In business, both the fixed and variable costs are used to determine the cost of production. Marginal costs measure the change in production expenses for making each additional item. Variable costs reflect the materials necessary to manufacture or make each product. As a result, the variable costs directly impact the marginal cost.
As the name implies, variable costs increase or decrease depending on production volume. As production of a product or service increases, the variable costs increase. As production of the product or service decreases, the variable costs decrease.
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Variable costs include the direct expenses necessary to produce the product, such as labor and materials. For example, if a company is producing cakes, variable costs include the flour, eggs, sugar and baking power required to make each cake. Fixed costs, on the other hand, remain constant regardless of how much or how little the company is producing. Some examples of fixed costs include rent, utilities and insurance.
The marginal cost of production is the change in the total cost associated with making just one product or item, and is determined by dividing the change in cost by the change in quantity.
Generally, marginal costs start high and decline as production increases. If you're only making two cakes a day, for example, you still need to use an entire oven and pay an employee to help, even if both are underutilized. Adding five more cakes may simply take advantage of that employee's extra capacity and the previously unused space in the over, which would mean that the marginal cost of each of those additional cakes would be low.
At some point, the costs increase again. For example, when production reaches a certain level, you may need to hire additional employees or purchase more material, which raises the production costs.
Knowing the Numbers
Knowing the marginal cost of an item can help you determine if it's worth continuing production. If you're charging more than the marginal cost, you're making a profit. However, if you're charging less than the marginal cost, you're losing money and you may need to reconsider your business plan.
For example, if you own a bakery and you're considering adding other options to your menu, such as sandwiches, you'll need to look at both the variable and marginal costs to determine if it's worth it. You'll want to calculate the average cost of the extra ingredients and labor necessary to make the sandwich. Then, you'll need to use the variable costs and fixed costs to calculate your marginal cost. If the marginal cost associated with a sandwich is too high to bring in profit, you wouldn't want to bother adding it.