Knowing the optimum level of production is essential for running a business successfully. With marginal profit analysis, you can know if you need to scale up or down the production levels to optimize profits. And this takes a lot of time and effort!
Marginal profit, in simple words, is the profit earned by producing and selling an additional unit. Under mainstream economic theory, to maximize profits, a firm should continue to increase production until its marginal profit is zero.
In this article, we will discuss what marginal profit is, how to calculate it, and how marginal profit becomes zero at the optimum level of production. Another benchmark for the optimum level of production is that the marginal cost equals marginal revenue. We will be discussing all that too.
What is marginal profit?
Marginal profit is the profit earned by a business when it produces and sells an additional unit. This cost incurred by producing the additional unit is marginal cost, and the revenue collected is marginal revenue. Marginal profit is marginal revenue less marginal cost.
Marginal profit doesn’t tell about the overall profitability of a business and is different from net profit and average profit.
Net profit is the income earned when all the expenses are deducted.
Average profit is a profitability metric that tells how many units of currency a business earns on average for each product sold.
Marginal profit only tells about the profit earned by selling an additional unit. It does not include anything other than that. When the marginal profit equals zero, it implies that the business has maximized overall profits. It happens when the marginal revenue equals the marginal cost. So, a business needs to ramp up production till that point is achieved.
Marginal cost is the cost incurred to produce an additional unit. The marginal cost is not influenced by fixed costs. Unlike variable costs, fixed costs do not go up as companies produce an additional unit. Marginal cost is one of the two components needed to calculate marginal profit. The formula for the calculation of marginal cost is
We can calculate the marginal cost for a single additional unit or a group of additional units. For example, the company Zee produced 10 units at the expense of $200. For the production of 10 additional units, its expenses increased to $300. Thus, the change in expenses is $300 - $200 =$100. By data, we know that the change in the number of units is 20-10 = 10.
Plugging in the values in the marginal cost formula
Marginal cost = 100/10 = $10
This means that the average marginal cost through 10 to 20 units was $10. The actual marginal cost for each unit in the group might differ from the average marginal cost i.e., 10.
An important key concept to understand here is that marginal cost gradually decreases with the increase in production levels till the business achieves economies of scale. The marginal cost then starts increasing. So, the marginal cost curve is often U-shaped.
For example, a big pharmaceutical company spends $50 to manufacture 1000 units of panadol. The cost spent on the next 1000 units will be $40 and so on. The marginal cost tends to decrease till the company achieves economies of scale.
The marginal cost increases after that point. For example, the pharmaceutical company utilized its maximum capacity at the economies of scale point. And production beyond that capacity will require another production plant to be set up. This would definitely increase the marginal cost. However, in practice, there can be many other factors that could contribute to the increase in marginal cost.
Marginal revenue is the sales price of the additional unit produced and sold. Marginal revenue is one of the two components needed to calculate marginal profit. The formula for the calculation of marginal revenue is
Marginal revenue = Change in revenue/Change in the number of units
We can calculate marginal revenue for a single additional unit or a group of units by plugging in the values in the marginal revenue formula. To calculate marginal revenue, divide the change in revenue by the change in the number of units. Thus, marginal revenue is additional revenue collected per additional unit or group of units.
As per the mainstream economic theory, companies in competition are forced to gradually decrease their marginal revenues by lowering the prices for additional units produced. An example of this can be the price-skimming strategies deployed by companies.
The marginal revenue curve is mostly downward sloping. It is because the marginal revenue decreases with the increase in production.
How do we calculate the marginal profit?
The marginal profit formula is
The calculation of marginal profit is important. The outcome may be a negative or positive value. A firm can’t continue to operate at a negative marginal profit. This is when the firm needs to scale back its operations to a production level with positive marginal profit.
It’s good to have a positive value. However, a business in competition can’t keep on operating at a positive marginal profit. The company has to lower marginal revenues eventually and thus the marginal profits. Profit maximization occurs when marginal revenue equals marginal cost. So, in perfect competition, MC = MR =Selling price of the unit.
What does it mean if marginal profit is positive?
A positive marginal profit is a healthy indicator for a company. It means that the marginal revenue exceeds the marginal cost.
However, ideally, a business with positive marginal profit should ramp its production to the point where marginal revenue equals marginal cost.
A business with negative marginal profit must scale back to the production level where marginal profit is positive. If the marginal profit remains negative at every production level, it is time to consider closing down the operations altogether.
Why do firms keep a tab on marginal profitability?
The cost structure of a firm that manufactures many products changes with the increase or decrease in production.
With profit margin analysis for each product, the business manager can make decisions about scaling up or scaling down the operations for each product. The production of products with positive marginal profit needs to be scaled up. The operations for those products with negative marginal profit need to be scaled down.
Managers rely on the historical numbers of a business to calculate marginal costs and marginal revenues for the future while forecasting and planning.
Marginal profit is the profit earned by producing and selling an additional unit. The two components for marginal profit calculation are marginal revenue and marginal cost. As per modern microeconomics, a company maximizes profits when marginal profit is zero or marginal cost equals marginal revenue. A positive marginal profit indicates that the production is to be ramped up. And a negative marginal profit indicates the urgency of scaling down the operations.