What is Marginal Cost?

What is Marginal Cost?

Definition

Marginal cost is defined as the change that takes place in total cost when an additional unit of output is produced. Businesses track their marginal cost so that they can optimize their production levels.

What does marginal cost mean?

The cost of production consists of fixed costs and variable costs. Here are some examples of these costs:

  • Fixed costs: Depreciation, insurance, rent, property taxes, and salaries.
  • Variable costs: Raw materials, manufacturing supplies, packaging supplies, and hourly production wages.

To calculate its total cost of production, a company would add its fixed costs to its variable costs. The total cost of production, when divided by the number of units produced, would give the unit cost of production.

Now, when the company increases its production level by one unit, it would incur additional variable costs, which may take the form of materials and hourly production wages. Fixed costs would remain constant.

As fixed costs do not increase, the marginal cost of producing one additional unit would be restricted to the variable cost. A company could continue to increase production as long as the marginal cost is limited to the variable cost.

However, after a certain production level is reached, the factory may reach the limit of its production capacity. To produce additional units, it would have to set up another production line. This could entail a very high marginal cost. At this point, it may not be economical for the company to increase production.

Example of marginal cost

Hermes Shoes manufactures 8,000 pairs of shoes every month. Its cost structure is:

  • Fixed monthly costs: $160,000 ($20 per pair)
  • Variable costs: $240,000 ($30 per pair)
  • Total costs (fixed + variable): $400,000
  • Average cost per pair of shoes: $50 ($400,000 divided by 8,000 pairs)

The company spends $30 for manufacturing each additional pair of shoes. This amount is entirely for variable costs. Fixed costs remain constant.

Hermes Shoes can increase production to 12,000 pairs per month without incurring any additional fixed costs. However, after that level, it would have to set up a new production line at a cost of $1 million.

The company’s study of its marginal cost structure reveals that it should limit production to 12,000 units per month. Till that level of production, its marginal cost is restricted to its variable cost.

Cost of producing 12,000 pairs of shoes:

  • Fixed costs: $160,000
  • Variable costs: $360,000 ($30 per pair)
  • Total costs (fixed + variable): $520,000
  • Average cost per pair of shoes: $43.33 ($520,000 divided by 12,000 pairs)

The company’s marginal cost of production is $30 till it reaches an output level of 12,000 pairs. After that its marginal cost shoots up because it would have to set up an additional production line at a cost of $1 million.

Summary

Marginal cost is the increase in cost that a business will incur by producing one additional unit of output.