Keep calm and keep an eye on your profit
A small profit is better than a big loss.
Are you a leader in your field? Do you take it upon yourself to make the important decisions on a daily basis? If this is the case, you need to know all there is to know about marginal analysis, which is vital during the decision-making process and to boost profits.
Let's break down that phrase, “marginal analysis.”
Definition of “margin”: “the amount by which one thing differs from another.”
Definition of “analysis”: “the division of a physical or abstract whole into its constituent parts to examine or determine their relationship or value.”
In this article, we'll examine exactly what marginal analysis is, show how it can be calculated, reveal some hypothetical examples, and explore some of its benefits and limitations.
A clear explanation of marginal analysis
Marginal analysis is a technique whereby you compare the benefits and costs produced by a particular activity. Through analysis, you can then decide whether the activity, change in circumstance, or new addition is worth it for the business. It's widely used to gauge the level at which a business should stop incurring more costs in order to generate more revenue.
A simple example is whether you can get a good return on investment (ROI). If you employ someone and pay them an annual salary of £50,000, you've got to figure out how much revenue they will bring in. If it's £70,000, then it's worth it. If it's £10,000, it's not.
Applying marginal analysis in a business is essential, as it helps with the decision-making process - such as whether it's worth expanding or investing in new product design. Additionally, it helps to equate or compare benefits with expenses, as well as contribute towards the planning of profit optimisation. It's also used to study consumer and producer habits, in order to predict future economic behaviour.
You might've heard the phrase, “opportunity cost.” This is what you're missing out on by picking one option over another. Marginal analysis is the opposite - it's what you gain from picking your option, the associated costs, and the benefits of a business decision.
The basic marginal analysis formula is: benefit - cost = net benefit. This can be used to compare the different options and then choose the option that has the highest net benefit.
Examples of how marginal analysis works
To get a clearer picture of how marginal analysis works, check out the three hypothetical examples below:
Beryl owns her own company - Beryl's Burger Joint. It's a well-established business with a loyal customer base and a great reputation. Because it's doing so well, Beryl's considering expanding the scale of production. The shop sells 10,000 burgers a month. The total fixed cost is £10,000 a month, and the expense incurred for each burger is £2. So, if the number of burgers sold per month is 10,000 and the total fixed cost is £10,000 a month, then the fixed cost per burger is £1 (£10,000/10,000). This means the total cost per burger is £3 (£2 + £1).
Beryl is inclined to up that number from 10,000 sales a month to 10,500. This decision to increase output using existing facilities means that Beryl needs to apply marginal analysis. It works out that the new fixed cost per burger would be £0.95 (£10,000/10,500), which means the new total cost per burger would be £2.95 (£2 + £0.95), a decrease of £0.05 per burger. Beryl concludes that increasing production of the burgers would help her to lower costs overall.
A baking company is planning to increase the sales of its baked goods. Because of this, they need to recruit four new bakers. Before going ahead, senior management undertakes a marginal analysis to compare the additional benefit and costs incurred of taking on new members of staff. The analysis indicates that hiring the bakers would be beneficial, because the income increase would outweigh the cost of the bakers' salaries.
Executives at a company that makes specialist tools are considering whether it would be beneficial to launch a new website to promote their goods. Those benefits could include an increase in sales, improved customer service, and better communication with key stakeholders. The cost to build the website, which might include the cost of development, hosting, and maintenance, has to be taken into account. A decision needs to be made as to whether to go ahead with the project or not, weighing up the benefits against the cost. Enter into the ring… marginal analysis. By analysing both the costs and the benefits, the company can make an informed decision about whether a new website is worth pursuing.
The benefits of marginal analysis
It's a common business trait for executive teams, business analysts, and other management professionals to capitalise on their analytical prowess and business acumen to understand the advantages and disadvantages of a project before making any decisions. If this in-depth marginal analysis is ignored, a company can make decisions that aren't beneficial for the organisation, and could actually be detrimental.
It helps to understand the cost to be spent and the benefit to be gained from an activity
It delves deep into comprehending the maximum potential and the potential loss from a unit change in an activity
Analysing the activity can determine the opportunity cost associated with a change in activity
The analysis reveals if the unit change would bring either short term or long term benefits to the business
The limitations of marginal analysis
Marginal analysis is based on projected results, which translates to the fact that the result and activity target are based on a benchmark rather than actual output. This means that the data and information provided by the analysis are hypothetical and, potentially, inaccurate.
If the assessment and analysis aren't conducted accurately, any slight error can lead to an unnecessary loss to the company in cost terms. Any assumptions within the analysis should be evaluated carefully, otherwise the whole test is useless to the company.
What's the difference between marginal cost and marginal benefit?
Marginal benefit is the incremental increase of a consumer's benefit in using an additional unit of something, whereas marginal cost is an incremental increase in the expense that a company incurs to produce an additional unit of something.
Marginal benefits decline at a steady rate the more times that a customer consumes or purchases a single product. Take Mae, who fancies buying a ring for herself. She makes a beeline for a high street jeweller and purchases the perfect ring for £100. But then she spies another ring that she loves. Mae knows that she doesn't need another ring, so she's unwilling to fork out another £100 on a second one. However, she might be tempted if that other ring was priced at £50. This means the marginal benefit decreases from £100 to £50 from the first to the second piece of jewellery.
Marginal cost can decline if a company produces more and more of the same goods. If a company is producing gadgets that are in high demand, they might want to increase production to meet that demand. It costs £5 to produce one gadget, but the company can afford to buy equipment that would reduce the average cost to produce each gadget, so the more they make, the cheaper they become. So, while it used to cost £5, producing the 100th gadget only costs £1 with the new equipment in place. This means the marginal cost of producing that 100th gadget is £1.
Now that you're fully informed about how marginal analysis works, take that information and put it to good use in the workplace. It might just make all the difference, especially when it comes to working out the next best steps for the business.
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