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Marginal Cost vs Marginal Revenue: The differences, how to calculate them and are real-world examples of their importance.

You’re a business owner, not a mathematician, but chances are, your business is growing, and you are contemplating producing more products. Understanding marginal cost and revenue will help you to understand the perfect balance between making enough to meet your customer growth demands without creating an overproduction problem. This blog post will help you to understand the difference between marginal revenue and cost, how to calculate each of these metrics and provide you with a real-world example of how this data can be used to increase the profitability of your business.

Marginal Cost:

Marginal cost is the additional cost incurred in producing one more unit of a product or service. This calculation represents the change in the total cost when the quantity of an item made or service is increased by one unit.

Formula:

The Importance of Marginal Cost :

Calculating the marginal cost of production helps businesses to determine the perfect balance of production so that they remain profitable. It helps clarify any decisions regarding increasing or decreasing production, as at a certain point producing more product when marginal cost exceeds marginal revenue would result in a loss.

Example:

BrightPeeps Boutique sells sunglasses. If the total cost of producing 100 sunglasses is $1,000, and the total cost of producing 150 sunglasses is $1,050, then the marginal cost of producing each additional pair of sunglasses is $1.

Marginal Revenue:

Marginal revenue is the additional revenue that a company earns from selling one more unit of a good or service. It calculates the change in the total revenue when the quantity of a product or service sold is increased by one unit.

Formula:

The Importance of Marginal Revenue :

Calculating the marginal revenue of your product or service helps to determine the amount of revenue that is made from each additional unit of product or service sold. This information is important for deciding on product prices and determining and increasing profitability. The general rule of thumb is that If the marginal revenue is greater than the marginal cost, the business should increase production; if not, then it should reduce production.

Example:

Continuing with the BrightPeeps Boutique example, if selling 100 sunglasses generates $2,000 in revenue, and selling 150 sunglasses generates $3,000 in revenue, then the marginal revenue for each of the additional 50 sunglasses is $20.

Given that the marginal cost of producing each additional sunglasse is $1, BrightPeeps Boutique can make an additional $950 profit from producing and selling these 50 sunglasses.

Why Is it Important to Calculate Marginal Cost & Revenue

Understanding the difference between marginal cost and marginal revenue and learning how to calculate it helps businesses to:

Find their optimal production levels: Running through these calculations can help business owners Identify the level of output where their profit can be maximized (where MR = MC).
Decide on product and service pricing: These calculations help business owners decide on the right prices that maximize profit rather than just cover costs.
Allocate their resources: Marginal cost and revenue help business owners to more efficiently allocate their resources so that the cost of additional production is justified by the revenue that it generates.
Maximize the profit margins: This calculation helps business owners avoid overproduction or underproduction by helping them understand where the production levels align with profit-maximizing principles.

In the case of BrightPeeps Boutique, as long as the marginal revenue of $20 a pair of glasses is greater than the marginal cost of producing them ($1), and they know that the demand for their product exists, the boutique could continue increasing production. If the marginal cost of the glasses were to rise above the marginal revenue, it would mean that producing more sunglasses is no longer profitable.

How LedgersOnline Can Help

LedgersOnline team of expert bookkeeping professionals can not only help you keep your books in order but they can prepare reports for you that outline metrics, such as marginal cost and revenue, that give you the strategic insight into how your business should be operating to move forward in the most profitable way. Schedule a 1:1 consultation and learn how we can help.

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