Few things are as important to a company’s success as its products. Regardless of industry, having a product that helps address customers’ pain points is often the key to growing a business. However, a high-quality solution is only half of the success equation — pricing also plays a significant role in the growth of a product-driven organization.
While outward pricing results from the market and what consumers are willing to pay, the production price of a good is something a business has control over. One way a company can manage the production cost of their products is to use marginal cost.
Marginal cost is a valuable tool for an organization that can help leadership teams:
- Set production activity levels
- Optimize production lines
- Set product pricing
- Compare other methods of production
- Create a hierarchy of products to manufacture throughout the year
Let’s dive in and see how utilizing marginal cost can save money and maximize product profitability.
Understanding marginal cost
Marginal cost is the additional cost to produce one more extra unit of a product. For instance, if your organization is currently making 100 units of your most valuable product per run, then the cost to create the 101 would be the marginal cost of that particular item.
When considering the marginal cost of producing one additional unit, you’ll need to consider specific cost factors, like labor and materials. However, you won’t need to account for fixed costs unless the additional unit requires increasing certain fixed expenses like overhead or administrative support.
Ultimately, by determining your marginal cost for each product, your organization can achieve economies of scale and optimize overall production.
How do you calculate marginal cost?
Most business owners might worry that it requires extensive financial knowledge or the help of an accounting professional. However, that’s not the case. All you need to know is the following marginal cost formula:
Marginal Cost = Change in Total Cost / Change in Quantity
By utilizing the “change in total cost” and “change in quantity” of a product batch, it’s possible to determine the overall marginal cost. Here is a closer look at both of the components of the equation.
Change in total cost
When considering an increase in production levels for a specific item, it’s essential to account for any additional costs. For example, your costs will naturally go up if you need more raw materials or additional staff to produce the product.
To determine the number to plug in for “change in total cost” you’ll want to subtract the cost of running your normal batch of a product from the cost of running the new, higher quantity batch.
Change in quantity
If you’re planning on increasing the number of products you make in each batch, you’ll need to consider how the change in quantity will affect the cost.
For the “change in quantity”, subtract the number of units you typically produce in a batch from the total units you plan to make in the new batch.
Marginal cost example
The easiest way to understand marginal cost is through an example — let’s look at how companies can use marginal costs in a manufacturing environment.
Suppose your company produces windows at a manufacturing plant. Typically, a single batch will produce 100 windows for $3,000. As your sales representatives continue to expand your business’s territory, demand for windows increases. To meet the growing demand, you now start producing 200 windows for $5,000.
The formula for uncovering the marginal cost in this scenario would be as follows:
Marginal Cost = ($5,000 – $3,000) / (200-100) = $20
In this example, the marginal cost to produce one extra window would be $20.
Why is it important to know your marginal cost?
Even though there are many benefits to knowing it, the most significant is allowing your company to maximize profits for each product. As you produce more units per batch, your production prices will continue to decrease until you reach economies of scale. This point is where each batch creates the maximum amount of units at the lowest per-unit cost.
Which is better — a high or low marginal cost?
While there isn’t a “higher or lower marginal cost,” there’s a point where it doesn’t make sense to produce additional units. This phase is referred to as diseconomies of scale and can cause companies to lose money if not quickly addressed.
During diseconomies of scale, products cost more to produce than what they sell for. Often inefficiencies in production, extensive overtime, or high overhead costs are the leading causes for diseconomies of scale.
Creating accounting efficiencies with Synder
Whether it’s determining the marginal cost of a product or streamlining your accounting processes, having a partner who can assist in the automation and optimization of your accounting is crucial.
Synder provides important business insights and the support you need to achieve profit maximization and simplifies your current accounting system. By allowing you to generate accurate P&Ls, balance sheets, and other financial statements, you can make critical business decisions in a matter of minutes. Try Synder today and see how it can help you reach maximum profitability.