Imagine that your business introduces a new product or service, and it starts to take off. If you continue investing in this new product line, would your profits improve? To answer this question, you’ll need to apply a decision-making process known as “marginal analysis.” Marginal analysis is a vital tool that seeks to evaluate the costs and benefits of a particular activity.

By applying marginal analysis in your business, you’ll be better equipped to determine the best return on your investment (ROI). Here are some tips and examples to help you understand and apply this decision-making tool.

What Is Marginal Analysis?

Marginal analysis is a method for weighing the benefits of a particular activity against the activity’s costs. For example, business leaders must weigh the potential benefits of increasing production against its costs.

In this method, businesses must consider the marginal benefits of an activity compared to its marginal costs. Marginal costs refer to the costs associated with producing just one additional unit of that activity. Businesses can use marginal analysis to optimize their business processes, such as production volume or inventory levels.

When Should You Use Marginal Analysis?

Some business leaders — including Henry Ford — are famous for making business decisions based on pure gut instinct but that doesn’t always work. In contrast, marginal analysis allows business professionals to make decisions based on data. There are two key scenarios in which marginal analysis proves the most helpful.

First, marginal analysis relates to something called “opportunity cost.” Marginal analysis can be used to make a choice between different available options. Imagine, for instance, that your company has enough in its budget to hire a single employee. Which would lead to profit maximization: hiring a marketing coordinator or an accountant? You can use marginal analysis to determine which option will lead to the greatest net benefit.

Second, marginal analysis can be used to determine the net marginal benefit of a business process based on changing variables. For example, suppose that a company wants to increase its production of a particular product. In that case, it can use marginal analysis to determine the quantity at which the marginal cost of each unit is low enough to justify the additional costs incurred from production.

How to Perform Marginal Analysis

How can you use marginal analysis in your business? The following steps will introduce you to the process of calculating your marginal cost, marginal benefit, and the net benefit of a future business decision.

1. Determine Your Business Activity

Marginal analysis can be applied to one business activity at a time. Start by identifying the specific business activity you want to measure. Common examples include:

  • Producing more product
  • Purchasing additional inventory
  • Applying for a small business loan
  • Hiring a new worker

Just make sure that whatever business process you choose to evaluate comes with concrete data. This will make your calculation of benefits more reliable.

2. Calculate the Marginal Cost

Once you determine your business activity, you’ll need to calculate the marginal cost. Remember, though, that the marginal cost is not simply the ordinary costs associated with that business activity. Instead, it refers to the associated costs of each additional unit of business activity, such as the cost of producing an individual unit of product.

To calculate marginal cost, use the following formula:

marginal cost

In this case, “total costs” should refer to the sum of all prior/marginal costs.

You can use this formula to calculate the additional costs incurred from just one unit change or from producing just one additional unit of business activity.

3. Calculate Marginal Benefit

Next, you’ll apply a similar formula to calculate your marginal benefit. As before, this is a new calculation showing the benefit of producing just one unit of business activity should you commit to this business decision.

marginal benefits

This data can be based on professional estimates or contracts with vendors or suppliers.

4. Calculate the Net Marginal Benefit

Now that you have data related to the marginal cost and benefit, you’re ready to apply the marginal analysis formula:

net benefit formula

Assuming that you’re working purely in dollars, the net benefit translates directly into marginal revenue. The formula will therefore tell you how a particular decision will impact your company’s bottom line.

If the net benefit is positive, this decision would be a wise move for your company, at least in terms of revenue. But if the net benefit is negative, pursuing this business activity would cause you to lose money.

Repeat for Each Unit Change

Marginal analysis is an iterative process, which means you’ll need to perform steps 24 for each change in the number of business units. For instance, if your initial calculation revealed a negative net benefit, you can adjust your variables, such as the number of additional units, until you yield a strong marginal profit.

Make a Decision

Once you collect this data, you’re ready to commit to a business decision. Positive marginal revenue indicates that it would be beneficial to proceed with your desired business activity. Negative marginal revenue indicates that you either need to change your variables again or abandon additional activity altogether.

