Marginal analysis is an important decision-making tool in the business world. Marginal analysis allows business owners to measure the additional benefits of one production activity versus its costs. This analysis can help an owner understand whether an activity is profitable and thus make a decision based on that information.
Marginal analysis involves a cost-versus-benefits comparison of various business activities. In marginal analysis, the cost of an activity is measured against incremental changes in volume to determine how the overall change in cost will affect the bottom line of a business. Marginal analysis can show the cost of additional production by a business all the way up to the break-even point. This is generally the maximum cost that a business can sustain without losing money.
When making a business decision using marginal analysis, take into account cost and production variables that will become the basis of your business decision. The quantity of the product purchased is one of those variables. In marginal analysis, the overall cost to the business owner will increase with each additional unit purchased. Other variables include the quantity of a goods you produce or the quantity of another cost added to the equation, such as shipping costs. To understand how your profitability changes, you make one of these your control variable, or the variable that you change. Changes are made in increments of one unit until your profitability decreases to zero. This will then provide you with a range of changes you can make with varying levels of profitability.
Assume, for example, that you produce a product that sells for $120 each and costs $100 a piece to produce if you produce 50 of those products. This will result in a total cost of $5,000 and a total revenue of $6,000. Once you produce the 51st unit of this product, your total revenue then goes to $6,120. Assume that your total cost goes to $5,150. In this case, the decision to produce the 51st unit would be a bad one because the cost of production per unit increases to $100.98 per unit. Your net benefit goes up by $120, while the overall cost increases by $150, meaning that the cost outweighs the benefit and that the production of the additional unit is not worth the extra cost.
In marginal analysis, continually increase the control variable to the point at which the marginal cost is either equal to or greater than the marginal benefit. The reason for this is simple. You can continue to experience some level of benefit, despite the increase in cost. In marginal analysis you are weighing the benefits versus the cost. When the additional benefits received do so at a greater cost per benefit, then you have reached the point where it is no longer reasonable to change the control variable.
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