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How To Calculate Marginal Revenue

how-to-calculate-marginal-revenue
How To Calculate Marginal Revenue

If your business produces 2,000 pairs of jeans every quarter and sells them for $100 each, you might think that selling 20 more pairs will bring in an extra $2,000. But it isn’t always so straightforward: To sell more, you may need to reduce prices to reach more frugal customers. To learn more about how and why this happens, we need to understand how to calculate marginal revenue and how to use the marginal revenue formula to better gauge profitability.

What is marginal revenue?

Marginal revenue is the amount of money generated from selling an additional item. The amount of marginal revenue you gain from producing and selling additional items tends to progressively dwindle, but it is typically justifiable as long as it’s profitable—when marginal revenue equals or exceeds the marginal cost of increased production.

Using the marginal revenue formula helps a business figure out if it needs to produce more or less to maximize profit. The concept stems from an economic principle known as the law of diminishing returns, which states that at some point increasing production yields decreasing revenue. The goal of this calculation is to help a business know when marginal revenue from more production equals the marginal costs. Beyond this breakeven point, additional production is unprofitable because marginal costs exceed marginal revenue—even if the change in total revenue is still positive.

Why is marginal revenue important?

Calculating marginal revenue is important because it can help a business:

  • Maximize profit. Marginal revenue minus marginal cost can show you how to wring more profit from additional production.
  • Forecast consumer demand. Historical data for marginal revenue allows a business to assess the strength of customer demand and how much they would pay for a business’s products.
  • Forecast production. Using demand data, a business can forecast production levels to avoid under or overproducing.
  • Set prices. Because marginal revenue reflects the selling price for an additional item produced, it can be used to determine competitive pricing.

How to calculate marginal revenue

Marginal revenue is expressed in terms of either total dollar amounts or individual units. Business managers and analysts typically use the per-unit measure to calculate marginal revenue, comparing changes in per-unit revenue from increased production. The marginal revenue formula is as follows:

Marginal revenue = Change in total revenue / Change in quantity

For example, the jeans company mentioned above has quarterly revenue of $200,000, selling 2,000 jeans at $100 each. Imagine that it decides to produce five more pairs of jeans and sells them for a total of $450. Divide this total increase in revenue by the five additional pairs of jeans to determine marginal revenue, which in this case is $90 a pair.

Marginal revenue = $450 / 5 = $90

This marginal revenue figure is less than the $100 per pair from current production.

Now, imagine the company decides to make 10 additional pairs, and total revenue increases by $800. The marginal revenue formula for this change in quantity then is:

Change in total revenue / Change in quantity = $800 / 10 = $80

In other words, marginal revenue from this batch of 10 additional pairs of jeans is $80 each.

Once more, let’s say the company boosts output by 15 pairs of jeans, resulting in a $1,050 revenue increase. Per-pair marginal revenue from this change in quantity is:

$1,050 / 15 = $70

These examples using the marginal revenue formula illustrate the law of diminishing returns based on a rising change in quantity. As the jeans manufacturer steps up production, the marginal revenue per additional unit diminishes even though the change in total revenue continues rising.

In another scenario, perhaps more realistic, let’s say the jeans maker considers increasing production by increments of 100 pairs. Assume the production cost is $75 per pair. Here is what a hypothetical schedule of marginal revenue calculations using the marginal revenue formula might look like:

Additional production Total revenue – original revenue Change in revenue Change in revenue / production change Marginal revenue per pair of jeans
100 $209,000 – 200,000 = $9,000 $9,000 $9,000 / 100 $90
200 $217,000 – 200,000 = $17,000 $17,000 $17,000 / 200 $85
300 $224,000 – 200,000 = $24,000 $24,000 $24,000 / 300 $80
400 $230,000 – 200,000 = $30,000 $30,000 $30,000 / 400 $75

So the jeans maker could produce as many 2,400 pairs of jeans, or 400 more than current production, to generate marginal revenue up to the point where it equals the cost of production, or $75 per pair.

How to calculate marginal cost

The above example assumes that the production cost of a pair of jeans stays at $75. In the real world, marginal costs of additional production eventually rise. These are usually due to variable costs, such as labor and raw materials. For instance, if the jeans maker has to pay overtime to workers or pay more for denim fabric, its marginal costs rise.

Calculating marginal cost uses a formula similar to the marginal revenue formula:

Marginal cost = Change in total cost / Change in quantity

A schedule of the jeans company’s marginal revenue along with marginal cost based on change in quantity of output might look like this:

Additional production Additional revenue Marginal revenue per pair Additional costs Change in cost / change in quantity Marginal cost per pair
100 $9,000 $90 $8,000 $8,000/100 $80
200 $17,000 $85 $16,000 $16,000/200 $80
300 $24,000 $80 $24,000 $24,000/300 $80

From this schedule, the jeans company can see that producing another 200 pairs is still profitable because marginal revenue of $85 a pair exceeds the additional cost of $80. But somewhere between making 200 and 300 additional pairs, increased production is no longer profitable: Marginal revenue of $80 a pair matches the marginal costs.

What is a marginal revenue curve?

The marginal revenue curve is a graphical representation of how marginal revenue changes as production increases. It also shows the point where marginal cost intersects with marginal revenue—where further production becomes unprofitable unless a business can cut manufacturing costs.

In the graph below, the downward-sloping straight lines represent marginal revenue and demand, while the upward-sloping curved line is for marginal cost. The marginal cost curve gets its shape from the fact that production costs tend to fall at first as output ramps up and the business enjoys economies of scale. After that, however, costs then start rising rapidly as the company strains to increase production.

Marginal revenue curve on graph from University of Minnesota.

Source: University of Minnesota

The graph has the vertical Y-axis showing price (as well as marginal revenue and marginal cost), and the horizontal X-axis showing the quantity of production. The demand line is also called the average revenue line. The downward slope of the lines from left to right reflects an inverse relationship between a product’s price and its demand—as a product’s price declines, demand for it increases, and vice versa. The economic principle behind this inverse relationship is known as price elasticity of demand, meaning the extent to which demand changes when a product’s price rises or falls.

The marginal revenue line is typically below the demand line because marginal revenue is less than average revenue for a given level of production, as the graph above shows.

Demand is elastic (meaning it’s sensitive to price changes) when marginal revenue is positive, meaning anywhere on the Y-axis above zero. Also, competitive businesses will keep producing until marginal revenue and marginal cost become equal.

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How to calculate marginal revenue FAQ

What is marginal revenue used for?

It's important that businesses know how to calculate marginal revenue, and weighing the results against rising costs can help a business maximize profit. Using the marginal revenue formula also helps in forecasting customer demand and production, as well as setting selling prices.

Is marginal revenue the same as profit?

No. Marginal revenue is different because it doesn’t account for costs. Profit is marginal revenue, derived from the marginal revenue formula, minus the cost of producing each additional unit.

What is the difference between marginal revenue and marginal cost?

Marginal revenue is the change in revenue received for producing and selling one additional unit of a product or service. Marginal cost is the money spent to increase the number of units sold.

How is marginal revenue used in cost-benefit analysis?

Cost-benefit analysis helps a business determine the point where marginal production costs equal marginal revenue. That is the point of maximum profit for a business. Beyond that point, marginal cost exceeds marginal revenue, and the business is producing at a loss. It must decide to either lower the number of units produced or reduce production costs to return to profitability.

This originally appeared on Shopify and is available here for wider discovery.
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