The Relationship Between Marginal Revenue & Marginal Cost as the Firm Increases Output

by David Ingram

Marginal revenue and marginal cost are microeconomic concepts related to the profitability of organizations. Marginal revenue represents the extra amount of revenue brought in by each unit sold. Marginal costs represent the additional costs incurred by each extra unit purchased. Both concepts are crucial for understanding a company's cost structure and profitability, and are useful for internal decision-making in pricing and purchasing policies. Marginal revenue and costs are both tied to output volume in distinct ways -- changes in output volume, or changes in purchasing volume due to increased output, can have different effects on revenue, costs and profitability.

Marginal Revenue

At constant prices, marginal revenue should remain the same for all units, but there are a number of real-world factors that can serve to alter marginal revenue figures. A company may sell outdated or damaged inventory at a discount, for example, reducing marginal revenue for specific items while marginal revenue for other items of the same type remains the same. Companies may offer price discounts for large-volume purchases, as well, which is where the relationship between revenue and volume comes into play.

Marginal Cost

Marginal costs represent the flip-side of marginal revenues. One company's marginal costs almost always coincide with another company's marginal revenue. For example, if company A purchases from company B at a cost of $5 per unit, company A's marginal cost and company B's marginal revenue will be $5 per unit. Because of this, marginal costs can be affected the same way as marginal revenues, but in reverse.

Correlation

Marginal costs can be reduced by purchasing higher volumes. In addition to price-volume discounts suppliers offer to everyone, specific suppliers may be willing to negotiate even steeper discounts for their most loyal customers. Therefore, as a company continues to purchase more materials, equipment or inventory due to its increased output, the company's marginal costs can continue to decrease. Marginal production costs can be lowered via economies of scale, which come from using the same equipment, tools and labor to produce greater output. Price increases are virtually the only way to increase marginal revenue. As mentioned, marginal revenue stays the same as volume increases on sales to a range of different customers, but increasing volume to individual customers usually has the effect of lowering marginal revenue due to price-volume discounts. Boosting product quality can be an effective way to increase prices (and marginal revenue) while continuing to increase output volume.

Profitability

Profitability relies on creating a balance between marginal costs and marginal revenue so that each unit of inventory sold brings in a consistent margin above direct costs. Different profit margins can bring in different total profit due to the volume variable. A company with a lower profit margin, for example, may sell so much more volume than a competitor with higher profit margins that the company with the lower margin brings in more total profit.

About the Author

David Ingram has written for multiple publications since 2009, including "The Houston Chronicle" and online at Business.com. As a small-business owner, Ingram regularly confronts modern issues in management, marketing, finance and business law. He has earned a Bachelor of Arts in management from Walsh University.

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