When Calculating Marginal Cost What Must the Firm Know?

by Jack Ori

The marginal cost is the change in total costs if a business changes how much it produces. Economists often look at it in terms of the costs of producing one unit of an item a business sells. If a business wants to maximize its profit, it must attempt to produce exactly enough of a product so that marginal costs and marginal revenues -- the amount revenue changes as production increases or decreases -- are close to equal.

Costs of Raw Materials

Marginal cost refers to the costs associated with producing one unit of merchandise for sale. Thus, companies must know the cost of raw materials to be able to compute marginal costs. The cost of raw materials impacts how much it costs altogether to produce a unit of product. If the raw materials are expensive, marginal costs will be higher than if the raw materials are cheap.

Efficiency of Production

Companies must understand the production process to calculate marginal cost. If production is inefficient -- that is, making a unit of product takes a lot of time -- this impacts the marginal cost. The company won't be able to afford to make very many of a product if each product takes a long time to make. These types of products are more expensive because workers must be paid for their time in making each product. To reduce marginal costs, companies may have to examine alternative means of producing the final merchandise.

Labor Costs

Labor costs are tied to the efficiency of production. Manufacturers must pay workers for their contributions to making the product. If a product requires a large labor force to create, the marginal costs will be higher than if one or two people can create it. It may be more cost-effective to hire several workers if they can get the work done faster than to hire one or two workers who take a long time to complete the work.

Production Location

Companies should also look at whether they can produce goods in-house to lower marginal costs. If a company has to outsource the production of goods, it'll cost more to produce each unit because the company has to pay the manufacturer for doing the job as well as pay shipping or other transportation costs. In addition, it may take longer to get product to the shelves if it is produced elsewhere than if it is produced in-house, which also raises marginal costs.