The marginal cost of production may be defined as the costs incurred for each extra output produced. For example, when a factory is operating at maximum capacity, processing additional products will require overtime pay for the workers.
Generally, the marginal cost of production tends to rise as the quantity being produced goes up. Through marginal cost, the manufacturer can determine how to allocate resources among the production units and maximize output.
Companies in competitive markets measure the size of the output to be produced with respect to the marginal cost of production and the pricing per-unit. If the market price is higher than the marginal cost, they may consider producing an additional unit and sell it. However, if the marginal cost of production is greater than the selling price, it will not be commercially viable to produce the unit.
The marginal cost of production is the amount incurred to generate an additional unit of output.
Analyzing marginal cost helps a company determine how to realize economies of scale and optimize production.
When the marginal cost of production is less than the product’s price-per-unit, the organization can potentially realize a profit.
Understanding the Marginal Cost of Production
Marginal cost is a valuable concept for optimizing production via economies of scale. A producer seeking to maximize profits will generate more output to the point where the marginal revenue is equivalent to the marginal cost of production.
In most scenarios, fixed costs remain unchanged against various levels of production. However, maximizing the output will lead to the reduction of fixed cost per unit since the total cost is allocated across a larger number of production units.
After examining the marginal cost of production, the manufacturer can analyze the total cost of processing an additional product and conclude whether to add one or more units in their line of production. Sometimes, producing a certain amount of additional units can create economies of scale and cut down the overall cost across all production units.
Examples of Marginal Costs of Production
The marginal cost of production comprises the following types of cost:
1. Variable costs
Variable costs vary with the changing levels of outputs, and they rise incrementally with the increasing number of units produced. For example, a shoemaker requires sixty cents for leather and plastic for each shoe made. Leather and plastic are variable costs as the costs increases as the quantity of shoes produced increases.
2. Fixed costs
Fixed costs remain constant and do not change with a decrease or increase in production output. An example is the rent paid for the shoe factory facility. The costs are spread across all production units, and on a per-unit basis will decrease with increased levels of output.
3. Short-run marginal cost of production
Short-run marginal cost is incurred when the additional output is produced only on a short-term basis. During the short-run production, the company may own a fixed amount of assets and, therefore, they may decide to decrease or increase the production levels considering the available number of assets.
4. Long-run marginal cost of production
The long-run marginal cost of production is the increased cost incurred during production when every input is variable. It is the additional cost that results when a company scales up its operations by adding more employees, expanding a factory, or venturing into a new market.
Importance of the Marginal Cost of Production
After determining the relationship between the marginal cost of production and marginal revenue, it is easier for a company to plan production levels and put in place per unit pricing strategies. Knowing marginal cost enables the organization to determine and come up with an optimal revenue margin for sustaining sales and increasing profits.
The marginal cost of production is used to measure the change in the cost of a product resulting from the production of an extra unit of output. When the company reaches the optimum production level, producing additional units will increase the cost of production per unit. For example, overproduction beyond a specific level may require overtime pay for workers and increased machinery maintenance costs.
If the marginal cost per unit is high, then increasing production capacity will be expensive. On the other hand, a low marginal cost of production may mean that a company is able to achieve economies of scale by working with lower fixed costs in some production lines.
The Marginal Cost of Production and Economies of Scale
Companies operating with economies of scale produce more units of output at a lower cost. Therefore, the production of additional units becomes cheaper, hence maximizing their profits while minimizing the marginal cost of production.
However, companies working with diseconomies of scale experience higher production costs per unit as more outputs are produced. For example, when a company that already reached its optimum limit production capacity wants to produce more, it will incur high marginal costs of production since the factory’s capacity will require expansion.
CFI offers the Commercial Banking & Credit Analyst (CBCA)™ certification program for those looking to take their careers to the next level. To keep learning and developing your knowledge base, please explore the additional relevant resources below:
Learn accounting fundamentals and how to read financial statements with CFI’s free online accounting classes.
These courses will give the confidence you need to perform world-class financial analyst work. Start now!
Building confidence in your accounting skills is easy with CFI courses! Enroll now for FREE to start advancing your career!