Marginal Revenue FormulaDefined along with Formula & How to Calculate
When talking about marginal revenue, it is the extra revenue generated from the additional product of units produced and sold.
From the management’s perspective, marginal revenues provide an indication of how an additional unit of product sold can change the overall income of a company.
What is Marginal Revenue?
Marginal revenue refers to the additional revenue generated by companies for each extra unit of output produced.
Because Marginal Revenue follows the Law of Diminishing Returns, it means that when a company reaches a level of optimal capacity, an additional factor in production will result in lesser increases in output.
Over a period of time, marginal revenue will remain constant but will eventually slow down as the level of output increases.
When a company aims to continually maximize their profits, their marginal revenue must equal marginal cost, which is the case for perfectly competitive firms.
If in the findings of a cost benefit analysis they find that the marginal revenue is lower than the marginal cost, it can be a basis for the company to completely cease production.
Marginal revenue and other economic metrics
Marginal Revenue vs Average Revenue
Where Marginal Revenue is the revenue generated for an additional output of a unit produced, while Average Revenue is the amount of revenue earned from each unit of output sold.
The formula to compute for Average Revenue is by dividing the number of units sold to the total revenue earned.
In a perfectly competitive firm, the marginal revenue and the average revenue equals the firm’s price because over varying levels of output, it remains constant.
The case is different for monopolies because selling an additional unit is either equal to or less than the market price.
Marginal Revenue vs Total Revenue
Total Revenue refers to the total amount of revenue that a company has generated regardless of the revenue source so it can be from the normal operations of the business (sales) or from a company’s investments, from the result of marketing or from customer success.
While Total Revenue refers to all sources that have contributed to the company’s revenue, Marginal Revenue simply refers to the incremental revenue from the additional output of units produced.
Marginal Revenue and Marginal Cost
Marginal Revenue and Marginal Cost play an important relationship when it comes to maximizing the profits that a company makes.
The cost a company makes to produce extra units is called a marginal cost and a company would always want to know the point at which the marginal revenue equals the marginal cost.
Put simply, when a company’s marginal revenue is higher than the marginal cost, the company is making a profit.
For this reason, when the marginal revenue is equal to the marginal cost, that means the company has already maximized their profits and should they want to generate more revenue, the production cost will also increase in the process.
Marginal Revenue Curve vs The Demand Curve
The demand curve shows the relationship between the price of a product and the quantity of demand over a period of time.
Marginal revenue falls below the demand curve and shows that when the marginal revenue is positive, the demand is elastic.
It is inelastic when the marginal revenue is negative but when the marginal revenue is equal to zero, the demand is considered to be unitary elastic.
How to calculate marginal revenue
The marginal revenue formula is shown below as:
Marginal Revenue = Change in Revenue / Change in Quantity
Where Change in Revenue = Total Revenue – Old Revenue, and Change in Quantity = Total Quantity – Old Quantity.
A change in revenue is computed by subtracting the revenue of a company before the additional output is sold from the revenue when the additional output sold is already included.
Marginal revenue: a practical example
For example, Company X produces biscuits and normally produces 1,000 boxes for $7.50 for each box.
The next day, they were able to produce and sell 1,100 boxes for a total of $9,350.
Based on the above example, the change in revenue is $1,100 and the change in quantity is 100 (1,100 – 1,000).
The Marginal Revenue therefore is $11 ($1,100 / 11).
For each additional unit that was sold, the marginal revenue is $11.
Why does your business need to calculate marginal revenue?
It is imperative that businesses calculate the marginal revenue for different reasons: the management needs to be able to maximize their profits, understand the effect of each increase in revenue and its impact on the business, and understand the relationship between sales and demand.
Producing what a company sells has an attached cost and the company would want to make sure that they are maximizing their profits, where the marginal cost will equal to the marginal revenue.
To continue to produce additional units to increase sales means that production needs to increase and with that, production cost as well.
When meeting a market demand, the decision has to be made on how many additional units a company needs to produce in order to meet their targeted revenue.
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