Marginal Cost Vs Average Cost – Key Differences

Marginal cost and the average cost of production are two important costing concepts. Both types of costing methods offer valuable information to the management.

Let us discuss what is marginal cost, average cost, and their key differences.

What is Marginal Cost?

The marginal or incremental cost is the additional cost of producing one unit of goods or service.

In other words, it is the change in the cost due to a change in the quantity. Therefore, it can be calculated by dividing the change in the cost by the change in the quantity.

The marginal cost of goods includes variable costs of production. It does not include the fixed costs of production.

The marginal cost of production only considers a proportion of fixed cost that is unavoidable for the production of additional products.

Under normal production conditions, producing more units will decrease the marginal cost. It means the cost per unit decreases with every additional unit of production.

However, in practice, the marginal cost follows a u-shaped curve. It means the cost per unit first decreases and then starts increasing again as newer fixed costs are incurred.

How to Calculate the Marginal Cost?

Marginal cost can be calculated by recording a change in the costs, quantity, or both when new units of products/services are produced.

Marginal cost can be calculated using the following simple method.

Calculate the Change in Cost

Variable costs of production will change with the change in the production levels. Most fixed costs will remain the same.

However, at a certain production level, the fixed costs will also change. Therefore, the first step is to determine the incremental cost of production due to a change in production.

A change in the cost can be calculated by subtracting the old cost of production from the new cost of production.

Change in Cost = New Cost of Production – Old Cost of Production

Calculate the Change in Quantity

With the changing production level, the quantity produced also changes. It can increase or decrease depending on the production level.

The formula to calculate the change in quantity is similar:

Change in Quantity = New Quantity of Production – Old Quantity of Production

Calculate the Marginal Cost

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Finally, we can use the marginal cost formula to determine the marginal or incremental cost per unit.

Marginal Cost = Change in Cost/Change in Quantity

Working Example

Suppose a company ABC Company produces sofa cushions and curtains. The company has a production capacity of 10,000 units per month.

The fixed costs per month are $ 300,000. The current variable costs of producing each unit are $ 25 per unit.

Fixed Costs = $ 300,000 or $ 30/unit       Variable Costs = $ 25/unit

Total Cost Per unit = $ 30 + $25 = $55.

Suppose ABC company wants to increase the production capacity to 15,000 units. It estimates an additional fixed cost of $ 100,000 per month (or $20 per unit) due to increased machinery and labor costs.

The variable cost proportion remains the same at $25/unit.

New Total cost Per unit = $ 20 + $25 = $45

Change in Cost = New Cost – Old Cost = $ 400,000 – $300,000 = $ 100,000

Change in Quantity = 15,000 – 10,000 = 5,000 units.

Therefore, Marginal Cost of Production = Change in Cost/Change in Quantity

Marginal Cost = 100,000/5,000 = $ 20.

The marginal or incremental cost for ABC Company is only $20. It reflects in the new total cost per unit of $45 as well.

Pros and Cons of Marginal Cost

Marginal cost analysis offers useful information to the management in several ways.

Advantages of marginal cost include the following points.

  • It helps identify incremental costs with a change in the production level.
  • It helps management make important decisions about the increased or decreased production level in a facility.
  • It can help a company make competitive pricing decisions.
  • It offers useful information to the management about achieving optimized production and efficiency levels.
  • It allows management to allocate resources where increased production may yield the highest profits.

Some disadvantages of marginal cost analysis include:

  • Separating additional fixed costs from the previous level of fixed costs can be difficult.
  • It only considers the incremental change in the cost or quantity.
  • It may not include the full cost of production.
  • Marginal costing considers only the variable cost of production anyway that may not be good enough for customized production facilities.

What is the Average Cost?

The average cost refers to the total cost of production per unit on average. It includes fixed and variable costs.

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The average cost is calculated by taking the total cost of production divided by the total number of units produced.

The average cost or the total average cost is a simple costing method that spreads the total cost of production uniformly.

The average cost is an important method of costing for facilities where production is in bulk and uniform. Unlike marginal cost, it considers fixed costs as well.

How to Calculate Average Cost?

The average cost of production can be calculated in a simple step-by-step method.

Calculate the Fixed Costs of Production

Fixed costs of production are those costs that do not change with a change in the production level. These are fixed expenses regardless of the production capacity of the company.

The first step is to calculate the total fixed costs of production.

Calculate the Variable Costs of Production

Variable or direct costs change with the production level changes. The second step is to calculate the variable costs of production.

Calculate the Total Costs of Production

Then, the total cost of production can be calculated by simply adding the fixed and variable costs calculated above.

Determine the Average Cost of Production

In the final step, divide the total costs by the total number of units produced.

The formula to determine the average cost of production will be:

Average Cost = Total Costs / Total Units

Working Example

Suppose a company ABC produces artificial jewelry with a maximum production of 10,000 units per month. The fixed costs include monthly rent, utilities, insurance costs, and salaries of permanent employees.

Suppose fixed costs per month amount to $50,000 or $5 per unit.

The variable costs include direct material, direct labor, and direct electricity costs of machinery. Suppose variable costs amount to $ 150,000 or $15 per unit.

Total Costs of Production = $ 50,000 + $150,000 = $ 200,000.

Average Cost of Production = $200,000/10,000 = $ 20.

Pros and Cons of Average Cost

The average cost of production analysis has its pros and cons.

Advantages of the average cost method include:

  • It is a simple and convenient method of calculating cost per unit.
  • It includes fixed and variable costs of production.
  • It is easier to understand and implement.
  • It helps in pricing decisions where the production levels are consistent and uniform.
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Disadvantages of the average cost method include:

  • Including some fixed or indirect costs may be inappropriate in some cases.
  • It may result in a higher cost per unit and make pricing uncompetitive.
  • It is not suitable for production facilities with customized and large products.
  • It offers valuable information with standard production facilities only.

Marginal Cost Vs Average Cost – Key Differences

Both costing methods are important concepts with varying advantages and some limitations.

Definition

Marginal cost is the incremental cost of production with an increased production level. It is the change in costs due to a change in the quantity.

The average cost is the average total cost against the total number of units produced. It is the total cost divided by the number of units produced.

Purpose

Marginal cost analysis the feasibility of increased production without incurring too many costs. It also helps in identifying the competitive pricing per unit.

Average cost aims to offer information about the total cost of production per unit at any production level.

Implementation

Marginal costing helps a company make important decisions about the changing production levels. It helps a company evaluate the incremental costs of production after maximizing the available resources.

Therefore, marginal cost will look to maximize the profits within the resources first and then evaluate the impact of additional costs.

On the other hand, average cost focuses on minimizing the costs of production. It means it aims to spread the total cost of production uniformly across the number of units produced.

Suitable For

Marginal costing is suitable for products with customization and a large proportion of variable costs.

It is useful in situations where a company wants to analyze the impact of acquiring additional production resources and compare new costs of production as compared to the previous ones.

Average costing is appropriate for production facilities with an equal proportion of fixed and variable costs. It is also suitable where there is little product customization and production is in bulk.

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