Within the definitions of finance and economy, there is a term that implies a lot of relationship with the production of goods; This term of marginal cost encompasses in itself several definitions that, intertwined, allow us to reach the final definition, in which a marginal cost is a variable rate that exists given the variation in production.

In slightly simpler terms, marginal cost can be defined as the increase that exists in the cost of producing one unit, when overall production increases. The marginal cost answers the question: How much does it cost me to manufacture 1 more unit? But to understand the meaning of this term more broadly, we must answer other questions, let’s start by analyzing what a cost is.

Marginal cost

When we refer to the production of any good, we always say that the joint participation of several elements is required, whose interaction allows the raw material to become the final product, which is destined to fall into the hands of the last customer.

But what is required to carry out this process?

Let’s take for example the process of assembling a simple chair, which requires some boards, some tubes, and screws. The assembly process is simple because it is enough to screw the tubes with the tables to have the complete chair, this means that to assemble a chair it is necessary to buy the raw material with which it will be manufactured, that is to say, the boards, the tubes, and the screws; it is in this way that we now know that there is a raw material cost. Now, let’s think about what this implies in terms of other types of investments.

marginal-cost-formula

To assemble a chair, not only the raw material is required but also one of the most important elements, a person. This person who is known as the worker or the operator is the one who is in charge of being able to carry out the assembly process, thanks to which we can obtain the assembled chair as a final result; something very important is that the investment in raw material, we now add the investment in labor, since the salary that is granted to obtain the human capital to be able to carry out the process, is also considered as a cost of production, but everything does not end here.

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For the worker to turn the tubes and tables into a beautiful chair, machinery is required to assemble the product, this machinery can be, for example, drills and some bases to support the assembly, so production investment and the cost for machinery are added to it. And, now, for the machinery to work correctly, it is necessary to have electrical or hydraulic outlets, to able to make the machines work, which implies that, for each assembled unit, it will also be necessary to load an energy investment.

Each of these investments that are made to reach the goal that is to produce a certain product is known as the cost of production of the product. But there are not only the aforementioned costs, there are also logistics or transportation costs, administration costs, tax costs, and maintenance costs, among others.

Investments

During the last years, the term investment has become fashionable, and although on many occasions we think that an investment is when shares or some other financial instruments are bought and sold, an investment is not always of that type; In manufacturing, the investment process is carried out when certain capital is made available to be able to produce a good. In these cases, the return on the investment that is made can vary in many aspects, however, it is the same end that is pursued.

In investments in manufacturing, we may find ourselves with a sales opportunity for a certain product that has become popular, or that is in very high demand; Continuing with the example of the manufacture of chairs, we may find that one of the areas with the most significant number of clients is the sale of chairs; Once this area of ​​opportunity has been identified, it is time to start talking about a project.

This project refers to the planning of the entire process that is required to achieve the final objective, which is to sell a certain number of chairs, with which the desired profits are obtained. It is during this planning that all the expenses that will be incurred to achieve the final goal are identified. These expenses are the investment to be made.

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Among the points that are considered to be able to determine the final investment amount, we have the investment in infrastructure, and that is that to manufacture our chairs we are going to require a space dedicated to storing the raw material that they provide us; After that, an area is required to be able to assemble the chairs; and then a space is required to store the already assembled chairs. In addition to this, space is required for the administration offices and the vehicles through which the production will be sent to the clients.

Another type of investment that is made in this project are the permits that are required to be able to operate correctly; Together with this, it is important to consider the investment in maintenance equipment, which will be used to keep the entire system and all the machines and tools used in the company running.

Now, as soon as the total amount to be invested is available, the goal is expected to be reached, and the main goal of a company is to generate profits, which is why the sales profits have to exceed the investments made. In this way, we can think of the following.

Once the analysis is done, a total investment of 1 million euros is required for our chair factory; and the project is planned to produce 100,000 chairs a year for the next 5 years; If we want to obtain profits from this production, the chairs must be sold at a price that allows us to cover the investment made at the beginning, and at the moment of maintaining production, and in turn, that covers the adequate profit margin.

In our example, planning tells us that a total of 500,000 chairs will be made, for which an amount of 1 million euros was invested at the beginning, plus monthly investments in terms of salaries and raw materials, which are equivalent to 10,000 euros per month. So the final investment is 1,600,000 euros. And if we desire to earn 15% concerning our investment, the profits would amount to 240,000 euros, which added to our investment gives us a total of 1,840,000 euros as the final amount to be earned from the sale of the chairs. So according to our production planning, each chair should sell for 3.68 euros.

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Marginal cost

When we carry out a project, the most natural thing is to have a projection of production and sales, however, there are occasions in which the demand for the good exceeds the projections of the project, so to have a margin of response time, The projects make assumptions about a possible increase in sales so that sometimes extra costs are included to be able to support the extra production, it is in these cases that the marginal cost is applied in a better way, that is: if instead, I want to produce 500,001 units of 500,000 units. How much more, in addition to the 1,840,000 euros, will I have to invest to obtain the desired production?

It is very important to know this information to be able to know the final price of these units, with which we can accurately define the sale price so that the objectives of the project are achieved and maintained. But how do we know the marginal cost?

Mathematically, the marginal cost is represented as the derivative of the total cost, between the derivative of the number of total units; This implies that the total cost invested to obtain the determined number of units must be divided by the number of real parts so that the unit cost can be defined.

This marginal cost is very useful when projects are carried out because, from the financial point of view, the optimum point is found between the cost of production and the sale price, so that it is possible to calculate the appropriate price at which the company does not lose money, but neither is the customer abused. Undoubtedly, taking this term into account when planning our projects will help us to have better financial results.