Marginal cost is the expense a business incurs to make an additional unit of product. Marginal costs tend to be higher at certain levels of production and lower at others. Marginal cost is defined as the change in total costs incurred divided by change in output.
How Marginal Cost Works
Marginal cost varies based on the company's production level and the overhead costs incurred to keep the company going. Understanding marginal cost can help a business predict future profit margins and develop a profitable pricing strategy.
Study.com notes that marginal cost tends to decrease as units of production increase due to economies of scale. At a certain point, though, marginal cost increases again. The increase typically occurs when management has to pay for more overhead costs because of business expansion. For example, marginal cost might increase when the business has to hire a chief operating officer or pay for an annual audit.
Calculating Marginal Cost
To find marginal cost, follow these steps:
- Subtract costs at the old level of production from costs at the new level of production to find change in total cost. For example, say that total costs for 2014 were $30,000 and total costs for 2015 were $40,000. Change in total costs is $40,000 minus $30,000, or $10,000.
- Subtract units produced at the old production level from units produced at the new production level to find change in output. For example, say that the company produced 15,000 widgets in 2014 and 23,000 widgets in 2015. Change in output is 23,000 minus 15,000, or 8,000 widgets.
- Divide change in total costs by change in output to find marginal costs. In this example, marginal cost is $10,000 divided by 8,000 widgets, or $1.25. That means that the marginal cost to make the extra widgets for 2015 was $1.25 per widget.