Marginal Profit

What is Marginal Profit?

Marginal profit refers to the profit earned by a business when an additional unit is produced and sold. Under the mainstream economic theory, the marginal approach to profit maximization states that if a company chooses to maximize its profits, it should continue producing a good or service up to the point where the marginal revenue is equal to marginal cost (marginal profit is zero).

Where, marginal revenue is the additional revenue realized when an extra unit is produced and sold, and marginal cost is the change in production cost when the quantity produced increases by one unit. Businesses use marginal profit to determine whether to expand, reduce, or terminate the production of a good based on the projected revenue and costs.

Understanding Marginal Profit

Businesses make a profit in various forms, i.e., operating profit, gross profit, marginal profit, and net profit. Each of these profits is calculated differently, and they provide insight into business operations and prospects.

What differentiates marginal profit is that it is concerned with the profit to be made by producing an extra unit of production, instead of focusing on the company’s cost structure. It implies that it accounts for the scale of production because a company’s profitability changes with the changes in the quantity of production.

Significance of Marginal Profit

Marginal profit excludes fixed costs and other variable costs that are not directly related to production. For example, if a company decides to keep an attorney on a retainer basis for $30,000 per annum, adding another unit of production will not change the retainer. In such a case, marginal profit will not take into account the expense tied to the attorney.

Take another scenario where an employee only makes 900 ice pops a day, and each employee is capable of making 1,200 popsicles. When calculating the margin profit, we exclude the employee’s cost until we reach the expected production capacity of 1,200 popsicles and exceed said production quantity by one extra unit.

As a company reaches the upper end of its available production capacity, producing goods becomes more expensive because of the increase in maintenance and overtime costs, which minimizes the additional sales achievable. As such, companies will only increase production up to the point marginal profit equals zero. Producing an extra unit does not make economic sense because, when the marginal profit is zero, the company will not earn any additional profit.

Calculating Marginal Profit

Marginal profit is expressed as the difference between the marginal revenue and the marginal cost as it relates to a sale of a unit. The marginal profit formula is expressed as follows:

Marginal Profit (MP) = Marginal Revenue (MR) – Marginal Cost (MC)

Companies produce goods up to the point where marginal cost equals marginal revenue to foster competition. By doing so, the producer is effectively left with no marginal profit. In modern microeconomics, perfect competition leaves no room for marginal profit because selling prices will be reduced down to marginal cost, with companies operating with zero marginal profit because of the competitive forces.

Companies that cannot sustain marginal loss will eventually stop production. Therefore, companies make the maximum profit in the production process until the marginal profit equals zero.

Marginal Profit Cap

The way marginal profit is calculated reflects a step-change view of a company’s performance. It may not hold for companies where, during production, the cost of goods sold is the largest cost incurred. Typically, marginal profit focuses on all income and costs. In the event of a significant increase in cost to increase production, a company’s marginal profit rate will plummet.

For example, consider a solar panel manufacturing company that produces 300 solar panel units at $100. Each unit contains $40 worth of materials, and the marginal profit on the 300^th unit is $60. If the company intends to acquire a small competitor at $50,000, the marginal profit for the 301^st item is -$49,940.

Key Takeaways

Marginal profit can help companies adopt plans that optimize profit by focusing on two important elements. One element is to maximize production with the current fixed costs to gain more marginal profit. A business can focus on creating an extra unit of production at the current fixed costs to maximize the marginal profits.

The second element involves knowing the point at which marginal profit turns negative and the number of units needed to offset the loss. For example, using the example of the solar manufacturer, if the company gets a tender to supply 500 solar units at $100 each, it would make sense to consider the takeover transaction.

Learn More

CFI is the official provider of the global Commercial Banking & Credit Analyst (CBCA)™ certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional CFI resources below will be useful:

• Cost Structure
• Marginal Cost Formula
• Fixed and Variable Costs
• Net Profit Margin
• See all accounting resources