Let’s say you run a denim business. You currently sell 2,000 pairs of jeans every quarter at $80 each. You’re thinking, “If I sell 20 more pairs, that’s an extra $1,600 in my pocket.” While that sounds simple, businesses don’t work that way.
That’s because you may have to drop your prices to achieve additional sales or reach more consumers. Suddenly, those additional sales aren’t as profitable as you thought.
This is exactly why understanding marginal revenue is so important – it helps you determine how much extra revenue you make from selling one more unit, and more importantly, whether it’s worth it.
Read on to learn everything you need to know about marginal revenue and why it’s essential to finding business success.
Table of Contents
What is marginal revenue?
Why marginal revenue matters for your business
How to calculate marginal revenue
Why marginal revenue decreases over time
Marginal revenue vs. marginal cost: Finding the break-even point
Graphing marginal revenue
Rounding up
What is marginal revenue?
Marginal revenue is the extra money your business makes by selling one more product. As you produce and sell more items, the revenue you’ll earn from each extra unit tends to decrease over time. However, it may still be worth continuing with a product if the results remain profitable (i.e., when the additional revenue meets or exceeds the extra cost of production).
Therefore, the marginal revenue formula can help decide whether increasing or decreasing production to maximize profits is worth it. The idea comes from the law of diminishing returns, which states that, after a certain point, producing more doesn’t necessarily lead to increased revenue.
Note: The goal of marginal revenue is to find a balance between extra revenue from additional production and the extra costs.
Why marginal revenue matters for your business
Why should you care about marginal revenue? Mostly, because it can help you avoid costly mistakes. Understanding your marginal revenue means that you can make smarter business decisions.
- Know when to stop producing: If marginal revenue is lower than your production costs, you lose money on every extra unit. Hence, it’ll be clear whether you can profit more from additional production.
- Set better prices: If demand drops as you increase production, you’ll know when to adjust your pricing strategy
- Predict future profits: Marginal revenue helps businesses understand whether scaling up is a good idea or a financial trap
How to calculate marginal revenue
You can calculate your marginal revenue in two ways: in total cash amount or on a per-unit basis. Most business managers and analysts focus on the per-unit approach, comparing revenue changes with additional units produced. The formula for calculating marginal revenue is therefore:
Marginal revenue = Change in total revenue/change in quantity
Using the denim brand as an example, let’s say the company makes USD 160,000 in quarterly revenue, selling 2,000 pairs of jeans at USD 80 each. If the brand wants to make 10 extra pairs and sell them for a total of USD 700, to find the marginal revenue, it must divide the increase in revenue by the number of additional pairs, which is USD 70 a pair in this example.
Marginal revenue = USD 700 / 10 = USD 70
Let’s say the denim brand makes an extra 15 pairs of jeans and increases its revenue by USD 900. Here’s what the marginal revenue will look like:
Marginal revenue = USD 900 / 15 = $60
Taking the example even further, if the business boosts output by another 20 pairs of jeans and increases its revenue by USD 1,000, the per-pair marginal revenue will be:
Marginal revenue = USD 1,000 / 20 = $50
This example shows that the more you produce, the less you make per unit – the law of diminishing returns in action.
Why marginal revenue decreases over time
With a new product, it may be that you sell more. But eventually, your revenue won’t be able to keep up with your production. Here’s why:
- Prices fall when a market becomes more saturated with a product, and people won’t pay the same price for additional units
- Production costs rise, since more products mean more materials, labor, and expenses
- Your market has limits, and even if you’re the best in your industry, there’s only so much demand out there
Therefore, businesses must track their marginal revenue carefully so that they know when producing a product is no longer fiscally sensible.
Marginal revenue vs. marginal cost (finding the break-even point)
Knowing your marginal revenue is only half the battle. You must also track marginal cost (making one more unit). Here’s the formula you can use (it’s similar to marginal revenue):
Marginal cost = Change in quantity / Change in total cost
Below, we’ll look at a comparison of marginal revenue vs. marginal cost using our jeans business, but before that, let’s assume it costs USD 50 to make one pair, and the company sold its regular inventory at USD 80 per pair. Based on the quantity change, here’s what its marginal cost would look like:
| Additional production (number of pairs) | Additional revenue (USD) | Marginal revenue per pair (USD) | Additional costs (USD) | Change in cost/change in quantity (USD) | Marginal cost per pair (USD) |
| 100 | 7,000 | 70 | 5,000 | 5000 / 100 | 50 |
| 150 | 9,000 | 60 | 7,500 | 7,500 / 150 | 50 |
| 200 | 10,000 | 50 | 10,000 | 10,000 / 200 | 50 |
Based on this chart, the jeans brand is still profitable at 100 and 200 extra pairs of jeans because the revenue exceeds the cost. However, it will only break even if it makes between 200 and 300 extra pairs, meaning it is no longer profitable.
So, you must keep this in mind:
- Keep producing if marginal revenue is greater than marginal cost
- If marginal revenue equals marginal cost, it’s your break-even point
- Stop production if the marginal revenue is lower than the marginal cost
That’s why businesses don’t just keep producing endlessly; they stop when marginal cost = marginal revenue.
Graphing marginal revenue (why it slopes downward)
You can use a marginal revenue curve to visually track how revenue changes as production increases. Another benefit is that graphs can help demonstrate when production will no longer be profitable (unless you find a way to lower production costs).
You can do this by plotting the quantity produced on the x-axis, while revenue and cost (basically price) are plotted on the y-axis. In this equation, the demand (or average revenue) curve will most likely slope downward, meaning demand will always increase when prices drop, and vice versa.
Experts call this relationship “price elasticity of demand,” which gives a good picture of consumers’ sensitivity to price changes. One thing to note is that the marginal revenue curve is always lower than the demand curve. Why? Because if a business wants to sell more units, it must lower its prices, which will drop revenue for each extra sale. Additionally, if marginal revenue is positive (above zero), demand will be elastic, meaning small changes in price may significantly affect demand.
Rounding up
Understanding how to calculate marginal revenue is like having a business cheat code. It can help businesses compare their revenue to rising costs and determine the most profitable time to stop production. But that’s not all, calculating marginal revenue can also help you to plan production, forecast demand, and set suitable product prices. In all, it’s a powerful business tool anyone can use to prevent losses due to overproduction.
