Average and Marginal costs are both important concepts. However, pricing your product according to these costs mechanisms can lead to dramatically different results. Understanding what this means for your business is critical to your success.
Understanding average and marginal cost is key to generating cash flow and becoming profitable. In order to be a profitable company over the long run, Total Revenues must exceed Total Costs. Anything less means that you are burning through your funds and at some point, you will run out of cash; therefore, you need to know your Average Cost. In addition, you can utilize Marginal Cost analysis to help understand and calculate the resources involved in creating a product or service.
Average and Marginal Cost
The definition of Average Cost is the Total Cost divided by the number of units produced and sold. Total Cost is the sum of all costs both fixed and variable.
- Fixed Costs are those expenses that do not change with the number of goods or service produced. Typically, they include such things as rent, capital loan payments, and insurance, which remain the same regardless of the production output.
- Variable Costs rise or fall with the increase or decrease with the level of production. These include direct labor involved in the production as well as the cost of material needed to produce the item or service.
Marginal Costs are simply the incremental cost to produce one additional item. It does not include all of the resources expended to get to that point, like the construction of the plant or purchase of equipment, only the expenses directly incurred in the making of that next item.
A fundamental question is once a product or service is ready for the market, how to price it? Fundamentally, the market dictates what you can sell your product for. Honestly, it doesn’t really matter how much it costs to produce, you can’t sell something for more than the market wants to pay, no matter how much you want that to be true. However, understanding whether at the equilibrium price you can actually make a profit is critical to your success.
Why does it matter?
The real question is what’s happening “at the margin,” when you’re making the decision whether or not to produce the next item.
It seems rational that if you can sell the next unit at more than it will incrementally cost to produce, you should do it. This will generate cash flow, but does it create a profit? For that to be the case, your revenue must cover all of your Average Cost to produce it as well.
Sometimes, in order to create cash to continue operations, you may sell a product with a net margin but not a profit. This may work on the short-run. However, this logic can lead to disaster if you use that as your overall strategy. Eventually, you will run out of money.
If your Marginal Costs are decreasing and your sales are increasing, you are on your way to both positive cash flow and a profit on your Income Statement. If your Marginal Costs are increasing and your sales are decreasing you are headed for a liquidity crisis.
On the other hand, you may find you in a favorable position where Marginal Cost decrease with scale. This means as production increases the added cost to produce the next item actually decreases. This is often the case with cloud-based software or mobile apps. Once the product is produced and a distribution system established, the Marginal Cost for someone to download the product decreases. Additionally, some variable costs like payment processing will actually decrease as the volume grows.
When demand allows for significant production growth and where there are diminishing Marginal Costs as production increases, you have become a scalable business. Average and marginal cost is what makes a company potentially investable. You can now attract investors and get your company funded.