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The total cost of a business is composed of fixed costs and variable costs. Fixed costs and
variable costs affect the marginal cost of production only if variable costs exist. The
marginal cost of production is calculated by dividing the change in the total cost by a one-unit change in the production output level. The calculation determines the cost of production for one more unit of the good. It is useful in measuring the point which a business can achieve economies
of scale.

Nội dung chính

    Key Takeaways Fixed Cost vs. Variable Cost Marginal Cost of Production Other Considerations Key Takeaways Calculating Marginal Cost of Production Reaching Optimum Production
    Calculating Marginal Revenue How Can Marginal Revenue Increase? Balancing the Scales of Marginal Revenue When Marginal Revenue Starts to Fall Marginal Revenue vs. Marginal Benefit Marginal Analysis The Bottom Line Which of the following is true of the relationship between marginal cost and average cost?What is relationship between marginal cost and average cost?Which of the following is true of the relationship between the marginal cost function and the average total cost and average variable cost functions?Which of the following statements about the relationship between marginal cost MC and average total cost ATC is correct?

Key Takeaways

    Marginal cost of production refers to the additional cost of producing just one more unit.Fixed costs do not affect the marginal cost of production since they do not typically vary with additional units.Variable costs, however, tend to increase with
    expanded capacity, adding to marginal cost due to the law of diminishing marginal returns.

Fixed Cost vs. Variable Cost

A fixed cost is a cost that remains constant; it does not change with the output
level of goods and services. It is an operating expense of a business, but it is independent of business activity. An example of fixed cost is a rent payment. If a company pays $5,000 in rent per month, it remains the same even if there is no output for the month.

Conversely, a variable cost is dependent on the production output level of goods and services. Unlike a fixed cost, a variable cost is always fluctuating. This cost rises as the production output level rises and decreases as the production output level decreases. For example, say a company owns a manufacturing plant and produces toys. The electricity bill varies as the production output level of toys varies. If no toys are produced, the company spends less on the
electricity bill. If the production output of toys increases, the cost of the electricity increases.

Marginal Cost of Production

The marginal cost of production is an economics and managerial accounting concept most often used among manufacturers as a means of isolating an optimum production level. Manufacturers often examine the cost of adding one more unit to their production schedules. At a certain level of production, the benefit of producing one
additional unit and generating revenue from that item will bring the overall cost of producing the product line down. The key to optimizing manufacturing costs is to find that point or level as quickly as possible.

Marginal cost of production includes
all of the costs that vary with that level of production. For example, if a company needs to build an entirely new factory in order to produce more goods, the cost of building the factory is a marginal cost. The amount of marginal cost varies according to the volume of the goods being produced.

It is not necessarily better or worse for a company to have either fixed costs or variable costs, and most companies have a combination of fixed costs and
variable costs. 

A company with greater variable costs compared to fixed costs shows a more consistent per-unit cost and, therefore, a more consistent gross margin, operating margin, and profit margin. A company with greater fixed costs compared to variable
costs may achieve higher margins as production increases since revenues increase but the costs will not. However, the margins may also reduce if production decreases.

Other Considerations

Although the marginal cost measures the change in the total cost with respect to a change in the production output level, a change in fixed costs does not affect the marginal cost. For example, if there are only fixed costs
associated with producing goods, the marginal cost of production is zero. If the fixed costs were to double, the marginal cost of production is still zero. The change in the total cost is always equal to zero when there are no variable costs. The marginal cost of production measures the change in total cost with respect to a change in production levels, and fixed costs do not change with production levels.

However, the marginal cost of production is
affected when there are variable costs associated with production. For example, suppose the fixed costs for a computer manufacturer are $100, and the cost of producing computers is variable. The total cost of production for 20 computers is $1,100. The total cost for producing 21 computers is $1,120. Therefore, the marginal cost of producing computer 21 is $20. The business experiences
economies of scale because there is a cost advantage in producing a higher level of output. As opposed to paying $55 per computer for 20 computers, the business can cut costs by paying $53.33 per computer for 21 computers.

The
marginal cost of production and marginal revenue are economic measures used to determine the amount of output and the price per unit of
a product that will maximize profits.

A rational company always seeks to squeeze out as much profit as it can, and the relationship between marginal revenue and the marginal cost of production helps them to identify the point which this occurs. The target, in this case, is for marginal
revenue to equal marginal cost.

Key Takeaways

    When it comes to operating a business, overall profits and losses matter, but what happens on the margin is crucial.This means looking the additional cost versus revenue incurred by producing just one
    more unit.According to economic theory, a firm should expand production until the point where marginal cost is equal to marginal revenue.

Calculating Marginal Cost of Production

Production costs include every expense
associated with making a good or service. They are broken down into two segments: fixed costs and variable costs.

Fixed costs are the relatively stable, ongoing costs of operating a business that are not dependent on production levels. They include general overhead expenses such as salaries
and wages, building rental payments, or utility costs. Variable costs, meanwhile, are those directly related to and those that vary with production levels, such as the cost of materials used in production or the cost of operating machinery in the process of production.

