Within the definitions of finance and economics, there is a term that implies a lot of relation to the production of goods; This term of marginal cost encompasses in itself several definitions that interlaced allow us to reach the final definition, in which a marginal cost is the rate of change that exists given the change in production.
In a little simpler terms you can define the marginal cost as the increase that exists in the cost of production of a unit, when the general production increases. In simpler terms, marginal cost answers the question How much does it cost me to make 1 more unit? But in order to understand the meaning of this term in a broader way, it is essential that we answer other questions, let's start by analyzing what it is a cost.
Marginal cost
When we refer to the production of some good, we always speak that the joint participation of several elements is required, whose interaction allows the raw material becomes the final product, which is destined to fall into the hands of the end customer.
But what is required to be able to carry out this process?
Take for example the process of assembling a simple chair, which requires boards, tubes, and screws. The assembly process is simple, since it is enough that the tubes are screwed with the boards to be able to have the complete chair, this means that in order to be able to assemble a chair it is necessary to buy the raw material with which it was manufactured, that is, boards, tubes and screws; It is in this way that we now know that there is a raw material cost. Now, let's think about what this implies in terms of other types of investments.
In order to assemble a chair, not only is required the raw material but also one of the most important elements, a person. This person who is known as the worker or the operator is the one who is in charge of being able to carry out the Assembly process, thanks to which we can obtain the assembled chair as a final result; And something very important is that, to the investment in raw materials, we now add the investment in labor, since the salary that is awarded in order to obtain the human capital to carry out the process, is also considered as a production cost, but it does not end here.
So that the worker can turn the tubes and boards into a beautiful chair, machinery is required to be able to assemble the product, this machinery can be, for example, drills and some bases to support the assembly, so to production investment it is added the cost of machinery. And now, for the machinery to function correctly, it is necessary to have electrical or hydraulic outlets, in order to be able to make the machines work, which implies that, for each assembled unit, one will also have to be loaded. investment in energy.
Each of those investments that are made to reach the goal of producing a certain product are known as the product production cost. But there are not only the aforementioned costs, there are also costs for logistics or transportation, costs for administration, costs for taxes, costs for maintenance, among some others.
Investment
In recent years it has become fashionable the term investment, and although on many occasions we think that an investment is when stocks or some other financial instruments are bought and sold, an investment is not always of that type; In manufacturing, the investment process is carried out when certain capital is made available in order to be able to produce a good. In these cases, the return on the investment that is made can vary in many aspects, however, it is the same end that is pursued.
In manufacturing investments, we may find ourselves with an opportunity to sale of a certain product that it has become popular, or that it is in very high demand; Continuing with the example of the manufacture of chairs, it is possible that we find that one of the areas with the largest number of customers is the sale of chairs; Once this area of opportunity has been identified, it is time to start talking about a project.
This project refers to the planning of the entire process that is required to achieve the final objective, which is to sell a certain number of chairs, with which the desired earnings. It is during this planning that all the expenses that will be incurred are identified in order to achieve the final goal. These expenses are the investment to be made.
Within the points that are considered to be able to determine the final investment amountWe have the investment in infrastructure, and it is that in order to manufacture our chairs we are going to require a space dedicated to storing the raw material that they provide us; after that, an area is required to be able to assemble the chairs; and then a space is required to store the chairs already assembled. In addition to this, a space is required for the administration offices and the vehicles through which the production will be sent to customers.
Another type of investment that is made in this project are the permits that are required to be able to operate correctly; Together with this, it is important to consider the investment in the maintenance equipment, which will be used to keep the entire system and all the machines and tools used in the company running.
Now, as soon as you have the total amount to invest, the goal is expected to be reached, and the main goal of a company is to generate profits, that is why the sales profits have to exceed the investments made. . In this way we can think of the following.
Once the analysis is done, to neustra chair factory a total investment of 1 million euros is required; and the project is planned to manufacture 100.000 chairs a year for the next 5 years; If we want to obtain profits from this production, it is necessary that the chairs are sold at a price that allows covering the investment made at the beginning, and at the time of maintaining production, and in turn, that it covers with the appropriate profit margin.
In our example, the planning indicates that a total of 500.000 chairs will be made, for which an amount of 1 million euros was invested at the beginning, plus the monthly investments in terms of salaries and raw materials, which are equivalent to 10.000 euros per month. So the final investment is 1.600.000 euros. And if our desire is to earn 15% with respect to our investment, the profits would amount to 240.000 euros, which added to our investment gives us a total of 1.840.000 euros as the final amount to be earned from the sale of the chairs. So according to our production planning, each chair should be sold at 3.68 euros.
Marginal cost
When we carry out a project, the most natural thing is to have a production and sales projection, However, there are times when the demand for the good exceeds the project's projections, so in order to have a response time margin, the projects make assumptions about a possible increase in sales, so that on some occasions costs are included extras to be able to support the extra production, it is in these cases that the marginal cost applies in the best way, that is: if instead of 500.000 units I want to produce 500.001 units, how much more, in addition to the 1.840.000 euros, will I have to invest in order to obtain the desired production?
It is very important to know this data in order to know the final price of these units, with which we can accurately define the sale price, so that the project objectives are achieved and maintained. But how do we know the marginal cost?
Mathematically the marginal cost It is represented as the derivative of the total cost, between the derivative of the number of total units; This implies that the total cost invested in order to obtain the determined number of units has to be divided by the number of real pieces, so that it can be defined as unit cost.
This marginal cost is very useful when projects are made because from the financial point of view, the optimum point is found between the cost of production and the selling price, so that the appropriate price is calculated at which the company do not lose money, but do not abuse the customer. Without a doubt, taking this term into consideration in the planning of our projects will help us to have a better financial result.