Marginal cost

What it means

Marginal cost is the extra cost incurred when a company produces or sells one more unit. If a bakery bakes 1,000 rolls and the 1,001st adds only flour, energy and packaging, the marginal cost is just those items. Rent, equipment and the baker’s wage do not change.

In the short run marginal cost is usually close to variable cost per unit, because fixed costs do not change with small changes in volume. With a larger increase, however, it can jump, for instance when an extra shift, machine or larger premises are needed.

The idea of marginal cost underlies decisions on price and volume. As long as the price of the next unit exceeds its marginal cost, it contributes to covering fixed costs and profit, meaning it generates a contribution margin.

How it works in practice

Marginal cost helps with decisions such as: should we take an order at a lower price when we have spare capacity? If the price covers marginal cost with something to spare and the order does not crowd out better-paying work, it is worthwhile even if it does not cover the full costing with overheads.

Marginal cost is not reported directly in the accounts, but it can be estimated by splitting costs into fixed and variable. Management accounting with cost centres and job costing shows which costs really change with volume.

In services such as software or digital content, marginal cost is close to zero: another user costs only a fraction. Such companies can therefore expand margins sharply as they grow, but can also easily slide into a price war when a competitor cuts the price to near zero.

What to watch out for

The most common mistake is selling for long periods at a price that only covers marginal cost. A single order may pay off, but if most work is priced that way the company fails to cover its fixed costs and makes a loss. Marginal thinking is a tool for exceptional decisions, not for the standard price list.

The second mistake is forgetting hidden marginal costs: overtime, express freight, machine wear or the opportunity cost when a cheap order takes up capacity a better customer would otherwise have used.