Guagua Community Colleges

Guagua, Pampanga

Bachelor of Science in Accountancy/Accounting Information System

Managerial Economics

Chapter 3-Marginal Analysis

WHAT IS MARGINAL ANALYSIS?

Marginal analysis is an examination of the additional benefits of an activity compared to the

additional costs incurred by that same activity. Companies use marginal analysis as a decision-making
tool to help them maximize their potential profits. Marginal refers to the focus on the cost or benefit of
the next unit or individual, for example, the cost to produce one more widget or the profit earned by
adding one more worker.

KEY TAKEAWAYS

 Marginal analysis is an examination of the additional benefits of an activity compared to the

additional costs incurred by that same activity. Marginal refers to the focus on the cost or benefit
of the next unit or individual, for example, the cost to produce one more widget or the profit
earned by adding one more worker.
 Companies use marginal analysis as a decision-making tool to help them maximize their potential
profits.
 When a manufacturer wishes to expand its operations, either by adding new product lines or
increasing the volume of goods produced from the current product line, a marginal analysis of
the costs and benefits is necessary.

Understanding Marginal Analysis

Marginal analysis is also widely used in microeconomics when analyzing how a complex system
is affected by marginal manipulation of its comprising variables. In this sense, marginal analysis focuses
on examining the results of small changes as the effects cascade across the business as a whole.

Marginal analysis is an examination of the associated costs and potential benefits of specific
business activities or financial decisions. The goal is to determine if the costs associated with the change
in activity will result in a benefit that is sufficient enough to offset them. Instead of focusing on business
output as a whole, the impact on the cost of producing an individual unit is most often observed as a
point of comparison.

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 Marginal analysis can also help in the decision-making process when two potential investments
exist, but there are only enough available funds for one. By analyzing the associated costs and estimated
benefits, it can be determined if one option will result in higher profits than another.

Limitations of Marginal Analysis

Marginal analysis derives from the economic theory of marginalism—the idea that human actors
make decisions on the margin. Underlying marginalism is another concept: the subjective theory of
value.

 Marginalism is sometimes criticized as one of the "fuzzier" areas of economics, as much of what
is proposed is hard to accurately measure, such as an individual consumers' marginal utility.

 Also, marginalism relies on the assumption of (near) perfect markets, which do not exist in the
practical world. Still, the core ideas of marginalism are generally accepted by most economic
schools of thought and are still used by businesses and consumers to make choices and
substitute goods.

Modern marginalism approaches now include the effects of psychology or those areas that now
encompass behavioral economics. Reconciling neoclassic economic principles and marginalism
with the evolving body of behavioral economics is one of the exciting emerging areas of
contemporary economics.

 Since marginalism implies subjectivity in valuation, economic actors make marginal decisions
based on how valuable they are in the ex-ante sense. This means marginal decisions might later
be deemed regrettable or mistaken ex-post. This can be demonstrated in a cost-benefit scenario.
A company might make the decision to build a new plant because it anticipates, ex-ante, the
future revenues provided by the new plant to exceed the costs of building it. If the company later
discovers that the plant operates at a loss, then it mistakenly calculated the cost-benefit analysis.

1. What Is Marginal Revenue?

Marginal revenue is the increase in revenue that results from the sale of one additional unit of
output. While marginal revenue can remain constant over a certain level of output, it follows from
the law of diminishing returns and will eventually slow down as the output level increases. In economic
theory, perfectly competitive firms continue producing output until marginal revenue equals marginal
cost.

KEY TAKEAWAYS

 Marginal revenue refers to the incremental change in earnings resulting from the sale of one
additional unit.
 Analyzing marginal revenue helps a company identify the revenue generated from each
additional unit sold.
 Marginal revenue is often shown graphically as a downward sloping line that represents how a
company usually has to decrease its prices to drive additional sales.

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  A company that is looking to maximize its profits will produce up to the point where marginal
cost equals marginal revenue.
 When marginal revenue falls below marginal cost, firms typically do a cost-benefit analysis and
halt production as it may cost more to sell a unit than what the company will receive as revenue.

Understanding Marginal Revenue

Marginal revenue is a financial and economic calculation that determines how much revenue a
company earns in revenue for each additional unit sold. As the price of a good is often tied to market
supply and demand, a company's marginal revenue often varies based on how many units it has already
sold.

Marginal revenue is useful in several contexts. Companies use historical marginal revenue data
to analyze customer demand for products in the market. They also use the information to set the most
effective and efficient prices. Last, companies rely on marginal revenue to better understand forecasts;
this information is then used to determine future production schedules such as material requirements
planning.

