How to Calculate Marginal Rate of Return
The marginal rate of return shows the rate of return a company stands to gain by producing a single additional unit. These "units" can be whatever the company uses to generate revenue, whether they are physical products, virtual downloads or hours of service. Because the production of each additional unit requires additional resources, the marginal rate of return helps companies determine if the production of that additional unit will generate revenues that will cover the costs of those resources.
The marginal revenue of a production process is the amount of revenue the company gains by producing an additional unit. In most instances, the marginal revenue is equal to the retail sales price -- the amount the company receives for producing and selling that additional unit. Products that are grouped together count as a single additional unit. For instance, a dozen eggs, a pair of shoes or an hour of massage all count as a single sales unit.
The marginal cost is the amount the company must spend to produce the additional unit. The marginal cost includes both the fixed costs and variable costs needed to produce that additional unit. Fixed costs include costs the company would have to pay, regardless of production levels; these costs include rent, utilities and taxes. The variable costs are costs the company must pay to increase its production; these costs include materials, labor and distribution expenses.
The marginal rate of return is the ratio of the marginal revenue to the marginal cost. For instance, Generic Games produces 100,000 copies of its football video game. Each copy sells for $60, which denotes the marginal revenue. The marginal cost for the next copy is $30. The marginal rate of return for the football game is 60/30, or 2; for each $1 spent to create the additional copy, the company will receive $2 in additional revenue.
Companies can use the marginal rate of return to determine the number of units they can produce to maximize profits. This happens when the marginal cost equals marginal revenue, or when the marginal rate of return equals 1. This point is known as the profit maximization point. For instance, Generic Games sells 200,000 copies of its football game. The marginal revenue is still $60, but the marginal cost is now $60. The marginal rate of return is 60/60, or 1, so the game has reached its maximum profit potential at this point.
As production increases, variable production costs will also increase. Any production past the profit maximization point will cease to be profitable. This is known as the_ law of diminishing returns_. If Generic Games produces 250,000 copies of its football game, the marginal revenue is still $60, but the marginal cost will rise to $80. The marginal rate of return is 60/80, or 0.75. The next unit now costs more to produce than the revenue it generates, so the company must cut back on production.