Calculating Marginal Cost |
Why is knowing Marginal Cost Important?Marginal cost measures the cost of producing an additional product unit or servicing an additional customer. Imagine you know have 50 powerful customers, all these customers costs you a certain amount of money to service. All of a sudden, you get another request to take on another customer. Business must be booming huh? For most people more customers is always good, but what if adding on that additional customer results in exceeding your capacity to serve the customers that you have fought so hard to get? Luckily there are methods to determine the impact of expansion on your business before you actually do it and that is what Marginal cost value can do for you. Let us assume that the business you hope to get from the additional customer is $45 000 per year. To calculate the Marginal cost, you use the following formula: Marginal Cost = change in cost / change in quantity Let us assume that servicing your current 50 customers costs you $200 000 per year. And adding one more customer will drive your costs to $250 000. Thus, change in cost = $250 000 - $200 000 What this means is that, if you choose to take on this additional customer, the cost on your business will be $50 000 more and you will only make $45 000 from the deal. In other words, you will be making a loss by taking on the additional customer. If the marginal cost was lower than what you would make per customer then the deal would still be a good one. What we have now is a no deal situation. Do not rely on Marginal cost calculations as the only means to justify or reject the idea of expansion, it is always a good idea to use other tools to determine the average and optimum costs as justification for expansion. |
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