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The marginal cost of production is the expense created by making one more unit of an item. This is an important consideration in business planning, where the goal is usually to maximize profits. If the marginal cost is higher than potential earnings, there are no obvious benefits to producing another unit. This can help companies decide how large to make their production runs, and how to expand in productive ways.
In a simple example, a company could be producing widgets and considering expanding the size of its production runs. An accountant could sit down to find out how much it would cost to produce one more widget per run. The difference might be negligible, as the equipment could be easily configured to add another unit, and the raw materials might be inexpensive. In this situation, it would be to the company’s advantage to make more, because it would be able to sell them and recoup the marginal cost and an additional profit.
Conversely, the marginal cost of production could be higher than the per unit price. This might occur because a factory is operating at capacity, and overtime would be required to make another unit. The raw materials might be expensive, or the company could jump into a new billing bracket by adding more raw materials to its orders. Other expenses, such as electricity to run equipment or additional insurance, could also come up. In these situations, the marginal cost of production would be too high, and the company might decide to keep production stable.
This is closely associated with marginal revenue, the additional income another unit would bring in. Companies can examine marginal cost of production and marginal revenue to make decisions about what to produce, where, and how. In some cases, the company may decide to accept a tradeoff because it offers long term benefits. For example, it might get popular with consumers by making sure enough of a low-cost product is readily available, which could entice them to buy other products. Taking a loss on production could equate to profits in the future.
Auditors and interested parties may also look at the marginal cost of production. Shareholders have an interest in what a company does and how it organizes its business. If they feel the company is not making decisions that benefit it in the long term, they may request changes in policy or push to remove board members who are responsible for those decisions. In these cases, members of the board may need to justify decisions that appear paradoxical or poorly planned.