Solo entrepreneurs can use marginal analysis to find strategies for the best possible profit margins. At larger organizations, financial professionals can use the above data to present a clear case for seizing a new business opportunity or investing in a given process.

Marginal Analysis Examples

Marginal analysis can help you determine how even small changes can impact a company’s bottom line. Consider the following examples of how marginal analysis can be applied to real-world scenarios.

Increasing Business Output

Marginal analysis is useful for most kinds of business decisions. Imagine that you operate a bakery and sell 15,000 doughnuts each month. The total fixed costs per month is $7,500, and the expense for each doughnut is $1.50. This makes the fixed cost per doughnut $0.50 ($7,500/15,000 doughnuts), bringing a total cost of $2.00 per doughnut.

donut making

Imagine that you are considering whether to increase production to 15,450 doughnuts per month, a 3% rise. The fixed cost per doughnut would drop to $0.49, bringing the total costs to $1.99 per doughnut ($0.49 + $1.50 expense). You would spend more money on ingredients, labor, and equipment total but less per donut, raising revenue. If the additional revenue offsets the raised total costs of increasing production, the increase is likely the best decision.

Applying for a Small Business Loan

Marginal analysis can also be useful when making more complex decision. For example, consider the common difficult decision of whether to take out a small business loan — in this case, a working capital loan in the amount of $15,000.

Positively, you will receive the cash flow you will need to increase your business revenue by about 2.5%. This means that in a given month, your revenue rises from $10,000 to $10,250 for a net benefit of $250 per month.

But you’ll also have to repay the small business loan, with interest. Your lender grants you a seven-year loan with an interest rate of 7.5%. These loan terms will mean that you’ll be making monthly loan payments in the amount of $230. Your net benefit comes to $20 per month.

While that’s a positive change, you’ll need to consider whether this small change in marginal profit is worth a small business loan, especially considering that loans risk harming your business credit if you neglect to pay them back.

Tips for an Impactful Marginal Analysis

Marginal analysis will provide a helpful way of evaluating your business quantitatively based on pure data. How can you make your marginal analysis more effective? The following tips can help you improve your analytical methods and strengthen your decision-making processes.

Use Accurate Data

Your marginal analysis is based on a specific set of calculations. That’s why you need to use only the latest, most accurate data when evaluating your business processes. Incorrect data and broad estimates will only lead to inaccurate conclusions (and thus may lead you to make bad decisions).

Ignore Sunk Costs

When making business decisions, don’t worry about sunk costs. Sunk costs refer to expenses that you’ve already incurred and can’t recover. For example, fees related to marketing, research and development, or installation services represent sunk costs and benefits that won’t impact your marginal analysis.

Consider External Factors

The calculations associated with marginal analysis are remarkably straightforward, though they only focus on internal variables like costs incurred and net benefits. In business, you’ll also need to consider external factors such as competition, market demand, and consumer behavior.

Don’t Just Focus on the Numbers

Marginal analysis provides clear, quantitative data that you can use to make well-informed business decisions. However, your decision-making process should consider qualitative factors as well. These can include your brand reputation, employee morale, and customer satisfaction.

Take the Long View

If there’s a weakness to marginal analysis, it’s that it tends to focus on short-term benefits regarding revenue. To make the best decisions, you’ll also need to consider the long-term implications for you as well as your employees, including cyclical trends that fluctuate over time.

Update Your Analysis Regularly

Revenue, market conditions, and costs are always changing, especially during an age when businesses are facing challenges due to inflation. For that reason, you’ll need to adjust your calculations and assumptions to allow for these sorts of variances.

Don’t Pass Up on the Power of Marginal Analysis

Every business leader should be making careful decisions based on the best possible data. Marginal analysis allows you to perform the calculations you’ll need to optimize your business results. The more you perform this basic analytical tool, the more you’ll be able to make smarter decisions about the future of your business.