It’s important for businesses to understand how to scale their businesses efficiently. If you are an entrepreneur, you must wonder how impactful additional costs will be for businesses when it comes to profitability. Will the additional costs be worth it? To understand such scenarios where decision-making is paramount, marginal analysis is the most effective tool at your disposal.
To learn more about this form of economic analysis and make better business decisions, read this post till the end.
What Is Marginal Analysis?
Marginal Analysis is the analysis of your business operations to better understand how profitable they are. According to marginal economics, it’s the study of the extra benefits business operations can bring in compared to their costs.
In simpler terms, it analyzes the worthiness of your costs by comparing them with the additional revenue it will lead to. Therefore, if you are spending on something for your business, the revenue it will bring should equal its costs. If it doesn’t, the costs might not be worth it. If it exceeds the cost, then its value depreciates.
Therefore, by conducting a marginal analysis, you will be able to make better decisions on whether the additional costs you wish to make will be profitable for your business or not.
How To Conduct A Marginal Analysis?
According to the Marketing Automation Bizleads Summit, it’s pretty easy to conduct a marginal analysis. It boils down to calculating the expected marginal benefit of the outcome of an expense. Then, you subtract the marginal cost from the marginal benefit to find its true profitability.
For example, let’s say you produce goods at $10 per unit. However, you buy new machinery that helps in producing the same goods at $5 per unit. Therefore, when you produce more goods at cheaper prices, your marginal costs are expected to go down if the goods you produce are in high demand.
Therefore, to conduct marginal analysis, you need to learn how to find marginal benefit. As a rule of thumb, the marginal benefit of your products goes down the more additional units a consumer buys.
But what’s the difference between marginal benefit vs marginal cost?
A marginal benefit refers to the additional benefits consumers will get by buying one extra unit of a product. On the other hand, your marginal cost refers to the additional expenses of producing one extra unit of a product. Therefore marginal cost and benefit are highly correlated with each other.
Rules Of Marginal Analysis
Since marginal analysis is focused on maximizing profits, there are two rules that businesses should abide by. These rules are as follows:
Rule 1: Continue Operations Until Marginal Cost = Marginal Revenue
The primary rule of Marginal Analysis is that you should perform business operations to maximize marginal revenue. Its first rule is that your marginal revenue should equal your marginal costs.
This is an important point since your operations will be successful or profitable only if your revenue exceeds your expenses. If your business operations are not fetching you any profits, then there is no point in continuing that activity. However, if the amount of additional revenue earned keeps getting lower with each additional expense, it’s not worth it.
For example, if you are producing goods that are $5 (marginal cost) a piece and selling them for $7 (marginal revenue), your marginal revenue is higher. However, if you are breaking even (producing and selling at the same cost) or running losses (selling at lower costs than producing), it’s not feasible to continue selling business operations unless you find ways to reduce costs and increase revenue.
However, this does not mean that you should stop operations when running on losses. There are various non-financial factors that need to be considered. Plus, long-term profitability also needs to be considered as well.
Rule 2: Equalize Your Marginal Returns Across All Products
When businesses get bigger, they start to expand and introduce new products. If you can create and sell more varied products, your revenue and profitability are expected to increase.
However, it has been seen that many businesses make the mistake of focusing resources only on one or some products. They eventually end up neglecting the others. Therefore, they end up making one or some operations profitable while the others suffer losses.
Here comes the second rule of marginal analysis – always equalize your marginal returns across all your products. Therefore, ensure that your returns are equally distributed amongst all your products. None of your products should be bearing the bulk of all your revenues by running others on losses.
Not doing so will lead to depreciating losses and straight line depreciation over time.
How Can Marginal Analysis Help In Better Decision Making?
Marginal analysis is a very powerful analysis tool that businesses of all sizes can use to maximize their profitability. Therefore, since you wish to earn more profits, your decisions should be based on maximizing profits as well.
Here’s how you can improve your marginal decision-making using marginal analysis:
1. Attain Maximum Net Benefits
To gain the highest net operating income and net benefit, you need to increase your business operations and reduce its costs at the same time. However, you should only do so by following the theory of marginal analysis – increase operations when your marginal benefits become more than your marginal costs.
Therefore, just when you start making profits from your business activities, it’s time for you to push your operations. If you start conducting more business activities when you begin making profits, you will be able to capitalize on your current business strategy and increase your profit margin even more.
It’s advised to do so since your business strategies must be in the right place if you are earning profits. Why miss the chance to capitalize on it?
2. Opportunity Costs Become Clear
Opportunity costs refer to expenses that a business can undertake when you have a surplus budget to work with. For example, you can hire an additional employee with this surplus budget to boost your activities, production, sales, and revenues.
However, doing so might not be a good idea, according to marginal analysis. This is because even if you yield more revenue, hiring an additional employee is sub-optimal and is not recommended.
Bottom Line: Are Your Expenses Worth It?
If you are an entrepreneur, it’s important that you conduct marginal analysis whenever you are trying to scale your business. It’s important to maximize your marginal revenue by making it equal to your marginal costs. Going below or above this point will lead to depreciating results.
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Debamalya is a professional content writer from Kolkata, India. Constantly improving himself in this industry for more than three years, he has amassed immense knowledge regarding his niches of writing tech and gaming articles. He loves spending time with his cats, along with playing every new PC action game as soon as possible.