If you want to know how much more net profit you would make if you invested an additional amount or produced a known additional number of units for sale, you can determine this by calculating the marginal rate of return. This metric predicts how much more you will earn by investing or producing more while holding all other variables steady.
The Concept of Marginal Rate of Return
The idea of a marginal rate of return exists in both equities investing and the worlds of business in general and unit production in particular. The general idea is to predict or pinpoint if an additional investment, in a given stock, in making more units, in increased advertising, etc., is worth it. As the team at the Corporate Finance Institute (CFI) explains, the traditional definition of marginal revenue is the revenue obtained from selling one additional unit.
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Marginal return must also consider the resources that produce the auxiliary unit, which writers from the Corporate Finance Institute call the marginal cost. Depending on the production model, producing additional units may be very resource-intensive or, conversely, making more units could be cheaper per unit. The marginal return is one way to capture this information.
Marginal Revenue Calculations
The team at MasterClass further explains how businesses use marginal revenue calculations to determine if certain business decisions are cost-effective. Two related ideas are the marginal rate of transformation (MRT), as explained by the CFI, and the point of diminishing returns, as explained by the CFI.
MRT measures how many additional units of Product X can be produced by decreasing production of Product Y, or, in other words, captures the opportunity cost of the products. In equities investing, you can express this as how many shares of Stock A you can buy by selling a share of Stock B.
The law of diminishing returns is the idea that ever-increasing production or investment does not lead to infinite profit. Eventually, the market becomes saturated, or other economic forces come into play. These forces create a point past which increased production or investment is not cost-effective.
The Marginal Rate of Return Formula
Calculating the marginal return on investment is, in large part, being able to isolate the moving parts. For example, if you invested $5,000 more in your marketing budget and sales rose by $10,000, it would be reasonable to want to calculate the marginal return. However, it's difficult to be sure the marketing increase was the only factor in play and that the rise in sales was due to it. Marginal revenue is more straightforward to calculate when looking at the traditional definition of revenue change versus quantity change. In this case, the marginal return formula looks like this: Marginal Revenue (MR) = (Total Revenue - Previous Revenue) / (Total Quantity - Old Quantity).
Again, this takes into account the cost associated with the increase in quantity. So, if you usually see revenue of $200 per day selling 100 units, say you made and sold 10 more units, and it cost you $10 to make those additional units for net revenue of $215 that day, then the marginal revenue would be: MR = ($215 - $200) / (110 - 100) = $15/10 = $1.5.
In the world of stock market investing, a useful way to look at this is with percentages. Say you bought shares in a company for $1,000 including commission and made a $200 profit off them. Looking at the total rate of return, $200 / $1,000 * 100 percent = 20 percent. If you made an additional $50 profit, then ($250) / $1,000 * 100 percent = 25 percent. Subtracting the total rate of return, you get 25 percent - 20 percent = 5 percent, or a 5 percent marginal return on investment.
Consider also: How to Calculate Gross Margin Return on Investment