What is Marginal Analysis?
Marginal Analysis is a practical decision-making tool to measure the costs and benefits of incremental changes from an activity for profit maximization.
The concept of marginal analysis is oriented around comparing the additional benefit (“marginal benefit”) to the additional cost (“marginal cost”) that stems from a change in activity level (or “output”).
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How to Perform Marginal Analysis
Marginal analysis quantifies the incremental impact of certain changes to optimize internal decision-making and improve operating efficiency.
The objective of conducting a marginal analysis is to determine the optimal level of output or activity where the marginal benefit equals the marginal cost.
Therefore, marginal analysis comprises the decomposition of a particular decision into a series of incremental choices, in which the marginal cost and marginal benefit are weighed against each other per additional unit of activity.
- Marginal Benefit (MB) ➝ The incremental increase or decrease in total benefit from one additional unit of activity.
- Marginal Cost (MC) ➝ The incremental increase or decrease in total cost from one additional unit of activity.
If the marginal benefit exceeds the marginal cost, proceeding with the incremental activity is deemed rational.
The iterative process is repeated until the optimal level is reached, which refers to the point at which marginal cost equals marginal benefit (and net benefit is maximized); hence, the analysis is often presented in a chart to illustrate the estimated point of optimal production (or output).
The step-by-step process to perform marginal analysis is as follows:
- Step 1 ➝ Identify the Activity to Be Analyzed
- Step 2 ➝ Determine the Current Level of Activity
- Step 3 ➝ Define the Incremental Change in Activity
- Step 4 ➝ Calculate the Marginal Cost (MC) of the Incremental Change
- Step 5 ➝ Estimate the Marginal Benefit (MB) of the Incremental Change
- Step 6 ➝ Compare Marginal Cost (MC) to Marginal Benefit (MB)
Note: The “Marginal Benefit (MB)” can be switched out with “Marginal Revenue (MR)”, which refers to the incremental rise or decline in total revenue from selling one more unit.
Marginal Analysis Formula
The net benefit—the difference between marginal benefits and marginal costs—is one of the core factors in marginal analysis.
Given a positive net benefit, the decision to proceed is implied to yield a favorable outcome on behalf of the company.
In short, if the marginal benefit is equal to the marginal cost, the entity has reached the optimal level of production (or output), where the total net benefit is maximized.
The formula to calculate the net benefit, an integral component to performing marginal analysis, subtracts the marginal cost from the marginal benefit.
Where:
- Marginal Benefit (MB) = Change in Total Benefit ÷ Change in Quantity
- Marginal Cost (MC) = Change in Total Cost ÷ Change in Quantity
If marginal revenue (MR) is used instead of marginal benefit (MB), the following formula would be applied:
- Marginal Revenue (MR) = Change in Total Revenue ÷ Change in Quantity
How is Marginal Analysis Connected to Profit Maximization?
Marginal analysis is directly linked to profit maximization, considering the fact that profits are maximized at the point where marginal revenue equals marginal cost, at least in theory.
Since the objective of performing marginal analysis is to identify the point of optimal production or consumption, where the net benefit is maximized, determining the inflection point at which the marginal benefit (or marginal revenue) is equivalent to the marginal cost (MB = MC or MR = MC) is the end-goal.
If the marginal benefit exceeds the marginal cost, the company should proceed with producing an additional unit because expected net benefit should increase.
In contrast, if the marginal benefit is less than the marginal cost, the entity should not proceed with producing an additional unit as the expected net benefit will decrease.
At the inflection point (MR = MC), the additional revenue gained from producing one more unit is equal to the additional cost of producing that unit.
However, the decision to continue producing beyond the determined level would result in marginal costs exceeding marginal revenues, reducing total profit.
Marginal Analysis Calculation Example
Suppose a manufacturing company is deciding on the total number of units to produce in the coming month.
The company’s current production is 1,000 units per month. However, due to constraints related to the factory, like aging equipment, downtime, and communication issues between shifts, the company starts experiencing diseconomies of scale at higher production levels.
The marginal cost and marginal revenue for each additional 100 units are as follows:
| Incremental Units | Marginal Cost (MC) | Marginal Revenue (MR) |
|---|---|---|
| +100 |
|
|
| +200 |
|
|
| +300 |
|
|
| +400 |
|
|
| +500 |
|
|
To maximize profit, the company should produce additional units up to the point where marginal revenue equals or exceeds marginal cost.
In this case, the optimal additional production is 200 units, as producing the next 100 units (300 total) would result in a marginal cost of $6,000, equal to the marginal revenue, so there is no additional profit.
At the optimal additional production of 200 units, we can compute the following financial data.
- Total Incremental Revenue = $7,000 + $6,500 = $13,500
- Total Incremental Cost = $5,000 + $5,500 = $10,500
- Incremental Profit = $13,500 — $10,500 = $3,000
The $3,000 represents the maximum profit the company can earn per month by increasing its volume of production (or output), given its current capacity constraints and other factors, which can contribute toward diseconomies of scale.
In closing, manufacturing inefficiencies and constraints that emerge with more production volume (i.e. output) contribute to rising marginal costs that eventually overtake the incremental revenue generated.
