Costs are a critical variable to consider when plotting business strategy. After all, if you can't recover the expenses required to create your product through revenue and profit, then the business just isn't viable.
Yet costs change as a company grows.
In most cases, expenses fall, relatively speaking, as volume rises. That's a key reason why businesses aim to ramp up their production as quickly as possible so they can achieve economies of scale. But that trend can't continue forever.
That's where the concept of marginal cost comes into play. Simply put, marginal cost is the cost of producing one additional unit of your product. And depending on where you are on the cost curve, the marginal cost can be falling, rising, or horizontal.
What is marginal cost?
Let's first define marginal cost by using an example. If I'm producing a physical item, say a ceiling fan, then there are a host of costs that go into that endeavor. These include things like parts, labor, and machining expenses.
Let's say my production line is currently generating 100 of these fans, for a total cost of $1,000 (or $10 per fan). If I increase the production pace to 101 fans, and my total cost rises to $1,009, then my marginal cost is $9.00, and average cost falls to $9.99 per fan. In other words, it cost me $9.00 to produce one additional fan.
The marginal-cost curve
The above scenario describes a situation where marginal cost is falling (the average cost of producing X items is higher than the average cost of producing X + 1 items). This is a happy environment for most businesses, and usually occurs while the company is in a period of growth. Production lines are getting more efficient, fixed costs are being spread out over greater sales volumes, and variable costs are dropping as a company gains pricing power with its raw material purchases. In this situation, the marginal cost curve is sloping downwards, and the company has a strong incentive to increase production.
By contrast, you can imagine a time when marginal costs are rising (the average cost of producing X items is lower than the average cost of producing X + 1 items). For example, your motorcycle factory is running at its 10,000-unit capacity, and will require an entirely new production line to get to unit number 10,001. Or let's assume that you've purchased all the cheap raw materials you can to satisfy your current level of production, and buying more will increase your average cost. In these scenarios, the marginal-cost curve is sloping upwards, and the company is pressured to lower production volume or keep it steady.
When the marginal cost is horizontal
Finally, we have the situation where the marginal cost curve is flat (the average cost of producing X items is equal to the average cost of producing X + 1 items). This is a special case because it can describe an equilibrium that's persistent. A company can't hope to have declining marginal costs forever, but it can organize itself in such a way that average costs don't rise, even as production ramps up.
Think of a business that sells software, like Microsoft. Mr. Softy has every incentive to deliver as many copies of its flagship Windows operating system that it can, since the cost of producing one more CD is negligible compared to the development expenses that went into creating the underlying code.
Or consider the example of Netflix, which provides a streaming-video service. The marginal cost of delivering content to one more subscriber is insignificant compared to its fixed costs for securing rights to that content. In this situation, Netflix would seek to sign up as many members as it can convince to join its service, because marginal costs effectively don't matter.
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Demitrios Kalogeropoulos owns shares of Netflix. The Motley Fool owns shares of and recommends Netflix. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.