Marginal cost and revenue: Formulas, definitions, and how-to guide

While it can sometimes be challenging to determine marginal costs, if you’re ready to begin looking at this metric it probably means your business or startup is at a crossroads of producing more and earning more. 

But a growing business also comes with growing pains that can prompt questions like, “Where does the balance lie between increasing profit and overproduction?” This is where profit margin analysis comes in.

Keep reading or use the links below to learn about marginal costs, and what looking at marginal costs can tell you about your business.

• What is marginal cost?
• How to calculate marginal cost
• Marginal cost example
• Additional factors to keep in mind
• What is marginal revenue?
• How to find marginal revenue
• Diagnosing your marginal revenue
• Using marginal costs and revenue data in your business

Marginal cost is how much money it costs your company to produce one additional unit of your product or merchandise. As a growing company, you don’t want to run the risk of an inventory shortage but you also don’t want to overproduce and not see the return on your investment. To avoid these risks, you need to look at your 2 types of business costs: fixed costs and variable costs. 

Fixed costs, as you may have already guessed, are the costs that are pretty much set in stone and they don’t change with production—like employee salary cost, for example. Variable costs are more flexible and change depending on the production output, like operating costs.

Why is marginal cost important? 

Marginal cost is important because if you’re looking to maximize profits, you’ll want to plan production so that your marginal costs are equal to your marginal revenue. It’s the blueprint needed to find the sweet spot of effective output and can yield several other benefits, such as:

• Preventing your company from losing money through loss of sales or overproduction
• Determining how many products are needed to satisfy customer demand
• Providing your company with important metrics for profit planning

If you're producing at a quantity where marginal costs exceed marginal revenue, that negatively impacts your profitability.

For example, let’s say a company produces 5,000 watches in 1 production run at $100 apiece. The manufacturer will want to analyze the cost of another multiunit run to determine the marginal cost. The average cost of producing a watch in the first run is $100, but the marginal cost is the additional cost to produce one more unit. Using the marginal cost formula, we can determine how an additional production run will impact profitability.

Marginal cost formula 

The marginal cost formula is change in cost divided by change in quantity. In the example above, the cost to produce 5,000 watches at $100 per unit is $500,000. If the business were to consider producing another 5,000 units, they’d need to know the marginal cost projection first.

The business finds the marginal cost to produce one more watch is $90. If the business has a lower marginal cost, it can see higher profits. If the business charges $150 per watch, they will earn a $50 profit per watch on the first production run, and they’d earn a $60 profit on the additional watch.

To calculate the marginal cost, divide the change in cost by the change in quantity or the number of additional units. See the formula below:

Marginal cost = change in cost / change in quantity 

The total cost of the second batch of 5,000 watches is $450,000. Dividing the change in cost by the change in quantity produces a marginal cost of $90 per additional unit of output.

How to calculate marginal cost 

Calculating marginal cost is a fairly simple process. As we learned above, the marginal cost formula consists of dividing the change in cost by the change in quantity. Now we’re going to look at those steps individually to make sure we have the process covered.

1. Calculate the change in cost

Change in cost is a simple formula that tells you the increase or decrease in cost over time. Here’s the formula: 

Change = new cost - original cost

2. Calculate the change in quantity

Change in quantity for marginal cost is not much different. We’re looking at the increase or decrease in quantity over time, so the same setup applies:

Change = new quantity – original quantity

3. Divide cost by quantity

Taking it back to our original formula, this is what the final equation will look like:

Marginal cost = change in cost / change in quantity

Marginal cost example

To fully understand marginal cost, we’re going to cover a simplified example below: 

Say you own a hat company and you want to see what the marginal cost will be to produce additional hats. 

It currently costs your company $100 to produce 10 hats and we want to see what the marginal cost will be to produce an additional 10 hats at $150.

Step 1: Calculate the change in cost

$150 - $100 = $50

Step 2: Calculate the change in quantity

20 hats - 10 hats = 10 hats

Step 3: Divide the change in cost by the change in quantity

50 ÷ 10 = $5

Based on the math above, your company is looking at a marginal cost of $5 per additional hat. Since it costs you less money to produce more hats, it makes sense for your company to produce the additional units and seize the opportunity to make additional profits. 

Additional factors to keep in mind

Now that you’ve been introduced to the basics, there are a few nuances you should be aware of to maximize your marginal cost experience.

How production costs affect marginal costs

Marginal costs are a direct reflection of production quantity and costs, according to our equation above. And since production is a product of cost and quantity, your output directly affects marginal costs. As production increases or decreases, marginal costs can rise and fall.

Marginal costs vs. variable costs

It’s easy to get confused when comparing marginal costs and variable costs, since marginal costs are made up of both variable and fixed costs. Let’s simplify each one:

• Marginal cost is the cost to produce 1 more unit of merchandise. For example, the marginal cost to produce more hats in our last equation was $5. 
• Variable cost is the changing costs associated with production. For instance, in that same hat example, variable costs would be the cost of supplies to produce those additional hats. As the output increases, so does the variable cost. 

