In business operations, there are five types of costs that accompany the production process, namely fixed costs , variable costs , total costs, average costs , marginal costs . Each type of cost has a different meaning, function and calculation method. Of the various types of costs, marginal costs are one of the most important which are useful for maximizing profits.
The definition of marginal in the Big Indonesian Dictionary (KBBI) means relating to boundaries or edges that are not very profitable. In economics, marginal or marginal cost is the change in total costs that arise when the quantity produced increases or the cost of producing an additional quantity.
In certain contexts, marginal costs can be interpreted as costs that arise in the production of one additional good or service. To understand more about the meaning of marginal in economics, see the following explanation.
Read Also : What is a Deficiency? Definition, Types and Relationship with Audit Findings
Understanding Marginal Cost
The definition of marginal cost is an important aspect that must be considered in the goods production process. Of course, the company must really know how much costs must be incurred in a particular production cycle and it is very important to be able to plan prices and production of goods.
In addition, marginal costs are a decrease or increase in all total costs paid due to additions or subtractions in one unit of additional product.
Marginal costs can also be defined as costs that describe the rate at which the amount of product costs changes. Another understanding is that marginal costs are predictions of economic costs that will change if output changes.
Initially, marginal costs tend to fall. However, then marginal costs will quickly rise because marginal returns to variable factor inputs will begin to decrease, so that the use of marginal factors becomes more expensive.
This is known as the law of diminishing marginal returns or also known as the law of diminishing marginal returns . When marginal costs increase, the prices of goods and services produced by a company will also increase to maximize profits.
So, what is the importance of marginal cost? The main purpose of marginal cost is to determine the point at which a company is able to achieve economies of scale, which is the value of the profits obtained when the product becomes more efficient. This is done to be able to maximize the operational system as a whole.
Marginal cost is a very important economic theory, because companies that maximize their profits will produce up to the point when marginal costs are equal to the company’s marginal revenue.
Entrepreneurs and management need to calculate marginal costs, especially before the production process starts in order to know the output targets needed to reach the company’s profit point.
A company that maximizes profits will compare the marginal revenue received from the output sold using the marginal costs of producing it.
If marginal revenue is equal to marginal cost, then the company will produce the quantity of output that can maximize profits.
If marginal revenue tends to be smaller than marginal cost, then profits can be increased by increasing production. However, if marginal income tends to be greater than marginal cost, then profits can be further increased by reducing production.
Therefore, determining marginal costs is very important as an ingredient for making decisions and planning a business. However, the decision to increase or decrease production to maximize profits must also be based on other considerations. Examples include market prices or price competition and consumer purchasing power.
Marginal Cost Components
Data related to the types of costs in production, for example fixed costs and variable costs, will usually be needed by the company. Fixed costs will not change, as the company’s production increases. Meanwhile, variable costs will exist in the opposite situation.
Variable costs depend more on production output and the constant number of each unit that will be produced by the company. When production volume and output increase, variable costs will also increase.
Examples are variable costs from sales commissions as well as direct human resource costs and raw materials. Meanwhile, fixed costs are costs that are constant regardless of production expenditure and the absence of output results. Examples include employee salaries, god costs, insurance and office supplies.
Formula and How to Calculate Marginal Costs
After understanding what marginal cost is or marginal cost and its components, here’s how to calculate marginal cost.
Basically, the formula used to calculate marginal costs is as follows:
Marginal cost = change in cost or change in quantity.
The following is an explanation of the marginal cost formula:
Cost Changes
Cost changes are a decrease or increase in production costs at each level of production and over a certain period of time, especially if there is a need to produce more or less.
If the additional unit is manufactured, it will require recruiting one or even two workers and increasing the cost of raw materials. Then it will be certain that there will be changes in overall production costs.
To determine the cost of changes, Mudalovers can deduct the production costs that existed during the first production process from the production costs in the next wave when there is an increase in production.
Read Also : What are Collateral Assets? Definition, Advantages and Disadvantages of Collateral Assets
Change in Quantity
At various levels of production, it is common for the number of goods produced to increase or even decrease. To determine changes in quantity, Mudalovers needs to calculate the number of goods made in the first production process, then subtract the volume of output made for the next production process.
After knowing the information and formula for marginal costs, Mudalovers needs to take at least three steps to calculate marginal costs. Here’s the explanation:
Step 1
Determine the change in quantity of the product or service.
To be able to calculate marginal costs, of course Mudalovers must be able to know all the costs needed to make one product or service item that can be produced by the company. This total cost consists of fixed costs and variable costs.
Fixed costs must be the same throughout the cost analysis. Therefore, the first step that must be taken to be able to calculate marginal costs is to determine at what point these costs can change.
Step 2
Calculate the change in costs.
