Operating a business means you’re going to incur a series of costs. These costs are built of various elements, and they help you calculate the expenses that the business is likely to deal with. This is also an essential part of when you’re creating a financial model in excel, so you will need to know exactly how to calculate your costs. One of the costs that you will need to keep a check on is your marginal costs. Here, we will talk about everything there is about marginal cost analysis and a few examples of it as well.
Marginal costing is the additional costs required to produce one more unit. So, you can say that if five cups of coffee cost $5, then the additional cost of creating the sixth cup will be the marginal costs. For instance, if the cost of creating six cups is $6, then the marginal cost would be $1. This is, obviously, a simplified understanding of what marginal costs is.
When you get to computing the marginal costs for your financial model in excel or other financial planning, then you will understand how essential it really is. In this, you will find an amalgamation of variable costs such as labor, raw materials. But that is not all. It also incorporates the change in the unit fixed costs of your business. So, you will know the entirety of the change when it comes to your costs per unit.
To understand the use of marginal cost in your financial model in excel and other cost calculations, you will need to know its formula. Below is the marginal costs formula that is used everywhere. The marginal cost is computed by dividing the change in costs by the change in quantity.
Marginal Cost=(∆ in Costs)/(∆ in Quantity)
The first thing that we have in the formula is the change in costs. This accounts for the total cost that your business will face. So, it is an amalgamation of variable and fixed costs. Many times, people confuse marginal costs with only variable costs. It is to be noted that variable costs make only a part of the total marginal costs. So, when we talk about a change in costs, we cover total costs, not just variable costs.
So, how do you calculate the change in costs? You subtract the beginning costs value with the value of the ending costs. For instance, 10 products have a total cost of $60, whereas 20 products will cost $110. You subtract $60 from $110 to get the change in total cost. The change will be $50. Keep in mind that this includes unitary fixed costs as well.
Next in the formula, we have the change in quantity. Here, you will assess the change in the quantity of the products. Let’s take the same example where 10 products cost $60 and 20 products cost $110. Now, the change in quantity will denote 10 units subtracted from 20 units. You follow the same formula for change, that is, subtracting the end value with the initial value. In this example, you will see that the change in quantity comes to 10 units.
If you’re still not clear about marginal costs for your financial model in excel, then let’s take a look at some examples of it. This will help clarify how you can use the marginal cost formula and compute the additional cost of making more products.
Henry owns a clothing business. He manufactures and sells t-shirts to children ages five to ten years. During his first year of business, he manufactures and sells 5,000 t-shirts for about $100,000. The costs associated were $ 60,000. In the following year, he sells 6,500 t-shirts for about $150,000. The costs in this year totaled to be $75,000.
Now, when we use the marginal cost formula for Henry’s financial model in excel, we will subtract $60,000 from $75,000 for the change in costs. Next, we will subtract 5,000 from 6,500 for the change in quantity. Change in costs comes out to be $15,000, whereas the change in quantity comes out to be 1,500. Let’s put these two into the equation.
Marginal cost = change in costs/change in quantity= $15000/1500= $10. The answer comes out to be $10. The additional cost per unit associated with producing 1,500 more units is $10.
Maggie owns a bakery in London. Her costs include fixed costs such as rent, machinery costs, and other bakery-related equipment. Other costs include variable costs such as utility bills, staff, and raw materials.
Her costs for the first year include $30,000 fixed costs and $40,000 variable costs. The total costs incurred were $70,000, and she managed to sell 20,000 baked goods for $125,000. The following year, she incurs fixed costs of $35,000 and variable costs of $50,000, leading to a total cost of $85,000. This year, she managed to sell 30,000 baked goods for $175,000.
Here, her costs went from $70,000 to $85,000 in the second year. This means a total change in costs of $15,000. Whereas, the quantity changed went from 20,000 to 30,000. This shows a change of 10,000 in quantity. Let’s apply the marginal cost formula now.
Marginal cost= $15000/10000= $1.50. Therefore, the cost of producing additional units comes to be $1.50.
Marginal cost is highly essential when it comes to business operations. It is assessed when the CFO or financial analyst of your company looks at the business’s financials. Here, they assess whether or not to produce the additional unit for the business. But how does one decide whether or not to move forward with the additional units?
The answer is simple. When you see that your marginal cost is lower than your selling price, it means that the product is profitable. However, when the marginal cost becomes greater than the selling price, you’re bound to incur losses. This will help establish whether you need to change the prices you’re selling at or discontinue production completely.
For your financial model in excel, you need to ensure that you have all the relevant costs added. This includes your marginal costs. You should know the incremental costs of manufacturing or producing more goods to forecast them better.
Making sure that you know which costs are increasing is essential when creating your forecasts. It helps you understand where your cash outflow will be. So, you will have a better understanding of how to create your projections more accurately.
Marginal costs are used in a range of jobs, especially related to finance and accounting. You will find accountants, financial analysts, investment bankers, and so much more jobs that make use of the marginal cost formula. One thing to note is that the marginal cost formula is used for every business since finance is a part of every business. So, you will find it being applied by every accountant in every business that you come across. If you’re a financial analyst or accountant, then this must be an easier concept to understand.
Businesses wish to achieve economies of scale where they incur less cost for every unit they make. Initially, every business incurs more cost for a product where the marginal revenue is less than the marginal cost. Moving forward, there creating a unit becomes cheaper as the business achieves economies of scale. To do this, businesses try to get to a point where their marginal cost is equal to their marginal revenue.
For instance, a business that can produce more goods will achieve economies of scale as it produces more goods. However, not every business is suited to achieve economies of scale. Many businesses deal with diseconomies of scales as well. Here, their marginal cost rises as their production increases. This has to do with the business having a lower capacity to produce and leases or rent out more production space.
Every aspect of your business should be given detailed thought. Marginal costs for your financial model in excel might seem like a small thing, but it caters to large decisions. You should make sure that you have the right CFO services on board to help you analyze your marginal costs and offer the ultimate business solutions.
We, at Oak Business Consultants, aim to secure every aspect of your business. With our expert financial analysts and business planners, you can avail the best of both worlds. Create your financial model to excel with our professional team’s help and ensure that your marginal costs are minimized to offer you vast benefits.
Visit our website at Oak Business Consultants, and get a free consultation.