Marginal Cost is the additional cost that is incurred for producing one additional unit of product. One of the classifications of cost divides all cost between fixed, semi-variable and variable costs. In other words, marginal cost can be defined as variable part of the total costs which is incurred for manufacturing a product. From another angle, marginal cost can be termed as the amount of resources that can be saved by not making or producing one unit of additional output.
Suppose a company manufactures a toy. It must have incurred some cost on buying plant and machinery which they are not going to incur again and again. It is their fixed cost and will remain same whether they produce toys or not. Suppose the company starts producing toys, it will have to incur a raw material cost, labor cost etc. These costs are variable costs which will incur only when the company is producing else they can be avoided. Normally, for producing a marginal or additional unit of product at any output level, only variable costs would incur as the fixed costs are constant. Therefore, these variable costs are called marginal cost.
Example of Marginal Cost
A company manufactured 2000 units of toys and incurred a total expense of $ 20,000 and for manufacturing 2001 units, the total cost was $20,006. The marginal cost is $6 whereas the average cost manufacturing 2000 units is $10 which is quite lesser than the former. The reason is quite interesting and simple too. Out of $20,000, there are some costs which have not incurred for making that addition 2001st unit. These are fixed costs which do not change with every change in output level.
Marginal Cost and Management Decision Making
Marginal cost is used in the marginal costing system. The best quality of the concept of marginal cost is that it helps management in taking various informed decisions. Since, at any point of time, for management, it is important to ensure that their marginal revenues should be more than marginal costs. Knowledge of marginal costs helps them in evaluating the revenue contracts whether they will increase the profitability of the company in the long run or not.
Calculate Marginal Cost
For the calculation of marginal cost, all the costs are segregated between fixed, variable and semi-variable costs. The second step is to bifurcate the semi-variable into two parts i.e. fixed and the variable part. Variable costs and the variable part of the semi-variable costs from the marginal cost. It seems quite simple in words, but the actual calculation of it is quite challenging.
When pricing is below marginal cost?
Pricing a product below marginal cost simply means inviting losses because neither the price is covering the variable costs nor it will not contribute anything towards fixed costs. It can still be a choice by some companies under certain special situations. These situations are normally guided by the strategy of the company. The company may be in the nascent stage of its product and may wish to capture the market share. At times, it may also be for running the machinery to maintain their good condition in bad product market situations.