Marginal revenue forms an important component of microeconomics. By analyzing marginal revenue, a business can identify the revenue generated based on every individual sale. This calculation is critical in maximizing profit potential. Without further ado, let’s dive in!

Marginal Revenue Definition

Before we learn how to calculate marginal revenue, we need to understand what this metric is (and why it’s so crucial to understanding your business):

Marginal revenue is the incremental change in earnings resulting from the sale of one additional unit.

Essentially, it’s the revenue that a company makes from every extra sale, all while considering the marginal costs incurred. If we take this theory and apply it to a sales scenario, it works as follows:

If you charge a lower price for a product, you’ll sell more… in theory. Now think about what happens if you charge items at a higher price. You’ll likely sell fewer units, but you’ll make a greater profit on each item. 

To track every working minute and make your payroll as accurate as possible, use the best time tracking software. Everhour is the top time tracker for SMB teams, including software developers, marketers, designers, consultants, lawyers, you name it! Seamlessly integrating with popular PM tools, its user-friendly interface and customizable reports make it the ultimate time tracking solution. With dedicated support, our team is here to help you promptly and with a smile!

The theory is sound, but in practice, you need to calculate whether the amount earned by raising your profits offsets the losses incurred from selling fewer items.

Of course, in a perfect market, no relationship would exist between the sale price and quantity. Your marginal revenue would always equal your sale price, and we wouldn’t even consider the concept. But in reality, monopolies eliminate the possibility of perfectly competitive markets, creating the need for businesses to calculate their marginal revenue. 

Understanding Marginal Revenue

Marginal revenue applies to all businesses, no matter how big or small. It’s applied to every sale at Walmart, all the way down to the micro-business owner. Let’s look at an example of a smaller business to understand how it works:

Imagine you have an artisanal candle business. Naturally, you want to maximize your profits. You need to calculate what your expenses are per unit, and how much you can charge to make the highest profit possible: 

👉 Either you set a high price for each candle, thus benefiting from high unit prices, or you make more candles and sell them at a lower price to maximize your sales. However, the latter diminishes your revenue. Ideally, finding a balance between the two is what you want to aim for. 

👉 Now let’s imagine you made 10 candles and sold 5 of them for $50 in Q1. This would lead to total revenues of $250. Now, you’ve made 10 more candles in Q2 in a bid to maximize your revenues. Based on your Q1 sales turnover, if you have 15 candles, you can expect to sell 5 of them at the same price. This means you’ll have 10 candles left in stock, increasing your need for storage space but not your revenue.

👉 Would it be wise then to lower your price to $45 per candle? Would you sell one more and make an extra $45 in revenue? The truth is, no. This is the perfect example of less equals more. 

👉 Lowering your price would lead to you losing $5 on each of the other candles. If you sell six candles at $45, you will make $270. If you sell another candle, you will make $20 more than you did in Q1. This is your marginal revenue. 

How to Calculate Marginal Revenue

The calculation is relatively straightforward: marginal revenue equals the change in total revenue, divided by the change in the quantity sold. Here how marginal revenue formula goes:

Marginal revenue = change in the total revenue/change in quantity sold.

So, how do you apply this formula? Let’s think back to the artisanal candle business. Naturally, you hope that you sell more than just one additional candle in Q2. Your best-case scenario is to sell 15.

Now, imagine that you reduced the cost of your candles even further to, let’s say, $35, and sold 8 of them, which is 3 more than Q1. This means you’d have made a total of $280 in revenue, and your marginal revenue would equal $10. You can calculate your marginal revenue by dividing your $30 increase in revenue by your 3 extra candles sold.

In this example, you would have lowered the cost of your candles by $15 and sold 3 more than you did previously, resulting in an extra $30 in revenue. This equates to marginal revenue of $10 per candle.

Using Marginal Revenue To Determine Success

Now, it’s time to ask yourself whether the effort you put into creating each of those candles was worth it, especially if you only made $10 per unit:

👉 Keep in mind the fact that you were able to sell five candles for $50 in Q1. Let’s just say that you wanted to sell 15 candles no matter what, so you slashed the price to only $15 and sold them all.

👉 This would mean you made $225, but that your marginal revenue equates to a negative $2.50.

👉 To calculate marginal revenue in the above scenario, you divide the $25 decrease in revenue by your 10 extra candles. 

❌ Here, you can see that you’re putting so much work into your business but are losing money instead. Essentially, you’re paying your customer $2.50 per candle to take them off of your hands. That’s a whopping $2.50 loss per unit, simply because you added more stock to your inventory!

Finding marginal revenue may seem overwhelming at first, but with these simple formulas, it’s quite easy to calculate. It’s also necessary to know what your marginal revenue is to determine whether you’re making good decisions for your business or not. 

Many businesses calculate their marginal revenue to determine whether they should increase production and if so, by how much. Eventually, a company will reach profit maximization, when the marginal cost equals the marginal revenue. 

When this happens, halting production is the best course of action, as adding more units will cause the marginal revenue to exceed the marginal cost. This leads to a net loss, as it will cost the business more to produce each additional unit than it will make from the sale.  

Understanding Total Revenue

It’s important to consider your marginal revenue and total revenue combined to garner a clearer understanding of how well your business is performing. 

Total revenue measures your business’ total sales or income for a specified number of items or services. 

In other words, it refers to the total amount of money customers have paid for a provided set of goods or services. It’s the money in the till before any costs are deducted. The calculation for total revenue looks like this:

Total Revenue = Price X Quantity 

What’s the difference between marginal and total revenues? A business’ total revenue measures the number of direct sales, whereas the marginal revenue measures the relationship between a change in sales and a change in quantity. For example:

👉 If you sell 50 of your artisanal candles at $10 each, your total revenue will equal $500—you’re simply multiplying the price of the candles by the quantity sold. 

👉 When looking at marginal revenue, on the other hand, imagine you sold 55 candles at $9.99 each. Your total revenue would equal $549.45. The marginal revenue would then equate to $9.89.

Based on the formulas, your marginal revenue will generally be less than your total revenue. If these numbers start to look too similar, you need to bring about a more profitable balance. This may mean reassessing your markup calculations, reducing the number of units you produce or halting production altogether. 

The Bottom Line

A major part of running a business is truly understanding the numbers that come along with it, and not just relying on estimates.  Once you understand the numbers and their formulas, you can use them to make informed decisions that give you the best chance of boosting your profits.

Enjoyed the article? For more tips, strategies, and tools that’ll help you make more informed business decisions and better manage your team, check out these publications next:

A Powerful Balance Sheet Template for Your Business

Balance sheet is essentially a financial statement that captures all assets and liabilities of an organization at a specific point in time, making it easier for you to make major decisions in an informed, rational way. Create one today with our hassle-free balance sheet template!

Imputed Income: A Full Beginner’s Guide

Every business owner needs to know the in’s and out’s of imputed income. In this article, we examine what imputed income means, provide some examples of imputed income, and how to report imputed income.

Team Communication Best Practices for Remote Work

Facing the need to run your business remotely? Discover how to facilitate remote team communication, and which strategies and tools work best!

The post Marginal Revenue: Your Key to Smarter Pricing Decisions appeared first on Everhour Blog.