Meaning of Marginal Cost
Marginal cost refers to additional cost incurred on producing one more unit of the good in production activity. It is calculated by subtracting the previous total cost from the current total cost incurred after producing one more unit.
It is extremely helpful during the calculation of business financials as it gives precise data about every cost that is incurred. It can also be used with other cost analysis tools. It is complex for a new business to segregate between different types of cost and they often end up landing into underestimation or overestimation of cost.
Despite these shortcomings, marginal cost is helpful in effective pricing, brings uniformity in calculations, and can easily chip in cost profit analysis.
Features of Marginal Cost
1. Measures Variable Cost
Typically, there are two types of cost in business – Fixed cost and Variable cost. Fixed costs are independent of production activities, for example- salaries, rent, etc. Variable costs are those costs that are directly related to production activities, for example – wages, raw material costs, etc.
Total cost is the sum of fixed cost and Variable cost. Therefore, any change in the total cost would be a result of a change in Variable cost only. Thus, it would be easy for the company to assess how much the Variable cost is being incurred to them for every additional unit they produce.
2. Ascertains Profitability
Lower the cost, higher the margin for profit.
Whenever there is declining marginal cost i.e, whenever additional cost incurred on producing every additional unit tends to decline it indicates that the company can automate its production and need not spend an equal amount for every unit.
Thus, its route to profitability increases as the cost per unit decreases. Even the overhead expenses are met without withdrawing any dollar extra from the reserve.
3. Assists management
Marginal costing helps management in taking the advantage of economies to scale. With the increase in production, the per unit cost of product declines. This is called economies to scale. Management can also, further, do inventory valuation based on this.
Example of Marginal Cost
Let us understand the concept of Marginal cost with the help of a hypothetical example.
Below is the cost incurred by small-scale crockery manufacturers in producing Glasses.
Assuming fixed costs to be rent (land for the industry), electricity, and salaries of employees and variable costs as raw material consumed, transportation cost, wages, etc.
|UNIT||Fixed Cost||Variable Cost||Total Cost||Marginal Cost|
Calculation of Marginal Cost
Let us understand the calculation involved in the above example.
i) As already discussed, fixed cost is independent of production. Thus, even at 0 unit production, there is a fixed cost of $20.
ii) When 1 unit of glass is produced, $15 is incurred as a variable cost. The total cost which is a sum of fixed and variable costs equals $35.
As marginal cost is the cost of additional units produced, it shows the difference between current and previous total costs. Here, it is $35-$20= $15.
iii) As more and more units are produced, variable costs incurred for every unit declines. This shows economies to scale. This also reduces the total cost and ultimately, the Marginal cost. Thus, businesses can yield huge profits with the help of declining marginal costs.
The concept of Marginal costing has gained importance in almost every business and is highly useful in ascertaining the break-even point (where profit = loss) of a business as well as of an industry as a whole!