How to Calculate Marginal Revenue

A company calculates marginal revenue by dividing the change in total revenue by the change in
total output quantity. Ideally, the change in measurements captures the change from a single quantity
to the next available quantity (i.e. the difference between the 100th and 101st unit sold). However, the
formula above can still be used to capture the average marginal revenue across a series of units (i.e. the
difference between the 100th and 115th unit sold).

The formula for marginal revenue can be expressed as:

For example, a company sells its first 100 items for a total of Php1,000.00 If it sells the next item
for Php8.00, the Marginal Revenue for the 101st item is Php8.00. If it sells a total of 115 units for $1,100,
how much is the marginal revenue based on the formula?

Marginal Revenue Curve

Like other related concepts, marginal revenue can be graphically depicted. It is most often
represented as a downward slowing straight line on a chart capturing price on the y-axis and quantity on
the x-axis.

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 The marginal revenue curve is often downward sloping because there is most often an
economically inverse relationship between price and quantity. As a company decreases the price of its
product, more units will likely be demanded; as the price is increased, demand often decreases.

For this reason, a company must often decrease its price to increase its market share. By
decreasing its price, the company will receive less marginal revenue for each additional unit sold. At
some point, the market demand for additional units will drive the product price so low that it becomes
unprofitable to manufacture additional units.

In the graph below, marginal revenue is depicted by one of the blue lines. The quantity in which
marginal revenue and marginal cost intersect is the optimal quantity to sell; the associated price point is
noted as bullet E (where quantity per period and demand intersect).

Average Revenue Curve

Marginal revenue can be analyzed by comparing marginal revenue at varying units against
average revenue. Average revenue is simply the total amount of revenue received divided by the total
quantity of goods sold.

In a perfect competition, marginal revenue is most often equal to average revenue. This is
because collective market forces make each participant a price-taker. For example, the market may
dictate that it is not profitable to sell a good below $10. However, charging more than $10 per unit puts
a company at a disadvantage to other companies selling at that price.

In an imperfect competition, marginal revenue and average revenue will vary. This is because a
firm must eventually lower its price to sell additional units. Both marginal revenue and average revenue

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tend to be downward sloping with marginal revenue often being the more steeper of the two lines.
Consider an example where a company sells one good for $100. If it prices its second good at $90, its
marginal revenue will be $90. However, its average revenue will be $95 (($100 + $90) / 2 units sold).

In the real world example shown graphically below, this is the theoretical average revenue and
marginal revenue curve for an agricultural chemical producer in a monopolistic industry. Both marginal
revenue and average revenue decrease as the firm lowers prices to sell more quantities, though marginal
revenue decreases faster than average revenue.

Example of Marginal Revenue

To assist with the calculation of marginal revenue, a revenue schedule outlines the total revenue
earned, as well as the incremental revenue for each unit. The first column of a revenue schedule lists the
projected quantities demanded in increasing order, and the second column lists the
corresponding market price. The product of these two columns results in projected total revenues, in
column three.

The difference between the total projected revenue of one quantity demanded and the total
projected revenue from the line below it is the marginal revenue of producing at the quantity demanded
on the second line. For example, 10 units sell at $9 each, resulting in total revenues of $90; 11 units sell
at $8.50, resulting in total revenues of $93.50. This indicates the marginal revenue of the 11th unit is
$3.50 ($93.50 - $90).

Marginal Revenue vs. Marginal Cost

Any benefits gained from adding the additional unit of activity are marginal benefits. One such
benefit occurs when marginal revenue exceeds marginal cost, resulting in a profit from new items sold.
If the sale of one additional unit yields marginal revenue of $100 and marginal expenses of $80, the
company will receive marginal profit of $20 for the additional item sold.

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 A company experiences the best results when production and sales continue until marginal
revenue equals marginal cost. Beyond that point, the cost of producing an additional unit will exceed the
revenue generated. If the company sells one additional unit for $100 but incurs marginal revenue of
$105, the company will lose $5 in the process of selling that extra unit.

When marginal revenue falls below marginal cost, firms typically adopt the cost-benefit
principle and halt production, as no further benefits are gathered from additional production.

What Is Marginal Cost?

In economics, the marginal cost is the change in total production cost that comes from making
or producing one additional unit. To calculate marginal cost, divide the change in production costs by the
change in quantity. The purpose of analyzing marginal cost is to determine at what point an organization
can achieve economies of scale to optimize production and overall operations. If the marginal cost of
producing one additional unit is lower than the per-unit price, the producer has the potential to gain a
profit.

