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Marginal Cost: Definition, Equation & Formula

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Shawn Grimsley

Marginal cost is an important concept in business. In this lesson, you'll learn what marginal costs are and their standard formula with some illustrative examples. A short quiz follows the lesson.

We also recommend watching Types of Competitive Advantage: Cost, Product, Niche & Sustainable Advantages and Pricing Cost: What Motivates Mark-up and Break-Even Pricing

Definition

Marginal cost is the increase or decrease in the total cost a business will incur by producing one more unit of a product or serving one more customer.

Key Concepts

If you plot marginal costs on a graph, you will usually see a U-shaped curve where costs start high but go down as production increases but than rise again after some point. For example, in most manufacturing endeavors, the marginal costs of production decreases as the volume of output increases because of economies of scale. Costs are lower because you can take advantage of discounts for bulk purchases of raw materials, make full use of machinery and engaged specialized labor.

However, production will reach a point where diseconomies of scale will enter the picture and marginal costs will begin to rise again. Costs may rise because you have to hire more management, buy more equipment, or because you have tapped out your local sources of raw materials, causing you to spend more money to obtain the resources.

Marginal Cost
Marginal Cost Graph

You can use marginal costs for production decisions. If the price you charge for a product is greater than the marginal cost, then revenue will be greater than the added cost and it makes sense to continue production. However, if the price charged is less than the marginal cost, then you will loss money and production should not expand.

Formula

The formula for marginal costs can be expressed as follows:

Marginal Cost = Change in costs/Change in quantity

For the more algebraically include, marginal cost can be also be expressed by the following equation:

Marginal Cost Formula

Application

Let's apply what we've learned. It costs $250,000 to produce 5,000 items, and $340,000 to produce 6,500. You have set the price for each item at $75.00. Should you increase production from 5,000 to 6,500 items?

Marginal Cost = Change in costs/Change in quantity

Marginal Cost = ($340,000 - $250,000)/(6,500 - 5,000)

Marginal Cost = $90,000/1,500

Marginal Cost = $60

$75>$60

Since the marginal cost is less than the price you charge per item, you can expand production.

Summary

Marginal cost is the increase or decrease in total production cost if output is increased by one more unit. The formula to obtain the marginal cost is change in costs/change in quantity. If the price you charge per unit is greater than the marginal cost of producing one more unit, then you should produce that unit. If the price you charge per unit is less than the marginal cost of producing one more unit, the unit should not be produced.

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