Marginal revenue product is an economic theory that helps a company determine the amount of money or value earned from producing an additional unit. Economically speaking, companies will set their production output where marginal revenue equals marginal cost. Past this point, the company will lose money on producing additional units. This theory also helps companies calculate the best use of limited economic resources. Using too many resources to produce units indicates high economic waste, driving down the marginal revenue product for goods produced.
While accounting focuses on the cost of both fixed and variable expenses when allocating costs to produced goods, fixed costs are primarily irrelevant for economic measurements. Fixed costs — such as payments for facilities or equipment — are sunk costs that the company cannot recover. Therefore, the variable costs of labor and materials usage are the primary concern when calculating marginal revenue product. Companies can avoid these costs if they determine that they cannot sell the additional products or that their products are inferior to a competitor’s product.
Marginal analysis focuses on the profit maximization of a company. The purpose of marginal analysis and marginal revenue product can help owners and managers create a plan to achieve an economy of scale or an economy of scope. Maximizing profits often means that a company can achieve lower costs and higher profits when producing more products. This concept relates to the economy of scale. Producing more goods or services will most often drive a company’s operating costs down since costs can be spread among more produced products. However, at some point, this benefit will cease to exist, increasing production costs over the benefits.
An economy of scope occurs when a company can decrease operating costs by producing more than one product. This results in multiple product lines for the marginal revenue product theory. For example, if a company has maximized its marginal revenue product on widgets but has extra raw materials, the owner may determine the extra material can be used to make cogs. By producing cogs in addition to widgets, the company can increase revenues and improve its economy of scope.
Even when companies achieve profit maximization through an economy of scale or economy of scope, the marginal theory of economics does not account for the actions of competitors. Therefore, a company should be careful when ramping up production too much without reviewing the impact of external forces on its actions. This can result in a backward effect on the company, with profit maximization falling due to tough competition.