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Definitions for Marginal Quantities

However, not all units of a product cost the same to make, nor are they always sold at the same price. So it is often of interest to determine the revenue, cost and profit of each additional unit produced and sold.

Marginal Revenue (MR) is the revenue received for one additional unit of product sold.

Marginal Cost (MC) is the cost paid to produce for one additional unit of product.

Marginal Profit (MP) is the profit obtained when producing one additional unit of product:

\(MP = MR – MC\).

Margins

Business people often talk of Gross Margin (GM), which is:

\(GM = \frac{Revenue – Cost~of~Goods~Sold}{Revenue}\).

Here, the Cost of Goods Sold (COGS) is simply Costs, or C. So Gross Margin becomes:

\(GM = \frac{R – C}{R}\).

Fixed Costs

Fixed Costs (FC) are the minimum costs required to produce any amounts of units (even zero amount). For example, just to get into business, a pizzeria has to buy an oven.

Fixed costs can affect marginal costs. For example, if a pizza oven costs $1,000, and other costs are $5 per the above example, then the marginal cost for the first unit of pizza is $1,000 + $5 = $1,005. However, the marginal cost to make the second pizza would only be $5.

Example

Let’s bring together several concepts now. Imagine you are a celebrity setting up an online retail firm selling tee shirts with your photo for $10. All orders are fulfilled using a third-party online service. They charge you $5 amount for each tee shirt.

Your marginal revenue is $10. Your marginal cost is $3. Your marginal profit is $7.

If you sell 100 tee shirts, your total profit would be:

\(Total~Profit = Total~Revenues – Total~Costs\)

\($400 = 100~shirts~ (\frac{$7}{shirt} –  \frac{$3}{shirt})\).

What if you had to pay for an up-front set-up fee of $100 to process your photo? This would be a fixed cost, as well as a start-up cost. Even if you sold no tee shirts, you would still incur the $100 just to go into business. If you sold no shirts, you would have a $100 loss instead of a profit.

However, if you once again sold $100 shirts, your profit after fixed costs would be the $400 from above less the $100 start-up fee, for a net profit of $300.

What is the minimum amount of shirts you should expect to sell in order to decide to go into business? You will need to at least break-even, which means to cover the fixed costs plus expected marginal costs. Here, marginal profit will provide $4 per shirt, so it takes 25 shirts to cover the initial $100 investment.

Other Important Quantities

There are other quantities that can affect a firm’s decisions.

Entry costs are the minimum cost to start a particular business. Such are closely related to fixed costs.

Opportunity Cost is the amount of profit given up by not pursuing a course of action. Typical sources of opportunity costs are risk and interest rates.

Risk is cost due to uncertainty.

Interest rates reflect a combination of costs due to risk and sacrificed opportunities. In reality, they can also represent bargaining power differentials.

The availability of Capital affects what courses of action are possible.

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