What is marginal cost?
Definition of marginal cost
What is marginal cost? ? Is the additional cost incurred when a business produces one more unit of product. This is an important factor in microeconomics, helping businesses make optimal decisions about production and pricing.
For example, if a company produces 100 products at a total cost of VND 10 million, and when it produces the 101st product, the total cost increases to VND 10.1 million, then the marginal cost of the 101st product is VND 0.1 million.
Why is marginal cost important?
Marginal costing helps businesses:
- Determine the optimal production level to maximize profits.
- Decide whether to continue production or not.
- Effectively manage costs and control product prices.
What is the concept of marginal cost?
Marginal Cost Formula
Marginal cost is calculated using the formula:
MC= ΔTCΔQ
In there:
- MC is marginal cost.
- ΔTC is the change in total cost.
- ΔQ is the change in output.
This means that to produce one more product, the business must spend an additional 2 million VND.
Marginal Cost Symbol
In economics, marginal cost is often denoted as MC (Marginal Cost). When drawing a cost graph, the MC curve shows how total cost changes as output changes.
When analyzing related factors, marginal cost is often accompanied by other symbols such as:
- TC (Total Cost) – Total cost.
- VC (Variable Cost) – Variable Cost.
- FC (Fixed Cost) – Fixed cost.
- ATC (Average Total Cost) – Average cost.
- AVC (Average Variable Cost) – Average variable cost.
Marginal cost symbols
Where Does Marginal Cost Intersect the Cost Curves?
The Relationship Between Marginal Cost and Cost Curves
In microeconomics, marginal cost (MC) is closely related to other cost curves, especially:
- Average Total Cost (ATC)
- Average Variable Cost (AVC)
Both ATC and AVC are U-shaped, showing that average costs initially decrease as efficiency increases, then increase as production costs increase.
Intersection Point Between Marginal Cost (MC) and Cost Curves
- The MC curve always intersects the ATC curve at the lowest point of ATC.
- The MC curve always intersects the AVC curve at the lowest point of AVC.
Explanation:
- When MC < ATC, average total cost is falling, meaning that each new unit of output produced costs less than the previous average. This reduces average cost.
- When MC > ATC, average aggregate cost is increasing, meaning each new unit of output costs more than the previous average, causing ATC to increase.
- When MC = ATC, this is the lowest point of ATC. This is also the point where the business achieves the most optimal production efficiency.
Similar to the AVC curve:
- MC < AVC → AVC is decreasing.
- MC > AVC → AVC is increasing.
- MC = AVC → AVC is at its lowest level.
Summary of Key Principles
- The MC curve always passes through the bottom of ATC and AVC.
- When MC is less than ATC or AVC, these two curves will fall.
- When MC is greater than ATC or AVC, these two curves will rise.
- When MC equals ATC or AVC, this is the minimum of these two lines.
Practical Significance
- Businesses should produce in the area where MC = ATC (minimum of ATC) to optimize costs and achieve the highest efficiency.
- If MC begins to exceed ATC, the firm needs to consider whether it is still profitable to continue expanding production.
The concept of marginal cost intersects the cost curves.
Applications of Marginal Costing in Business
Marginal cost (MC) is not just a theoretical indicator but also has many important practical applications in business and financial management. Here are some ways that businesses use marginal cost to make strategic decisions.
Determine Optimal Production Level:
Every firm wants to produce a level of output that maximizes profit. This is determined by comparing marginal cost (MC) with marginal revenue (MR):
- If MC < MR → The firm should continue production because each product generates more profit.
- If MC > MR → The firm should stop expanding production because the cost of additional production exceeds the revenue earned.
- When MC = MR, this is the optimal production point that helps the business maximize profits.
Marginal Cost Based Product Pricing
Marginal cost is an important factor in determining selling price. Businesses often use the marginal cost pricing model by ensuring that the selling price is higher than the marginal cost to make a profit.
Marginal cost pricing strategy
- Minimum price: Businesses need to set prices higher than MC to ensure they do not incur losses.
- Optimal Price: If the product is in high demand, the business can set the price higher than the minimum to increase profits.
- Market Penetration Price: When wanting to expand the market, businesses can set prices close to MC to compete.
Control and Management of Production Costs
By tracking marginal costs, businesses can better manage production costs, especially as they scale.
- When MC is low and stable, firms can expand production to reduce costs per unit.
- As MC begins to increase rapidly, businesses should consider optimizing production processes or investing in technology to reduce costs.
Decision Support Whether to Produce More or Not?
One of the most important applications of marginal costing is to help a business decide whether to continue expanding production. If the cost of producing one more unit is too high, the business can choose to stop expanding or adjust its business model.
Help Determine Break-Even Point
The break-even point is the level of output at which total revenue equals total costs (no profit, no loss). When businesses understand MC, they can easily determine when profits begin to increase.
Support Decision to Suspend or Continue Production
In the short run, businesses may experience a situation where MC > revenue, reducing profits. At that time, they need to decide whether to continue production or temporarily stop.
- If MC > revenue, the business can consider suspending production or cutting output.
- If MC < revenue, the business is still profitable and can maintain operations.
Investment Decision Support for Production Line Expansion
When a company wants to expand production, it needs to compare marginal costs with investment costs. If expansion reduces MC in the long run, it is a good sign to invest.
The above is an important factor in economics and business management. LiveTrade Pro has helped us understand how to calculate and apply What is marginal cost? As a result, businesses can determine the optimal production level, ensuring that costs do not exceed revenue. At the same time, MC also supports businesses in pricing products, controlling costs and maximizing profits. Applying MC properly helps businesses compete effectively and maintain sustainable growth in the long term.
