Marginal Revenue Product (MRP)

What is Marginal Revenue Product (MRP)?

Marginal revenue product (MRP) explains the additional revenue generated by adding an extra unit of production resource. It is an important concept for determining the demand for inputs of production and examining the optimal quantity of a resource. It can be analyzed by aggregating the revenue earned by the marginal product of a factor. When calculating MRP, costs incurred on factors of production remain constant.

Marginal revenue product indicates the amount of change in total revenue after adding a variable unit of production. Company executives use the MRP concept when conducting market research, as well as in marginal production analysis. The additional revenue generated from adding a unit of input determines the maximum price that a company is willing to pay for additional units of input.

An input with a significant marginal revenue product value attracts a greater price than an input with a small marginal revenue product value. However, as MRP decreases, the employer is motivated to spend less on each additional input of production. Marginal revenue product explains production in terms of the revenue produced.

How Marginal Revenue Product Works

Businesses use marginal revenue production analysis to make key production decisions. They apply the concept of MRP in estimating costs and revenues, using the information to gain a competitive advantage against their rivals.

When evaluating the demand for its products, the management uses the marginal revenue product for each unit to determine the number of resources to employ.

How to Calculate Marginal Revenue Product

The formula for calculating marginal revenue product is as follows:

MRP = MPP x MR

Where:

• MRP is the Marginal Revenue Product
• MPP is the Marginal Physical Product
• MR is the Marginal Revenue Earned

For example, assume that John is the manager of a shoe manufacturing plant, and he is considering hiring another employee to meet the increasing demand. Assumes that each unit sells for $10, and John knows that a new employee will produce an extra 200 pairs of shoes every week, the marginal revenue product is calculated as follows:

MRP= 200 x $10

MRP = $2,000

Therefore, if John hires a new employee, the employee will generate an additional $2,000 in weekly revenue for the manufacturing plant.

Marginal Revenue Product of Labor

Companies use marginal revenue product to determine the demand for labor, based on the level of demand for their outputs. In a perfectly competitive market, the profit-maximizing hiring decision is to hire new workers up to the point where the marginal revenue product of the last employee equals the market wage rate, which is also the marginal cost of the last employee. If the marginal revenue of the last employee is less than their wage rate, hiring that worker will trigger a decrease in profits.

The marginal revenue product of labor represents the extra revenue earned by hiring an extra worker. It indicates the actual wage that the company is willing and can afford to pay for each new worker they hire, and the wage that the company pays is the market wage rate determined by the forces of supply and demand.

This is because, when there is perfect competition, the company is a price-taker, and it does not need to lower the price to sell additional units of output. The market wage rate represents the marginal cost of labor that the company must pay each additional worker it hires.

Marginal Revenue Product and Optimal Input Level

When a company is utilizing inputs to their optimal level, the marginal revenue product of an extra input of production is equal to the marginal cost of an extra resource. Therefore, if the marginal revenue product surpasses the marginal cost of input, the company will maximize profits by hiring more inputs, which will, in turn, increase the volume of outputs.

However, if the marginal cost exceeds the marginal revenue product, the company will be forced to reduce the number of inputs in the production, which will subsequently cause a reduction in the number of units produced.

Limitations of Marginal Revenue Product

In most businesses, it is difficult to measure the level of each worker’s productivity. Therefore, businesses need to make the best estimation of productivity and the utility of every worker. For example, public sector jobs are not directly affected by existing factors, but by government policies.

Additional Resources

CFI offers the Financial Modeling & Valuation Analyst (FMVA®) 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:

• Labor Force KPIs
• Marginal Analysis
• Perfect Competition
• Marginal Cost of Production
• See all accounting resources