Marginal Analysis: What It Is, How It Is Done And An Example

The marginal analysis is an examination of the additional benefits of an activity compared to the additional costs incurred for the same activity. Companies use it as a decision-making tool to help them maximize their potential profits.

In this sense, marginal analysis focuses on examining the results of small changes as the effects cascade throughout the company.

Companies want to get the most out of their resources. They must ensure that the benefits of certain activities exceed the costs in order for them to be profitable.

One tool for weighing this relationship is marginal analysis, examining the costs and benefits of a small or marginal change in the production of goods or an additional unit of an input.

This decision-making tool is useful in helping individuals and businesses decide how to allocate their scarce resources to minimize costs and maximize profits.

What is marginal analysis?

Marginal analysis is an examination of the associated costs and potential benefits of specific business activities or financial decisions. The objective is to determine whether the costs associated with the change in activity will generate a sufficient profit to offset them.

It is the process of identifying the benefits and costs of different alternatives, by examining the incremental effect on total income and the total cost caused by a very small change in the output or input of each alternative.

Marginal analysis supports decision making based on marginal changes in resources, rather than based on totals or averages.

Instead of focusing on total production, the impact on the cost of producing an individual unit is seen as a point of comparison.

Decision-makers take into account cost and production variables, such as units produced, to determine how the company’s profitability changes based on incremental changes in these variables.

Tool to maximize profits

Marginal analysis is used as a profit maximizing tool, which performs a cost-benefit analysis on a marginal change in the production of a good, seeking to determine how an incremental change in production volume can affect business operations.

Governments evaluate the costs and benefits associated with a government decision. They allocate their resources efficiently to generate additional benefits for the public good.

How to do it?

Marginal decision making means considering a little more or a little less than what you already have. It is decided by marginal analysis, which means comparing the costs and benefits of a little more or a little less. You could think of marginal analysis as the analysis of change.

Marginal cost

Marginal cost is the change in cost of a different option. For a consumer, marginal cost is the additional cost of purchasing one more item. For a company, it would be the additional cost of producing one more item.

Marginal benefit

Marginal benefit is the change in what is received from a different option. For a consumer, the marginal benefit would be the added satisfaction of buying one more item. For a business, it is the additional income received from the sale of one more item.

Let’s say you are considering membership in a local recreation center. The basic membership gives access to the pool, while the full membership gives access to the pool and weight room.

Since they both give access to the pool, the fringe benefit of the full membership is access to the weight room.

The amount of benefit a person receives from a particular product or service is subjective. For example, someone might enjoy ice cream more than a friend who is allergic to dairy.

The amount of benefit received can also change. For example, ice cream may be more enjoyable on a hot day than on a cold day.

Revised economic rationale

The decision is made by comparing the marginal benefits with the marginal costs. An economically rational decision is one in which the marginal benefits of the choice are greater than its marginal costs.

Taking the example of the recreation center, let’s assume that the basic membership is $ 30 per month, while the full membership is $ 40 per month.

Making an economically sound decision means asking yourself: Is the marginal benefit of having weight room access worth the marginal cost of an additional $ 10 per month?

For some people, the answer will be yes. For others, it will be no. Either way, marginal analysis is an important part of economic rationality and good decision making.

Example

Be a company that sells hats. The company employs six workers in the production process. You want to perform an analysis to develop an efficient compensation program.

Each worker produces a different number of units. The analysis will provide information on the marginal cost and marginal benefit of each employee. A table is created with the following information:

This system allows you to determine which employees are profitable and which are not. Profitable employees create more value than their cost. On the other hand, loss-making employees create less value than their cost.

Looking at the table, it is concluded that employee 2 and employee 4 generate less value than their cost. This is because the marginal cost is greater than the marginal benefit.

These employees are not using the organization’s resources effectively. The firm will need to determine how to allocate the resource so that these two employees perform at a level where marginal benefit is at least equal to or exceeds marginal cost.

Expansion of operations

When a manufacturer wants to expand its operations, whether by adding new product lines or increasing the volume of current products produced, a marginal analysis of costs and benefits is necessary.

Among the costs to be examined are the cost of additional machinery, additional employees, the need for a larger facility for manufacturing or warehousing, and the cost of additional raw materials.

After identifying and estimating all costs, these amounts are compared to the estimated increase in sales, attributed to this additional production.

If the increase in income exceeds the increase in cost, expansion can be a smart investment.

References

  1. Investopedia (2018). Marginal Analysis. Taken from: investopedia.com.
  2. Study (2018). Marginal Analysis in Economics: Definition, Formula & Examples. Taken from: study.com.
  3. My Accounting Course (2018). What is Marginal Analysis? Taken from: myaccountingcourse.com.
  4. Business Dictionary (2018). Marginal Analysis. Taken from: businessdictionary.com.
  5. OER Services (2018). Marginal Analysis. Taken from: courses.lumenlearning.com.

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