If you’ve ever done any economics, the term ‘marginal cost of production’ might ring a bell. If you haven’t, it might sound very dry and boring, but it’s a crucial concept to understand in business. Read on to find out everything you need to know about it.
The marginal cost of production in layman’s terms
Let’s imagine that you run a business producing coffee tables (or cakes or any physical good)
Your marginal cost of production is the cost of producing one extra item of whatever it is that you sell.
How to figure out your marginal cost
Some of your costs won’t change if you produce one extra item. For example, your rent in your business premises won’t change.
Costs that don’t change regardless of how many products you produce are called fixed costs.
Fixed costs do not affect your marginal cost.
Other costs will change if you produce an extra item. For example, you may need more raw materials to produce your product, and you might have higher labour, electricity and other costs by doing it as well.
Costs that do change when you produce more or less of any item are called variable costs.
Example of marginal cost
Let’s say that your factory can produce 100 coffee tables per week and that you have fixed weekly costs of $4,000 and variable costs of $6,000 per week at that production level.
If you produce 101 coffee tables, your fixed costs will not change. However, let’s assume your variable costs (like wood) will increase by $100 to $6,100.
Your marginal cost of producing that one extra coffee table is $100.
Does the marginal cost of production apply to services?
Yes, the same concept applies.
The marginal cost of producing a service is the cost of delivering that service one more time. Once again, you will have both fixed and variable costs associated with delivering a service.
Why knowing your marginal cost of production is crucial
Knowing your marginal cost of production is key to maximising your business profit. This is best explained by using a few examples.
- Scenario 1: If your marginal cost of production is $100 and you can sell the additional unit you produce (or service you deliver) for more than $100, then you will make more profit.
Therefore, if you have both the capacity to do it and the customer demand, the decision to produce the extra unit (or provide one extra service) is a no-brainer financially.
It makes financial sense for you to increase production until you reach your break-even point, when the profits are equal to the costs (see Scenario 2 below).
By the way, the extra revenue you get from selling the extra unit is called the marginal revenue in economic jargon.
Marginal cost should always be analysed in relation to marginal revenue to help you make production or service delivery decisions in your business.
- Scenario 2: If your marginal cost of production is $100 and you can sell the additional unit you produce (or service you deliver) for $100, then you will break even on the extra unit. Your profit won’t increase or decrease because your marginal revenue will be equal to your marginal cost.
- Scenario 3: If your marginal cost of production is $100 and you can’t sell the additional unit you produce (or service you deliver) for more than $100, then you will make a loss on it. It doesn’t make financial sense to do it because your marginal cost will be higher than your marginal revenue.
One reason why your marginal cost might increase is if your staff are at full capacity and you have to pay them overtime to produce or deliver the extra unit.
What if you’re just starting out in business?
If you’re just starting out in business, it’s important to understand all your variable costs (and how you can reduce them if possible), while also maximising your revenue.
Ways that you can reduce your variable costs include:
- Sourcing the cheapest suppliers (provided the quality is suitable for your needs)
- Negotiating better deals with suppliers — for example, by buying materials in bulk
- Using the most efficient production processes
Ways that you can maximise your revenue include:
- Selling more units
- Increasing your price per unit (provided it’s still competitive and acceptable to your target market)
It’s crucial that the revenue you generate allows you to cover all your costs and reach your break-even point as soon as possible. If you can’t, then your business isn’t sustainable.
Why this should matter to you
Unfortunately, the failure rate of new start-up businesses in Australia is high.
Just over half (52%) of businesses started in Australia in 2017 still exist in 2022.
While the tough conditions of COVID-19 lockdowns and restrictions over the past couple of years have no doubt played a part in that failure rate, the latest figures are in line with previous five-year small business survival statistics.
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How to estimate your costs when you’re just starting out
The best way to estimate your business costs accurately when you’re just starting out is to research all of your fixed and variable costs.
Some of those costs will be one-off start-up costs, while others will be ongoing operating costs.
It is the effective management of your ongoing costs that will be crucial to the sustainability of your business.
Once you have done your research, draw up weekly, monthly, quarterly, half-yearly and yearly budgets for all of your expected fixed and variable costs, as well as your expected revenue.
This will help you to determine your break-even point so you can plan your production or service delivery level to maximise your profit.
Make sure you monitor this budget regularly and take corrective action where necessary. For example, if your:
- Variable costs are higher than you forecast, try to minimise or eliminate any non-essential expenses
- Revenue isn’t as high as you forecast, try to increase it (possibly by increasing production)
Once you look at it, marginal cost makes sense to use as a yardstick when deciding whether to increase, decrease or hold steady on your current output.
- Understanding your marginal cost of production or service delivery allows you to make business decisions to maximise your profit.
- It’s crucial to know your break-even point and not to produce beyond that point if it results in reducing your profit.
- If you’re just starting out in business, accurately estimating your production or service delivery costs and reaching your break-even point as soon as possible will help to ensure your survival.
The information contained in this blog post is provided for informational purposes only and should not be construed as an endorsement or advice from GoDaddy on any subject matter.