KEY TAKEAWAYS

 Marginal cost is an important concept in managerial accounting, as it can help an organization

optimize its production through economies of scale.
 A company can maximize its profits by producing to where marginal cost (MC) equals marginal
revenue (MR).
 Fixed costs are constant regardless of production levels, so higher production leads to a lower
fixed cost per unit as the total is allocated over more units.
 Variable costs change based on production levels, so producing more units will add more variable
costs.
 Companies must be mindful of when increasing production necessitates results in step costs due
to changes in relevant ranges (i.e. additional machinery or storage space needed).

Marginal Cost Formula

Marginal cost is calculated as the total expenses required to manufacture one additional good.
Therefore, it can be measured by changes to what expenses are incurred for any given additional unit.

Marginal Cost = Change in Total Expenses / Change in Quantity of Units Produced

The change in total expenses is the difference between the cost of manufacturing at one level
and the cost of manufacturing at another. For example, management may be incurring $1,000,000 in its
current process. Should management increase production and costs increase to $1,050,000, the change
in total expenses is $50,000 ($1,050,000 - $1,000,000).

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 The change in quantity of units is the difference between the number of units produced at two
varying levels of production. Marginal cost strives to be based on a per-unit assumption, so the formula
should be used when it is possible to a single unit as possible. For example, the company above
manufactured 24 pieces of heavy machinery for $1,000,000. The increased production will yield 25 total
units, so the change in quantity of units produced is one (25 - 24).

The formula above can be used when more than one additional unit is being manufactured.
However, management must be mindful that groups of production units may have materially varying
levels of marginal cost.

Understanding Marginal Cost

Marginal cost is an economics and managerial accounting concept most often used among
manufacturers as a means of isolating an optimum production level. Manufacturers often examine the
cost of adding one more unit to their production schedules.

At a certain level of production, the benefit of producing one additional unit and generating
revenue from that item will bring the overall cost of producing the product line down. The key to
optimizing manufacturing costs is to find that point or level as quickly as possible.

Marginal cost includes all of the costs that vary with that level of production. For example, if a
company needs to build an entirely new factory in order to produce more goods, the cost of building the
factory is a marginal cost. The amount of marginal cost varies according to the volume of the good being
produced.

Marginal cost is an important factor in economic theory because a company that is looking to
maximize its profits will produce up to the point where marginal cost (MC) equals marginal revenue (MR).
Beyond that point, the cost of producing an additional unit will exceed the revenue generated.

Benefits of Marginal Cost

1. When a company knows both its marginal cost and marginal revenue for various product lines,
it can concentrate resources towards items where the difference is the greatest. Instead of
investing in minimally successful goods, it can focus on making individual units that maximum
returns.
2. Marginal cost is also essential in knowing when it is no longer profitable to manufacture
additional goods. When marginal cost exceeds marginal revenue, it is no longer financially
profitable for a company to make that additional unit as the cost for that single quantity exceeds
the revenue it will collect from it. Using this information, a company can decide whether it is
worth investing in additional capital assets.
3. Marginal cost is also beneficial in helping a company take on additional or custom orders.
Consider a company that sells a good for $50. It has additional capacity to manufacture more
goods and is approached with an offer to buy 1,000 units for $40 each. Marginal cost is one
component needed in analyzing whether it makes sense for the company to accept this order at
a special price.

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Example of Marginal Cost

Production costs consist of both fixed costs and variable costs. Fixed costs do not change with an increase
or decrease in production levels, so the same value can be spread out over more units of output with
increased production. Variable costs refer to costs that change with varying levels of output. Therefore,
variable costs will increase when more units are produced.

For example, consider a company that makes hats. Each hat produced requires $0.75 of plastic and fabric.
Plastic and fabric are variable costs. The hat factory also incurs $1,000 dollars of fixed costs per month.

If you make 500 hats per month, how much is the fixed costs?

In this simple example, how much is the total cost per hat?

If the company boosted production volume and produced 1,000 hats per month, then how much would
be the fixed costs per hat?

If the hat factory was unable to handle any more units of production on the current machinery, the cost
of adding an additional machine would need to be included in marginal cost. Assume the machinery
could only handle 1,499 units. The 1,500th unit would require purchasing an additional $500 machine.
In this case, the cost of the new machine would need to be considered in the marginal cost of production
calculation as well.

What Is Marginal Profit?

