In economics and finance, businesses often need to use a number of measurements to calculate revenue and costs so that they can create strategies for maximizing profits. As supply and demand levels fluctuate, so too do revenues and expenses. Businesses should recalculate their marginal revenue and cost amounts on a regular basis to keep sales and growth at a steady level.
Marginal cost is the change in total cost which occurs when the number of units produced change by just one unit. In other words, marginal revenue is the cost of producing one additional unit of a particular good. Marginal revenue is calculated by dividing the total variable cost of production by the total quantity of goods (MC = VC / Q). For example, if the variable cost of producing 5 widgets is $40, then the marginal cost for producing one more unit would be $8 ($40 / 5 units).
Marginal revenue is the added revenue that one extra product unit generates for a business. It is represented by the additional income collected from selling one more unit. Marginal revenue can also be thought of as the change in the total revenue divided by the change in the number of units sold. To calculate marginal revenue, you need to divide the total revenue by the quantity of units sold. For example, it the total revenue for a business was $10,000 for 2,000 units sold, then the marginal revenue amount would be $5 ($10,000 / 5 units).
When marginal revenue is equal to marginal cost, profit is maximized. Every business should strive to reach the point where marginal revenue equals marginal cost to get the most out of their costs of production and sales generation. When marginal revenue is greater than marginal cost, greater profits are generated, however these profits will be tempered by higher production rates. The result is that each additional amount of output yields an increasingly smaller added return. When marginal revenue is equal to a lesser amount of marginal cost, the business has unrealized profit potential in that added output.
Economies of Scale
“Economies of scale” is a concept that manufacturing businesses use over the long run, which take both marginal cost and marginal revenue into account. Over the long run, a period of time where all inputs are varied by the business so that there are not fixed costs. Economies of scale exist if an extra unit of output can be produced for less than the average cost of all previously produced units. In other words, if the marginal cost is less than the average cost over the long run, economies of scale exist. On the other hand, if production results in a marginal cost that is higher than the average cost, economies of scale do not exist.