How does a company determine its ideal production targets? It’s a lot more complicated than “make more, sell more, get more money.” Facilities need to understand their own internal workings and costs, as well as their markets, in order to optimally set their levels of production for the best profit margin. To do so, it’s important to understand how costs and revenue change marginally, an economic term for how changing the number of units produced changes both cost and profit.
When digging into the details of production costs, it’s important to determine the difference between fixed costs and variable costs. Fixed costs are usually facility and overhead costs and do not change depending on the level of production; variable costs change depending on the production level. Fixed costs can include utilities, general equipment and overhead; variable costs include labor, materials and other things that change with production.
Marginal cost equals the additional cost of producing one more unit, generally the variable costs of labor and materials for that unit. This can be represented by the marginal cost formula:
Marginal Cost = (Change In Total Cost) / (Change In Quantity)
Change in total cost can be obtained by examining the costs of additional labor and materials needed to make additional units. Change in quantity is the number of additional units. Once both are known, marginal cost can be obtained.
Marginal costs come into play because, for certain types of production, producing the second item is less costly than producing the first item, and so on. This is because of economies of scale, or cost benefits that can be obtained at a larger scale. The concept behind economies of scale is that efficiency increases at higher levels of production, decreasing the overall cost per unit made.
For production, normally, marginal costs will decrease as production increases. The more a company makes, the less each unit costs to make, relatively. Scale economies can be seen in other areas of business as well; for example, it’s often cheaper per pound to buy 1,000 pounds of a good versus 10 pounds.
Understanding these efficiencies requires an understanding of the production process. At what point is an employee working at their most efficient level? At what level of production is a machine reaching its full capacity? A good way to explore that is by looking at marginal product.
When considering production levels, it’s also important to understand the potential increase in output that could result by increasing production inputs. For example, hiring another employee or increasing hours. Marginal product is the term for this increase, defined as the extra output generated by one additional unit of input. It can be considered a measure of productivity, or efficiency, of whatever that unit of input may be (an additional worker, an additional workday, and so on).
Marginal cost and marginal product are generally inversely related: if marginal product is high, meaning productivity is high, then marginal costs will be lower. If marginal product is lower, meaning less efficient use of production inputs, then marginal costs will increase. This is how economies of scale come into play: increased efficiency at higher levels of output.
The relationship between marginal cost and marginal product also ends up following the law of diminishing returns over time. For example, a company hiring one additional employee increases output (which, ideally, creates revenue) at the additional cost of that one worker. However, if a company hires 10 additional employees, they are likely to be limited by other factors, like equipment (availability, capacity) or materials (cost, availability), and the cost of those 10 employees will outweigh the benefit of the added production.
As expected, breaking down revenue in a similar way provides a better understanding of revenue. Marginal revenue is the additional revenue that will be generated by selling one more unit. It can be represented by a similar equation:
Marginal Revenue = (Change In Total Revenue) / (Change In Quantity)
While marginal costs depend on production variables – materials, facility, labor – marginal revenue depends on the market conditions, because market conditions determine price.
In a “perfectly competitive” market – one where the market is driving the price of the unit sold, and the company can sell as many units as it can at that market price – marginal revenue is usually constant. This means that changing the output quantity will proportionally change the total revenue: make more units, sell more units, get more revenue. In an economy of scale, overall costs will decrease as more units are made, and if this happens at a constant marginal revenue, overall profits increase.
In a monopoly market, however, supply and demand will determine the marginal revenue. The company cannot simply make more units and expect them to sell at the same price; to sell more units, the company will have to reduce the price of said units. At some point in this market, marginal costs will become greater than the marginal revenue, at which point the company is no longer making a profit.
These markets are models, of course, and in reality do not behave quite as neatly; however, the generalizations can be made to help a company estimate their pricing, and as such, their marginal revenue.
When marginal costs equal marginal revenue, a facility is assumed to be operating at its best efficiency, which will work to maximize profits. The relationship between marginal costs and marginal revenue helps to determine production levels:
- If marginal revenues are greater than marginal costs, the company is making a profit per unit and should increase production levels to make more units.
- If marginal revenues are less than marginal costs, the company should reduce production levels, as it is losing money on each unit.
- If marginal revenues equal marginal costs, this is the most efficient and most profitable point of operation.
In this way, costs and revenues both come into play when determining maximum profit – and ideal production levels.
Production targets affect both costs and revenues. While increasing production can lead to increased profit for a company, there will always be a point of diminishing returns where the cost-benefit analysis stops making sense. Companies can’t always expect to make more profit simply by hiring more hands or increasing output.
A real understanding of process efficiency, fixed and variable costs and one’s specific market are required in order to hit the sweet spot where production levels are maximizing the company’s bottom line. Being able to calculate and understand marginal costs versus marginal revenues is an important step towards understanding how to optimize business.