to iron out.

However, as supply chains become more efficient, workers become familiar with on-site machinery and the business begins to get a handle on its fixed expenses, so marginal costs decrease. This leads to a dip in the curve, which is commonly known as economies of scale.

This continues for a while, but as output increases, so does the strain on available resources. Workers feel stretched, machinery requires more maintenance and space becomes a limitation.

As a result, the cost of production becomes less efficient as output increases. The organisation sees diminishing returns as each additional unit produced delivers smaller gains. For this reason, you’ll often see marginal cost compared to marginal revenue, as seen in this average cost curve.

This graph highlights how marginal cost steadily rises, with marginal revenue decreasing as a result. The point where these two lines meet (marked ‘G’) is the profit-maximising output for a business, right before costs begin to exceed revenue.

This is why monitoring production levels is so important. It shows where the point of diminishing returns begins, helping you reach optimal production and adapt your prices without negatively impacting your profits.

Analytics solutions like Tableau can help you visualise marginal cost graphs using business data, test different output or pricing scenarios and model how changes affect profit, letting you see exactly where your optimal output lies before costs overtake returns.

Knowing your margin cost is a practical way to make smarter decisions about production and pricing, as well as where to invest your resources for the biggest returns. Instead of just guessing whether ‘more’ is better, an analysis will help you see the real cost of producing the next unit so you can judge if it will add to your profits or erode them over time.

Here’s how understanding marginal cost can support smarter decision-making across your business.

Marginal cost shows how much extra you’ll spend to produce one more unit. When you compare this to your marginal revenue, you can decide whether increasing output makes financial sense. This helps you set clear rules about when it’s time to ramp up production and when it’s time to scale back.

As marginal cost tells you the minimum cost of producing an additional unit, it essentially gives you a baseline for profitable pricing. If your price dips below marginal cost (such as for promotions) too regularly, you know you’re losing money on each unit sold. This information can help you set price floors and test new offers and strategies to protect your margin.

When you know the marginal cost and marginal revenue for each product or service, it’s easy to see which lines are genuinely worth pushing. For instance, if one product has a significantly lower marginal cost relative to its selling price, you may decide to allocate more budget or marketing efforts toward it. This helps you shift your focus to activities that will drive the greatest value.

Tracking marginal cost over time can reveal when your production process is becoming less efficient. As an example, a sudden jump in marginal cost might help you identify issues such as machine downtime or supply chain problems. This lets you investigate and fix the root cause of the issue proactively.

Marginal analysis also shows when economies of scale will start and end. As you increase output, your margin cost will fall as you spread fixed costs. Then, as capacity increases, costs will rise again as you reach diminishing returns. Understanding this curve will help you plan capacity increases, negotiate with suppliers and avoid expanding beyond the ‘sweet spot’.

Marginal cost keeps you focused on the future rather than on the money you’ve already spent. It’s all too easy to fall for the sunk cost fallacy, continuing a project or production run just because you’ve invested heavily in it. Looking at marginal cost and marginal revenue answers a simple question: ‘Is producing one more unit profitable?’ If the answer is no, you know it’s time to stop.