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The total cost of a business is composed of fixed and variable costs. Fixed and variable costs affect the marginal cost of production only if variable costs exist. The marginal cost of production is calculated by dividing the change in the total cost by a one-unit change in the production output level. The calculation determines the cost of production for one more unit of the good. It is useful in measuring the point at which a business can achieve economies of scale.
Key Takeaways
- The marginal cost of production refers to the additional cost of producing just one more unit.
- Fixed costs do not affect the marginal cost of production since they typically don’t vary with additional units.
- Variable costs tend to increase with expanded capacity, adding to marginal costs due to the law of diminishing marginal returns.
Fixed Costs vs. Variable Costs
A fixed cost remains constant so it does not change with the output level of goods and services. It is an operating expense of a business but is independent of business activity. Rent is an example of a fixed cost. If a company pays $5,000 per month in rent, it remains the same regardless of output.
A variable cost, on the other hand, depends on production output which means they always fluctuate. These costs have a direct relationship with output, rising and decreasing simultaneously with production. the electricity bill for a toy manufacturer varies with production. If no toys are produced, the company spends less on electricity. If output increases, the cost of electricity does, too.
Marginal Cost of Production
Manufacturers often use the concept of marginal cost of production to isolate an optimum production level. They often examine the cost of adding one more unit to their production schedules. At a certain production level, the benefit of producing an additional unit and generating revenue from it will bring the overall cost of producing the product line down. The key to optimizing manufacturing costs is to find that point as quickly as possible.
The marginal cost of production includes all costs that vary with that level of production. For example, if a company needs to build an entirely new factory to produce more goods, the cost to build the factory is marginal. The amount varies according to the volume of the goods being produced.
A company with greater variable costs compared to fixed costs shows a more consistent per-unit cost and, therefore, a more consistent gross margin, operating margin, and profit margin. A company with greater fixed costs compared to variable costs may achieve higher margins as production increases since revenues increase but the costs will not. However, the margins may also reduce if production decreases.
Important
It isn’t necessarily better or worse for a company to have either fixed or variable costs, and most companies have a combination of the two.
Other Considerations
Marginal costs can show how a company’s total costs can change when output changes. Changes in fixed costs, however, don’t affect a company’s marginal costs. Consider this: If only fixed costs are associated with producing goods, the marginal cost is zero. If the fixed costs double, the marginal cost is still zero. Therefore, the change in the total cost is always zero when no variable costs exist.
However, the marginal cost of production is affected when there are variable costs associated with production. Suppose a computer manufacturer has fixed costs of $100 along with variable costs to produce computers. The total cost to produce 20 computers is $1,100 and 21 computers is $1,120. Therefore, the marginal cost of producing computer 21 is $20.
The business experiences economies of scale because there is a cost advantage in producing a higher level of output. As opposed to paying $55 per computer for 20 computers, the business can cut costs by paying $53.33 per computer for 21 computers.
What Are Economies of Scale?
The term economies of scale refers to cost advantages that companies realize when they increase their production levels. This can lead to lower costs on a per-unit production level. Companies can achieve economies of scale at any point during the production process by using specialized labor, using financing, investing in better technology, and negotiating better prices with suppliers..
What Are Examples of Fixed Costs?
Fixed costs are any expenses that remain the same regardless of production volume or output. This means they never change even when production drops. Examples of fixed costs include rent, insurance, employee salaries, property taxes, utilities, and business licenses.
Do All Companies Have Variable Costs?
It generally isn’t possible for businesses to have only fixed costs. As such, all companies have some variable expenses. These are costs that fluctuate based on production or sales volume. For instance, shipping costs are an example of variable costs. These can change with consumer demand so when orders increase, shipping costs increase. Similarly, when orders fall, shipping costs fall, too.
The Bottom Line
Fixed costs never change regardless of production while variable costs do. While fixed costs don’t affect marginal costs—the change that comes with producing an additional unit—variable costs can have a direct impact. When variable costs rise, the marginal cost of production rises. When they drop, the marginal cost also falls.
