Cost, Marginal

Marginal cost is the cost of producing an additional unit of output. For example, supposing a supplier produces 100 units at a cost of $1000, and the cost of making 101 units is $1005. The average cost per unit is $10, but the marginal cost of the 101st unit is only $5. When negotiating with suppliers, buyers may seek to persuade the supplier to set a price that covers their marginal costs only, rather than adopt absorption costing. Absorption costing means that the product absorbs all of the variable costs and overheads. In the example above, a marginal costing argument might be used to suggest a price of $6 per unit, covering the supplier’s variable costs and making a contribution towards overheads and profit. See also Total Absorption Costing.

In short

Marginal cost is the extra cost of producing one more unit. Buyers use it to judge how far a supplier can go on price for extra volume.

How to calculate marginal cost

Marginal cost = change in total cost / change in quantity. In the example above: ($1,005 - $1,000) / (101 - 100) = $5.

Within normal output, fixed costs do not change, so marginal cost is close to the variable cost per unit: materials, direct labour, energy and freight. It rises when the supplier runs short of capacity and needs overtime, extra shifts or new equipment.

Marginal cost vs average cost and absorption costing

• Average cost is total cost divided by units, so it includes a share of fixed overheads.
• Absorption costing gives each unit its variable costs plus a share of overheads. It is the usual basis for list prices.
• Marginal costing counts only variable costs and treats the rest of the price as a contribution to overheads and profit.

Average cost that falls as volume grows is the basis of economies of scale.

When a marginal cost argument works in negotiation

It is strongest when the supplier has spare capacity, the volume is extra to business that already covers overheads, or the work can fill quiet periods. It is weak when the volume is the supplier's core business or capacity is tight. A supplier that sells too much at marginal cost cannot cover its overheads and may cut quality, raise prices later or fail. Use the argument for genuine extra volume, not as the basis for all pricing.

Estimating a supplier's marginal cost

• Build a cost model from the main materials, labour and energy inputs.
• Ask for cost data on large contracts, as in an open book contract.
• Compare the price breaks in the supplier's volume quotes.

Help with supplier cost negotiation

Comprara prepares and runs supplier negotiations through its purchase negotiations and auctions service.