Marginal profit is the profit earned by a firm or individual when one additional or marginal unit
is produced and sold. Marginal refers to the added cost or profit earned with producing the next unit.
Marginal product is the additional revenue earned while the marginal cost is the added cost for
producing one additional unit.

Marginal profit is the difference between marginal cost and marginal product (also known
as marginal revenue). Marginal profit analysis is useful for managers because it aids in deciding whether
to expand production or to slow down stop production altogether, a moment known as a shutdown
point.

A shutdown point is a level of operations at which a company experiences no benefit for continuing
operations and therefore decides to shut down temporarily—or in some cases permanently.

Under mainstream economic theory, a company will maximize its overall profits when marginal
cost equals marginal revenue, or when marginal profit is exactly zero.

KEY TAKEAWAYS

 Marginal profit is the increase in profits resulting from the production of one additional unit.
 Marginal profit is calculated by taking the difference between marginal revenue and marginal
cost.

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  Marginal profit analysis is helpful because it can help determine whether to increase or decrease
the level of output.

Understanding Marginal Profit

Marginal profit is different from average profit, net profit, and other measures of profitability in
that it looks at the money to be made on producing one additional unit. It accounts for the scale of
production because as a firm gets larger, its cost structure changes, and, depending on economies of
scale, profitability can either increase or decrease as production ramps up.

Economies of scale refer to the situation where marginal profit increases as the scale of
production is increased. At a certain point, the marginal profit will become zero and then turn negative
as scale increases beyond its intended capacity. At this point, the firm experiences diseconomies of scale.

Companies will thus tend to increase production until marginal cost equals marginal product,
which is when marginal profit equals zero. In other words, when marginal cost and marginal product
(revenue) is zero, there's no additional profit earned for producing an added unit.

If the marginal profit of a firm turns negative, its management may decide to scale back
production, halt production temporarily, or abandon the business altogether if it appears that positive
marginal profits will not return.

How to Calculate Marginal Profit

Marginal cost (MC) is the cost to produce one additional unit, and marginal revenue (MR) is the
revenue earned to produce one additional unit .

Marginal profit (MP) = Marginal revenue (MR) - marginal cost (MC)

Price @ Php 30.00 = MR

Output Variable Cost Fixed Cost Total Cost Marginal Cost Marginal
Revenue
0 0 20 20 0 30
1 12 20 32 12 30
2 22 20 42 10 30
3 27 20 47 5 30
4 40 20 60 13 30
5 60 20 80 20 30
6 100 20 120 40 30

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 In modern microeconomics, firms in competition with each other will tend to produce units until
marginal cost equals marginal revenue (MC=MR), leaving effectively zero marginal profit for the
producer. In fact, in perfect competition, there is no room for marginal profits because competition will
always push the selling price down to marginal cost, and a firm will operate until marginal revenue equals
marginal cost; therefore, not only does MC = MP, but also MC = MP = price.

If a firm cannot compete on cost and operates at a marginal loss (negative marginal profit), it will
eventually cease production. Profit maximization for a firm occurs, therefore, when it produces up to a
level where marginal cost equals marginal revenue, and the marginal profit is zero.

Special Considerations

It is important to note that marginal profit only provides the profit earned from producing one
additional item, and not the overall profitability of a firm. In other words, a firm should stop production
at the level where producing one more unit begins to reduce overall profitability.

Variables that contribute to marginal cost include:

 Labor
 Cost of supplies or raw materials
 Interest on debt
 Taxes

Fixed costs, or sunk costs, should not be included in the calculation of marginal profit since these
one-time expenses do not change or alter the profitability of producing the very next unit.

Sunk costs are costs that are unrecoverable such as building a manufacturing plant or buying a piece
of equipment. Marginal profit analysis does not include sunk costs since it only looks at the profit from
one more unit produced, and not the money that has been spent on unrecoverable costs such as plant
and equipment. However, psychologically, the tendency to include fixed costs is hard to overcome, and
analysts can fall victim to the sunk cost fallacy, leading to misguided and often costly management
decisions.

Of course, in reality, many firms do operate with marginal profits maximized so that they always
equal zero. This is because very few markets actually approach perfect competition due to technical
frictions, regulatory and legal environments, and lags and asymmetries of information.

Managers of a firm may not know in real-time their marginal costs and revenues, which means they
often must make decisions on production in hindsight and estimate the future. Additionally, many firms
operate below their maximum capacity utilization in order to be able to ramp up production when
demand spikes without interruption.

-End of Chapter-

10 | P a g e C h a p t e r 3 - M a r g i n a l A n a l y s i s