Total production costs
include all the expenses of producing products current levels. As an example, a company that makes 150 widgets has production costs for all 150 units it produces. The marginal cost of production is the cost of producing one additional unit.

For instance, say the total cost of producing 100 units of a good is $200. The total cost of producing 101 units is $204. The average cost of producing 100 units is $2, or $200 ÷ 100. However, the marginal cost for
producing unit 101 is $4, or ($204 – $200) ÷ (101-100).

Reaching Optimum Production

At some point, the company reaches its optimum production level, the point which producing any more units would increase the per-unit production cost. In other words, additional production causes fixed and variable costs to increase. For example, increased production beyond a certain level
may involve paying prohibitively high amounts of overtime pay to workers. Alternatively, the maintenance costs for machinery may significantly increase.

The marginal cost of production measures the change in
the total cost of a good that arises from producing one additional unit of that good.

The marginal cost (MC) is computed by dividing the change (Δ) in the total cost (C) by the change in quantity (Q.). Using calculus, the marginal cost is calculated by taking the first derivative of the total cost function with respect to the quantity:

M C = Δ C Δ Q.
where: M C = Marginal cost Δ = Dividing the change
C = Total cost Q. = Change in quantity beginaligned&MC=fracDelta CDelta Q.\&textbfwhere:\&MC=textMarginal cost\&Delta=textDividing the change\&C=textTotal
cost\&Q.=textChange in quantityendaligned ​MC=ΔQΔC​where:MC=Marginal costΔ=Dividing the changeC=Total costQ=Change in quantity​

The marginal costs of production may change as production capacity changes. If, for example, increasing production from 200 to 201 units per day requires a small business to purchase additional equipment, then the marginal cost of production may be very high. In contrast, this expense
might be significantly lower if the business is considering an increase from 150 to 151 units using existing equipment.

A lower marginal cost of production means that the business is operating with lower fixed costs a particular production volume. If the marginal cost of production is high, then the cost of increasing production volume is also high and increasing production may not be in the business’s best interests.

Calculating Marginal Revenue

Marginal revenue measures the change in the revenue when one additional unit of a product is sold. Assume that a company sells widgets for
unit sales of $10, sells an average of 10 widgets a month, and earns $100 over that timeframe. Widgets become very popular, and the same company can now sell 11 widgets for $10 each for a monthly revenue of $110. Therefore, the marginal revenue for the 11th widget is $10.

The marginal revenue is
calculated by dividing the change in the total revenue by the change in the quantity. In calculus terms, the marginal revenue (MR) is the first derivative of the total revenue (TR) function with respect to the quantity:

M R = Δ T R Δ Q. where: M R =
Marginal revenue Δ = Dividing the change T R = Total revenue
Q. = Change in quantity beginaligned&MR=fracDelta TRDelta Q.\&textbfwhere:\&MR=textMarginal revenue\&Delta=textDividing the change\&TR=textTotal revenue\&Q.=textChange in quantityendaligned ​MR=ΔQΔTR​where:MR=Marginal revenueΔ=Dividing the changeTR=Total revenueQ=Change in quantity​

For example, suppose the price of a product is $10 and a company produces 20 units per day. The total revenue is calculated by multiplying the price by the quantity produced. In this case, the total revenue is $200, or $10 x 20. The total revenue from producing 21 units is $205. The marginal revenue is calculated as $5, or ($205 – $200) ÷ (21-20).

How Can Marginal Revenue Increase?

Marginal revenue increases whenever the revenue received from producing one additional unit of a good grows faster—or shrinks more slowly—than its marginal cost of production. Increasing marginal revenue is a sign that the company is producing too little relative to consumer demand, and that there are
profit opportunities if production expands.

Let’s say a company manufactures toy soldiers. After some production, it costs the company $5 in materials and labor to create its 100th toy soldier. That 100th toy soldier sells for $15, meaning the profit for this toy is $10. Now, suppose the 101st toy soldier also costs $5, but this time can sell for $17. The profit for the 101st toy soldier, $12, is greater than the profit for the 100th toy soldier. This is an
example of increasing marginal revenue.

Balancing the Scales of Marginal Revenue

For any given amount of consumer demand, marginal revenue tends to decrease as production increases. In equilibrium, marginal revenue equals marginal costs; there
is no economic profit in equilibrium. Markets never reach equilibrium in the real world; they only tend toward a dynamically changing equilibrium. As in the example above, marginal revenue may increase because consumer demands have shifted and bid up the price of a
good or service.

It could also be that marginal costs are lower than they were before. Marginal costs decrease whenever the marginal revenue product of labor increases—workers become more skilled, new production techniques are adopted, or changes in technology and capital goods increase
output.