After Mudalovers knows what a change in production quantity is, the next stage is to calculate the change in costs. These cost changes can be obtained from reducing the total costs of old production from the costs of new production.
The value of overall production costs can be obtained by adding up fixed costs and variable costs. Fixed costs are costs that have a value that does not change during the period that Mudalovers is evaluating. These fixed costs include rent, equipment costs and so on.
For variable costs themselves, in general they will increase along with the increase in production costs. These variable costs include raw material costs, equipment costs, employee salaries and so on. To get variable costs, Mudalovers can get them from the interval of production of goods or services.
After Mudalovers values fixed production costs and variable costs, all production costs will be easy to obtain. Apart from that, the value of variable production costs will also be obtained.
After knowing the value of fixed production costs and variable costs, the total production costs will be obtained. The value of changes in production costs will also be obtained.
Step 3
How to calculate marginal costs .
Marginal cost is the cost required by a company to be able to make one additional unit of product. This means that you can calculate marginal costs in order to determine the increase in costs required for each additional production item.
In order to find out the marginal cost, Mudalovers can get it by dividing the change in production costs required by the change in the number of products.
Mudalovers can also obtain it by using the formula MC = TC/ Q, where MC is marginal cost, while TC is the change in costs and Q is the change in product quantity.
Marginal costs will be obtained by dividing the changes in production costs required by changes in product quantity. Apart from that, Mudalovers also calculated it using the formula MC = TC/ Q as previously explained.
Carrying out calculations on marginal costs will be very useful to determine whether the flow of production should continue to be changed or not. In general, when there is an increase in output volume, the company will be able to achieve higher economies of scale and marginal costs can be reduced.
These economies of scale can be obtained from specializing human resources and utilizing production machines that work more efficiently. An increase in output volume can help producers to get very large discounts or discounts for purchasing raw materials or raw materials.
However, in the end, at a certain point a diseconomy of scale will emerge, namely when costs will increase much more than the increase in output.
This kind of problem will generally occur due to overlapping work. This means that there will be more workers who will operate the company’s production machines.
An increase in the number of employees will also mean that work cannot be coordinated well. Likewise, the price of raw materials and raw material prices will become more expensive, because local supplies have run out.
In general, a company will operate at maximum output, if marginal costs are equal to total units at average cost. If Mudalovers depicts a graph, then marginal costs will form a curve that resembles the letter U.
Example of Calculating Marginal Costs
In general, the marginal cost formula is the total change in production costs then divided by the change in the amount of production.
Marginal cost = change in total production costs or change in production quantity.
For example, marginal costs are part of production costs. Marginal costs can be seen from the production process. In the production process, there are several resources that are fixed and constant regardless of how much additional demand is received.
These resources include fixed costs, for example sales, administration and overhead . Meanwhile, additional resources may be needed later to increase production speed. The goal is to be able to meet additional demand.
The costs used to purchase and maintain these resources are referred to as variable costs which change with changes in production volume. Examples include the costs of raw materials and labor.
For example, an entrepreneur named Ana has a cookie production business. Every day, Ana produces 20 cakes using two cake making machines and three employees.
Approaching the Eid holiday, Ana received additional requests for 50 cakes every day, so to speed up the production process, Ana finally added 3 new employees and bought another cake machine. Apart from that, Ana also expanded the kitchen used for production.
In this example, the increased number of workers and machines are included in variable costs. Marginal costs are calculated from how much additional costs are used to pay for new workers and buy one unit of the new machine. These costs will add to the total production costs. Meanwhile, kitchen costs are fixed and constant, and do not affect production costs.
From Ana’s case example, the way to calculate marginal costs is as follows:
Total production costs, before additional requests = IDR 5 million
. After additional requests come in, additional raw material costs = IDR 200 thousand
Labor wages = IDR 1 million
So that means, there is a change in total production costs of IDR 5 million + IDR 200 thousand + IDR 1 million = IDR 6,200,000
There is also a production quantity that was initially 20, then increased by 50. So, the change in production quantity is 50 – 20 = 30.
That way, the marginal cost is IDR 6,200,000 / 30 = IDR 206,667. So, to maximize profits, Ana has to sell her cakes for more than IDR 206,667 per piece.
Read Also : What is Management Accounting? Definition and Duties
Closing
That is an explanation of the meaning of marginal costs. It can be concluded that marginal costs are additional costs that must be incurred by the company to make each additional unit of business product that the company will produce.
So that a company can obtain marginal costs, it can be determined by using the formula for changes in costs divided by changes in quantity.
Please note that marginal revenue and marginal costs must always have the same amount. That way, the profits obtained by the company will be maximized.
When you have carried out the calculation process using the formula above, the company can find out the amount of output value that can produce the highest profit.
So, for Mudalovers who are interested in knowing further explanations about marginal costs or other material about economics, Mudalovers can get the information by reading article.