Illustration of MC:MR curve (Supply curve); average total (ATC) and variable costs (AVC) can be analyzed as well
Marginal Cost (MC) is "the cost added by producing one additional unit of a product or service." The analysis of MC is used heavily in all departments that have a need to maximize output (sales) and minimize input (dollars spent)
So-called "what if scenarios" exist everywhere in modern business management and administration. They are largely based on the relationships of MC variables to demand. "What if we lowered the price of our product from $8 to $5 in this market, what will happen?"
Depending on the demand in that market, the marginal cost (MC), and thus the maximum possible profit point could rise (if demand increases are less than the $3 per unit less being recovered in sales) or lower (if the lowered price leads to higher demand than the demand at the $8 price).
Whether the maximum possible profit point rises or lowers depends on how much demand is associated with the product when it is sold at $5. Assuming the business can produce more of the item per day at $5, unless demand increases production quantity so much that the maximum possible profit is higher at $5 than it is at the $8 price, the decision to lower the price from $8 to $5 is not a profitable one.
Often, companies find themselves with the luxury of being able to lower prices to generate high demand because their production costs are so low when producing at such high scale (what is known as possessing "economies of scale") or because their advertising costs are so low or because they can simply afford to take on losses to break into the market with hopes that they can someday achieve the economies of scale of like those of the market winners once they have established themselves as a legitimate market competitor.
Marginal Cost by Quantity equals changes in Cost over changes in Quantity
Break-Even is defined as "the amount of money, or change in value, for which an asset must be sold to cover the costs of acquiring and owning it. It can also refer to the amount of money for which a product or service must be sold to cover the costs of manufacturing or providing it."
Many businesses do not make much money. However, generating enough income to pay all of your employees and utilities and taxes in addition to all the business expenses that generate economic activity- is not an easy feat and is in no way a failure (a business failure is a business that only ever consistently loses money- never breaking even or generating profit).
A simple illustration of the break-even concept is if an individual bought 90 cans of Pepsi in advance of a big event in their town. If the purchase price for the bulk 90 cans (3 30-packs) was $45 and they sold the individual cans to event-goers for $5/ea, they would only have to sell 9 Pepsis to breakeven- the remainder (minus applicable permit or taxes)- is profit 45 / x(5) = 1 where x = 9
Traditional Make vs. Buy:
Companies are frequently faced with the decision to create something within the company or opt to purchase from a third party vendor. The latter usually makes sense; the former only makes sense if the company can consistently produce a material or service input at a lower price than could be paid to a third party.
Additionally, any in-house materials development should not interfere with on-going production operations.
In Production Planning:
With machines sitting largely idle unless there is sufficient capacity for them to process, a manufacturing manager has to contest with a host of variables in configuring the production floor and which machines will be used to maximize production of the amount they need to deliver each interval (day, week, month, year).
In CPQ and Pricing Analysis:
The price point at which there is an intersection of MC and MR is known as Price Equilibrium (PE). Quantity produced and sold at the PE ("Maximum Possible profit" in the chart above) maximizes profit as PE represents the price and output level at which MC is lowest.
Other notes:
Federal, State and local governments can institute price limits (also known as price floors) which restrict the ability of a producer to recover all of the profit area they might gain for product sold at prices in excess of the price equilibrium. Selling at the price equilibrium is selling at the "break-even" point.
The ability to isolate P, MC, MR, Q and analyze their response to changes in the other variables is an invaluable tool for organizational and financial planning.
References:
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