Politics & Society

Economics 101: What Is the Marginal Cost Formula? Learn How Marginal Cost Formula Is Used in Business

Written by MasterClass

Aug 9, 2019 • 3 min read

Have you ever stood in a hardware store and wondered why a terra cotta pot for a houseplant costs more than a large box of metal nails? Shouldn’t the nails be more expensive? After all, they are made of steel, a composite that requires the mining of minerals that are then refined using enormous amounts of energy and labor. By contrast, the terra cotta pot is made of clay, which can be found in most people’s backyards. The reason the nails are cheaper is that they are produced on a massive scale, and this lowers their marginal cost.

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What Is Marginal Cost?

Marginal cost is a representation of the costs incurred when additional units of a product are produced. When physical products (such as a steel nail) are produced, the primary cost factors are:

  • Labor (the workers who make the nails).
  • Physical goods (the raw materials that are turned into nails, plus the machinery required).
  • Real estate (expenses involving the factory where the nails are made).
  • Transportation (costs incurred for transporting both raw goods and finished products).

Some of these costs are static no matter how many nails are produced. In particular, the cost of physical space is unlikely to change whether the factory produces one nail or one million nails. Manufacturing equipment, once purchased, also becomes a fixed cost, notwithstanding long term wear-and-tear plus the extra electricity needed to keep the machines running.

Other cost factors will fluctuate based on how many units of a product are produced. If you make more nails, you need more raw iron and that iron needs to be shipped to the factory. The completed nails also need to be shipped to hardware stores. Labor costs may go up as well, if more worker hours are required to produce the extra nails.

What Is The Marginal Cost Formula?

To calculate marginal cost, businesses, economists, and market analysts use the following formula:

Marginal Cost = (Change in Costs) / (Change in Quantity)

This produces a dollar amount for each additional unit of a product that is produced.

The change in costs will greatly depend on the scale of production that is already in place. For instance:

  • A baker working out of their home kitchen may be able to produce anywhere from one to fifty baguettes without a significant change in costs since they can continue using the same oven in the same room. (Their largest cost increase in going from a single loaf to a 50 loaf production run would be the extra flour, salt, water, and yeast—all quite low as far as raw materials go.)
  • However, if the baker wants to scale up to producing hundreds of baguettes, they will probably need to start working in a much larger space than their home kitchen. In this case, increasing the quantity of output will result in a much greater fixed cost, since they will probably have to lease space in a larger facility, and perhaps purchase new equipment.
  • Increased production costs do not necessarily indicate diminished total revenue. To the contrary, most businesses lower their per-unit cost of production by increasing their level of output. This ties to the principle of “economies of scale.” As the level of production increases, the average cost per unit produced tends to go down—provided, of course, that there is a sufficient market for consumers willing to purchase your product.

How Is the Marginal Cost Formula Used?

The marginal cost formula is used by economists, particularly those studying microeconomics, to derive data about the costs associated with physical production.

The formula is also routinely employed by businesses wishing to predict the additional cost and, ideally, the additional profit that may stem from increasing their scale of production. Business leaders make production decisions based on whether an increased total production cost will yield increased total profit. By keeping close tabs on the cost of labor, real estate, raw materials, and transportation, business executives can apply the marginal cost formula and make informed decisions about the future of their company.

What Is the Difference Between Marginal Cost and Marginal Product?

The marginal product of a business is the additional output created as a result of additional input placed into the company. In practical terms, this might mean the additional donuts produced at a donut shop once they hire an extra employee, for example, or the additional number of strawberries harvested by a farmer who plants additional seeds.

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