Marginal opportunity cost is designed to explain in concrete terms what it will cost a business to produce one more unit of its product. In addition to the obvious material costs of producing more of a product, marginal opportunity cost attempts to identify the complete costs of each additional unit, from raw materials to increased labor costs to other variables. Calculating the marginal opportunity cost can help a business make financially prudent decisions.
When a business produces additional product, it costs more money. Marginal opportunity cost attempts to incorporate all of these costs to help a business make a decision about maximizing its own profitability. For example, if a baker decides to make extra chocolate cake, he will have to pay for more raw ingredients, such as sugar and flour. The baker might have to hire additional staff to make or sell the extra cakes. With more cakes, the baker might have to buy a larger display case, which also might raise costs for lighting and refrigeration. Lastly, opportunity cost factors in what the baker has to give up to make those extra cakes. For example, the baker might not be able to offer bagels if the extra cake baking takes up more time. If a customer turns up and only wants a bagel, this results in a loss for the baker.
Marginal opportunity cost can be used with sales data to point a business in the right financial direction. By subtracting the marginal opportunity cost from the additional revenue generated, a company can determine whether or not it is worth it financially to produce extra product.
Let's assume the baker in the above example incurs a total cost of $500 to produce an extra 100 cakes. This results in a marginal opportunity cost of $5. If the baker can generate more than $5 additional revenue per cake sold, the baker will be making additional profit by producing those extra cakes. Armed with that information, the baker can run the same calculation on producing extra bagels and determine which is a more profitable course of action.