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 of working out whether you should double down on your manufacturing efforts or scale back and lower your output.

If you’re planning on expanding your business, 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.

Marginal cost 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.

Marginal cost (also known as incremental cost) is an economics 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 will change as your production increases. For instance, if creating more units requires you to invest in new machines and hire a new team member, this expense will need to be factored 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. Let’s take a look at how it works alongside some examples.

We’ll start by focusing on the basic formula.

Here’s the marginal cost calculation.

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

Now that you understand the formula, here’s 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, consider that 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 units - 200 units = 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 1200 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, this means 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 a month due to increased demand.

You test the increase in production and find that this will grow your production costs 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 both of these calculations used in tandem. As a rule, if a business has a higher marginal revenue than its marginal cost, it can continue increasing production. By contrast, if marginal cost is higher than marginal revenue, it’s time to rethink, as producing more units is eating into profits.

The sweet spot is the point where marginal revenue and marginal cost are perfectly aligned. This is the output level that maximises profits, where the amount of units is at its maximum potential before margins begin to decrease.

Knowing your marginal cost is essential if you’re looking to make smarter decisions and stay profitable. Here are five benefits highlighting the importance of marginal cost analysis.

• Decision-making: Calculating marginal cost lets you decide when it's a good time to increase your level of production and when it's time to scale back.
• Pricing: Marginal cost shows you how much you’ll need to charge to make a profit. This can also be helpful if you’re looking to price products to beat competitors.
• Economies of scale: As you scale up production, marginal cost shows when you can expect to reach the optimum production level, letting you plan ahead.
• Inefficiencies: Marginal cost can alert you to inefficiencies in your production process before they become detrimental, letting you identify and address problems proactively.
• Resources: If you notice that one product has a better cost-to-revenue ratio than others, you can focus your resources toward your most profitable items.

When you plot it on a graph, marginal cost usually follows a U-shape. (AVC refers to the average variable cost.)

When production starts, costs are elevated, with fixed and variable costs, plus inefficiencies to contend with.

However, as workers grow familiar with on-site machinery, supply chains become more efficient and the business begins to get a handle on its fixed expenses, meaning marginal costs reduce. 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. All of this leads to the cost of production becoming more inefficient as output increases. The organisation reaches diminishing returns with smaller gains for each additional unit produced.

For this reason, you’ll often see marginal cost compared with 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 eating into your profits.