When marginal revenue and the marginal cost of production are equal, profit is maximized that level of output and price:

M R =
Δ T R Δ Q. M C = Δ C Δ Q. E
q . = M R = M C beginalignedMR&=fracDelta TRDelta Q.\\[-9pt]MC&=fracDelta CDelta Q.\\[-9pt]Eq.&=MR=MCendaligned MRMCEq.​=ΔQΔTR​=ΔQΔC​=MR=MC​

Example

For instance, a toy company can sell 15 toys $10 each. However, if the company sells 16 units, the selling price falls to $9.50 each. The marginal revenue is $2, or ((16 x 9.50) – (15 x10)) ÷ (16-15). Suppose the marginal cost is $2.00; the company maximizes its profit this point because the marginal revenue is equal to its marginal cost.

When marginal
revenue is less than the marginal cost of production, a company is producing too much and should decrease its quantity supplied until marginal revenue equals the marginal cost of production. When, on the other hand, the marginal revenue is greater than the marginal cost, the company is not
producing enough goods and should increase its output until profit is maximized.

When Marginal Revenue Starts to Fall

When expected marginal revenue begins to fall, a company should take a closer look the cause. The catalyst could be
market saturation or price wars with competitors.

If this is the case, the company should plan for this by
allocating money to research and development (R&D), so it can keep its product line fresh. Should a company believe it will be unable to increase its marginal revenue once it’s expected to decline, management will need to look both its marginal revenue and the marginal cost of producing an additional unit of
its good or service, and plan on maintaining sales volume the point where they intersect.

If the company plans on increasing its volume past that point, each additional unit of its good or service will come a loss and shouldn’t be produced.

Marginal Revenue vs. Marginal Benefit

Although they sound similar, marginal revenue is not the same as a marginal benefit. In fact, it’s the flip side. While marginal revenue measures the additional revenue a company earns by selling one additional
unit of its good or service, marginal benefit measures the consumer’s benefit of consuming an additional unit of a good or service.

Marginal benefit represents the incremental increase in the benefit to a consumer brought on by consuming one additional unit of a good or service. It normally declines as more of a good or service is consumed.

For example, consider a consumer who wants to buy a new dining room table. They go to a
local furniture store and purchase a table for $100. Since they only have one dining room, they wouldn’t need or want to purchase a second table for $100. They might, however, be enticed to purchase a second table for $50, since there is an incredible value that price. Therefore, the marginal benefit to the consumer decreases from $100 to $50 with the additional unit of the dining room table.

Tying the two together, let’s go back to our widget-maker example.
Let’s say a customer is contemplating buying 10 widgets. If the marginal benefit of purchasing the 11th widget is $3, and the widget company is willing to sell the 11th widget to maximize its consumer benefit, the marginal revenue to the company would be $3 and the marginal benefit to the consumer would be $3.

Marginal Analysis

All these calculations are part of a technique called
marginal analysis, which breaks down inputs into measurable units. First developed by economists in the 1870s, it gradually became part of business management, especially in the application of the cost-benefit method—the identification of when marginal revenue is greater than marginal cost, as we’ve been explaining
above.

According to the cost-benefit analysis, a company should continue to increase production until marginal revenue is equal to marginal cost. If the optimal output is where the marginal benefit is equal to marginal cost, any
other cost is irrelevant. So marginal analysis also tells managers what not to consider when making decisions about future resource allocation: They should ignore average costs, fixed costs, and sunk costs.

For example, a toy manufacturer could try to measure and
compare the costs of producing one extra toy with the projected revenue from its sale. Suppose that, on average, it has cost the company $10 to make a toy. The average sales price over the same period is $15.

This doesn’t necessarily mean that more toys should be manufactured, however. If 1,000 toys were previously manufactured, then the company should only consider the cost and benefit of the 1,001sttoy. If it will cost $12.50 to make the 1,001st
toy, but will only sell for $12.49, the company should stop production 1,000.

The Bottom Line

Manufacturing companies monitor marginal production costs and marginal revenues to determine ideal production levels. The marginal cost of production is calculated whenever productivity levels change. This allows businesses to determine a profit margin and make plans for becoming more competitive to improve profitability.

The best entrepreneurs and business leaders understand,
anticipate, and react quickly to changes in marginal revenues and costs. This is an important component in corporate governance and revenue cycle management.

Which of the following is true of the relationship between marginal cost and average cost?

If MC is less than ATC, then ATC is increasing.

What is relationship between marginal cost and average cost?

When the average cost increases, the marginal cost is greater than the average cost. When the average cost stays the same (is a minimum or maximum), the marginal cost equals the average cost.

Which of the following is true of the relationship between the marginal cost function and the average total cost and average variable cost functions?

Answer and Explanation: The answer is (b) If MC is greater than ATC and AVC, then ATC and AVC will increase. When the marginal cost (MC) curve is above the average total cost (ATC) curve and average variable cost (AVC) curve, then increasing the production by a unit increases both the ATC and AVC.

Which of the following statements about the relationship between marginal cost MC and average total cost ATC is correct?

Answer and Explanation: The correct option is a. MC < ATC; ATC is falling. In the case where the marginal cost of producing a good is lower than the average cost, then the average cost tends to decline.
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