Marginal Cost is the additional cost that is incurred for producing one additional unit of product. One of the cost classifications divides all costs between fixed, semi-variable, and variable costs. In other words, marginal cost can be defined as a variable part of the total costs incurred for manufacturing a product. From another angle, it can also 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 the same whether they produce toys or not. Suppose the company starts making toys, it will have to incur a raw material cost, labor cost, etc. These costs are variable costs that 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 costs.
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 of manufacturing 2000 units is $10, which is relatively lesser than the former. The reason is quite interesting and simple too. Out of $20,000, some costs have not been incurred for making that additional 2001st unit. These are fixed costs that 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 this cost is that it helps management make various informed decisions. Since, at any point in time, for management, it is important to ensure that their marginal revenues should be more than marginal costs. Knowledge of marginal costs helps them evaluate the revenue contracts. And whether they will increase the company’s profitability in the long run or not.
Calculate Marginal Cost
To calculate 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., the fixed and the variable part. Variable costs and the variable part of the semi-variable costs from the marginal cost. It seems pretty simple in words, but the actual calculation is quite challenging.
Refer to Marginal Costing Ratios Calculator.
When Pricing is below Marginal Cost?
Pricing a product below marginal cost means inviting losses because neither the price is covering the variable costs nor will it not contribute anything towards fixed costs. It can still be a choice by some companies under certain special situations. The strategy of the company normally guides these situations. 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.