Economics

What does marginal opportunity cost mean?

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meaning of marginal opportunity cost

Study.com offers a simple definition to marginal opportunity cost (MC). They define it as “an economic term that analyzes the effect of producing additional units of a product on the costs of a business, as well as the opportunities the companies give up to produce more of a product.”

Knowing how to compute the MC will help business make wise and prudent financial decisions.

There are 2 kinds of MC: explicit and implicit. Explicit costs are usually tangible. If your business is making and selling soap, examples of explicit cost would be the ingredients, storage, display, and manpower. The money you invest on these cannot be used for other things. Implicit costs usually refer to things that are intangible, like the activities that you could not participate in or be involved in because of the additional volume or new product or service you want to introduce. These are usually lost opportunities to work on another project.

One thing to remember though is that if you work with an accountant, he will only consider explicit costs, whereas an economist will think of both. And because of this, an accounting profit computation may always be higher than an economic profit computation.

Other expenses that you need to consider are production costs. There are 2 kinds: fixed costs and variable costs. Fixed costs, as the name implies, are fixed or constant, like rent, taxes, cost of equipment, licenses, and so on. Variable costs, may change, like ingredients, utilities, and labor.

To compute your MC, you divide your additional cost (AC) by the additional quantity (AQ).

Here is a sample computation. You are a soapmaker who produce 100 bars of soap for 30 cents per piece. Let’s say that you want to increase your volume to 150 bars, which means you want an additional 50 bars daily. The production cost is the same, except for the addition of labor cost at USD 20 for 2 hours overtime pay per day. Following the formula, divide AC (USD 20) by AQ (50 bars). Your MC is 40 cents.

But if the person you got only produced 1 bar of soap in 2 hours, your MC will change. When you divide your AC (USD 20) by AQ (USD 1), your MC is USD 20. In this case, your marginal cost increases, and is therefore not profitable.

Sometimes, increasing your AQ (or additional quantity) does not necessarily mean loss. It may even mean profit if your MC goes down especially when you are able to optimize your production cost.

There are many considerations when expanding or growing a business. Just make sure you crunch numbers to find out if the venture or project is worthwhile.

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