Marginal cost refers to the increase or decrease in the cost of producing one more unit or serving one more customer. It is also known as incremental cost.
Marginal costs are based on production expenses that are variable or direct – labor, materials, and equipment, for example – and not fixed costs the company will have whether it increases production or not. Fixed costs might include administrative overhead and marketing efforts – expenses that are the same no matter how many pieces are produced.
It is often calculated when enough items have been produced to cover the fixed costs and production is at a break-even point, where the only expenses going forward are variable or direct costs. When average costs are constant, as opposed to situations where material costs fluctuate because of scarcity issues, marginal cost is usually the same as average cost.
Calculating the marginal cost helps a business determine the point at which increasing the number of items produced will push the average cost up. Costs can increase when volume increases if the company needs to add equipment, move to a larger facility, or struggles to find a supplier that can provide enough materials.
For example, if a company can produce 200 units at a total cost of $2,000 and producing 201 costs $2,020, the average cost per unit is $10 and the marginal cost of the 201st unit is $20.
Here’s the formula for calculating marginal cost: Divide the change in total costs by the change in quantity. Using the example above, the change in cost is 20 and the change in quantity is 1. 20 divided by 1 equals 20.
When charted on a graph, marginal cost tends to follow a U shape. Costs start out high until production hits the break-even point when fixed costs are covered. It stays at that low point for a period, and then starts to creep up as increased production requires spending money for more employees, equipment, and so on.
Understanding a product’s marginal cost helps a company assess its profitability and make informed decisions related to the product, including pricing.