Let’s say it costs your favorite coffee chain spends $10 to make ten cups of coffee. It might, however, cost them 90 cents to make an additional cup of coffee, since part of their cost is being spread over more units. For example, they might be able to cut labor costs or buy their coffee beans in bulk. The additional cost of the eleventh unit — the eleventh cup of coffee — is known as the marginal cost. The fact that production costs often decrease as the number of units produced increases can often explain why prices are lower at bulk stores like Costco than smaller independent grocery stores.
Marginal costs are determined by the cost of production, which is made up of both fixed costs and variable costs. Fixed costs do not usually fluctuate depending on the number of units being produced, so whether your coffee chain makes ten or twenty cups of coffee, their fixed costs will stay the same. These can include rent, the price of electricity to run the coffee shop, or the salaries of the baristas. Variable costs, on the other hand, will change depending on the number of units being produced. Whilst the stores will have to pay rent and utilities even if they don’t produce any coffee, they will only have to pay for coffee beans, milk, and cups if they are producing cups of coffee. Variable costs can include labor, packaging costs, and raw materials.1
In order to run a profit, companies want to ensure that the marginal cost does not exceed the marginal revenue of selling an additional unit. At some point, the cost of an additional unit would be equal to what the unit is sold for, which means the company isn’t making money anymore. Knowing exactly what a company’s marginal costs are being therefore important to ensure that each additional unit being made is selling for a profit. Companies want to optimize their revenue by keeping their marginal costs low and their market price high.