The bottom line is that variable cost is part of marginal cost, with the other part being fixed cost. If you need to buy or lease another facility to increase output, for example, this variable cost influences your marginal cost.

Earlier we uncovered that marginal cost is the cost to produce additional units. Marginal product is simply the change in output as a result of the change in input from those additional units

Going back to the hat example, since the additional hats were only going to cost $50 instead of $100 as the originals had, there was incentive to produce more hats. Those additional 10 hats are what is known as the marginal product.

Understanding the marginal cost curve

The marginal cost curve is presented in a graph. Production quantity is on the x-axis and price is on the y-axis. On the graph, the marginal cost curves down before increasing. The U-shaped curve represents the initial decrease in marginal cost when additional units are produced. The marginal cost rises as production increases.

The curve represents diminishing marginal returns. At some point, your business will incur greater variable costs as your output increases. The point where the curve begins to slope upward is the point where operations become less efficient and profitability decreases.

What is marginal revenue?

In addition to marginal cost, another important metric to consider is marginal revenue. Marginal revenue is the revenue or income to be gained from producing additional units.

Why is marginal revenue important? 

 Marginal revenue is an important business metric because it is a measure of revenue increases from increases in sales. When marginal costs exceed marginal revenue, a business isn’t making a profit and may need to scale back production.

Marginal revenue formula 

This formula is similar to the marginal cost calculation. It divides the change in revenue by the change in quantity, or number of units sold. The formula is as follows:

How to find marginal revenue

Similar to finding marginal cost, finding marginal revenue follows the same 3-step process.

1. Calculate the change in revenue

Calculating the change in revenue is performed the exact same way we calculated change in cost and change in quantity in the steps above. To find a change in anything, you simply subtract the old amount from the new amount.

Change in revenue = new revenue – old revenue

2. Calculate the change in quantity

Plug in these numbers in the same way as above.

Change in quantity = new quantity – old quantity

3. Divide the revenue by the quantity

This brings us back to the original formula for marginal revenue:

Marginal revenue = change in revenue / change in quantity

Diagnosing your marginal revenue

To determine which pricing strategy works best for your business, you’ll need to understand how to analyze marginal revenue. The key to sustaining sales growth and maximizing profits is finding a price that doesn’t dampen demand. When it comes to setting prices by unit cost, you have 2 options. 

You can increase sales volume by producing more items, charging a lower price, and realizing a boost in revenue. Or you can produce fewer items, charge a higher price, and realize a higher profit margin.

But be careful—relying on one strategy may only work if you have the market cornered and expect adequate sales numbers regardless of price point. Ultimately, you’ll need to strike a balance between production quantity and profit.

Factors that lead to decreases

The major cause of a decrease in marginal revenue is simply the rise in marginal cost. As we touched on before, that sweet spot is anything that results in marginal cost being equal to marginal revenue. Otherwise, the company is either underproducing or overproducing, and either way that creates a loss of money. 

A good example of this would be marginal cost of production costing more than original production. For instance, in the hat example—if the first batch of hats cost $100 to make but the second batch cost $200 to make, the company is now in a tough spot. It has to either decide on finding a more efficient way to produce the product or raise the prices to see a profit.

Factors that lead to increases

Let's put that last concept in reverse—what causes marginal revenue to increase? Simply put, less production costs. The less money the company is using to produce more products, the more profits it can retain.

Marginal revenue is the income accrued from producing 1 additional unit of merchandise. Marginal benefit is the maximum amount a consumer is willing to pay for a product.

Both are important metrics for looking at business’s profitability and planning.

Marginal Cost and Revenue FAQ

Marginal analysis is an intertwined process of metrics which are simple when arranged separately, but can pose plenty of questions when forming a unit. Here are some of the most common questions (and answers) you may encounter on your marginal cost and revenue journey:

What is the relationship between marginal cost and marginal revenue?

The maximum profitability of a company results when marginal cost equals marginal revenue. Anything swaying on one side or the other may result in a loss of profits for the company.

What happens if the marginal cost is less than marginal revenue?

A company ultimately wants to aim for marginal cost equalling marginal revenue for the maximum profitability. If your marginal cost is less than marginal revenue, the result is underproduction.

What happens if the marginal revenue is less than the marginal cost?

Again, a company ultimately wants to aim for marginal cost equalling marginal revenue for the maximum profitability. If your marginal cost is more than marginal revenue, the result is overproduction.

Using marginal costs and revenue data in your business

Knowing your marginal cost and how it relates to your marginal revenue is critical for pricing and production planning. You may need to experiment with both before you find an optimal profit margin to sustain sales and revenue increases.

Closing: Now that you have a clearer understanding of marginal cost and marginal revenue, the next step is implementation. Using your variable costs and fixed costs, you can determine marginal cost and find your marginal revenue for better business profitability planning. And with tools like QuickBooks Enterprise, finding these metrics are easier than ever to help you build efficiency and visualization for your business.