Marginal cost is the variable cost associated with producing additional product. Total cost is comprised of marginal or variable costs and fixed costs. Variable costs change with the level of output, while fixed costs remain even if production is at zero. Common ways to increase marginal cost are to increase the number of units produced or the variable costs associated with producing additional units.
A simple way to figure marginal cost is to calculate the change in total costs of production at level "A" versus level "B." For example, if the total cost of producing 11 units of a good is $20 US Dollars (USD) and the total cost of producing 12 units is $25 USD, the marginal cost is $5 USD. Marginal cost will increase with each increase in production output and is usually not a negative value.
Companies that manufacture tangible goods incur both variable and fixed costs. They will often make decisions about whether to shut down production on a product line or in a facility based on marginal cost. As long as the marginal revenue is equal to or greater than fixed costs, production will continue. Fixed costs cannot be traced to a particular product and can include expenses such as rent and utilities.
An increase in variable costs will cause companies to increase marginal cost. Variable costs are the driving factor behind marginal cost and include expenses such as direct materials and direct labor. Companies typically attempt to find the level of unit production where marginal revenue is the highest. With low levels of production, companies increase marginal cost slightly until it equals average total cost.
Once variable costs associated with increases in production rise, companies tend to increase marginal cost more rapidly. This typically begins to happen when marginal cost exceeds average total cost. Depending upon the type of product involved, it can occur at any level of production. For example, a car manufacturer might exceed average total cost when it begins to produce 1,000 cars while a pencil manufacturer might exceed it at 100,000 units.
Since companies typically rely on vendors and suppliers in order to complete the manufacturing process, variable costs can increase with a change in vendors or an increase in a vendor's prices. Manufacturers may respond with a increase in their own selling prices in order to keep marginal benefit or profit the same. In most business environments, an increase in variable costs due to labor pay increases, overtime pay expenses or changes in the prices of raw materials will increase marginal cost.
