When Is the Marginal Cost Horizontal?

Where your costs don't change, regardless of how many units you produce.

Dec 5, 2015 at 10:27PM

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.

The next billion-dollar iSecret
The world's biggest tech company forgot to show you something at its recent event, but a few Wall Street analysts and the Fool didn't miss a beat: There's a small company that's powering their brand-new gadgets and the coming revolution in technology. And we think its stock price has nearly unlimited room to run for early in-the-know investors! To be one of them, just click here.

This article is part of The Motley Fool's Knowledge Center, which was created based on the collected wisdom of a fantastic community of investors based in the Foolsaurus. Pop on over there to learn more about our Wiki and how you can be involved in helping the world invest, better! If you see any issues with this page, please email us at knowledgecenter@fool.com. Thanks -- and Fool on!

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.

Money to your ears - A great FREE investing resource for you

The best way to get your regular dose of market and money insights is our suite of free podcasts ... what we like to think of as “binge-worthy finance.”

Feb 1, 2016 at 5:03PM

Whether we're in the midst of earnings season or riding out the market's lulls, you want to know the best strategies for your money.

And you'll want to go beyond the hype of screaming TV personalities, fear-mongering ads, and "analysis" from people who might have your email address ... but no track record of success.

In short, you want a voice of reason you can count on.

A 2015 Business Insider article titled, "11 websites to bookmark if you want to get rich," rated The Motley Fool as the #1 place online to get smarter about investing.

And one of the easiest, most enjoyable, most valuable ways to get your regular dose of market and money insights is our suite of free podcasts ... what we like to think of as "binge-worthy finance."

Whether you make it part of your daily commute or you save up and listen to a handful of episodes for your 50-mile bike rides or long soaks in a bubble bath (or both!), the podcasts make sense of your money.

And unlike so many who want to make the subjects of personal finance and investing complicated and scary, our podcasts are clear, insightful, and (yes, it's true) fun.

Our free suite of podcasts

Motley Fool Money features a team of our analysts discussing the week's top business and investing stories, interviews, and an inside look at the stocks on our radar. The show is also heard weekly on dozens of radio stations across the country.

The hosts of Motley Fool Answers challenge the conventional wisdom on life's biggest financial issues to reveal what you really need to know to make smart money moves.

David Gardner, co-founder of The Motley Fool, is among the most respected and trusted sources on investing. And he's the host of Rule Breaker Investing, in which he shares his insights into today's most innovative and disruptive companies ... and how to profit from them.

Market Foolery is our daily look at stocks in the news, as well as the top business and investing stories.

And Industry Focus offers a deeper dive into a specific industry and the stories making headlines. Healthcare, technology, energy, consumer goods, and other industries take turns in the spotlight.

They're all informative, entertaining, and eminently listenable. Rule Breaker Investing and Answers are timeless, so it's worth going back to and listening from the very start; the other three are focused more on today's events, so listen to the most recent first.

All are available for free at www.fool.com/podcasts.

If you're looking for a friendly voice ... with great advice on how to make the most of your money ... from a business with a lengthy track record of success ... in clear, compelling language ... I encourage you to give a listen to our free podcasts.

Head to www.fool.com/podcasts, give them a spin, and you can subscribe there (at iTunes, Stitcher, or our other partners) if you want to receive them regularly.

It's money to your ears.


Compare Brokers