<p>Rock solid financial planning includes a good understanding of Marginal Cost. &nbsp;&nbsp;If you are unaware of how it affects the bottom line, it can turn that boffo box office sale into the dead weight that drags the net income into the dreaded red ink zone.</p> <p>Month in and month out, an employee and you have been churning out 100 pet rocks per month.&nbsp; However, you get the midnight call from a boutique, they would like an extra 100 pet rocks that month as a thank you gift to their best customers.&nbsp; You are over the moon!&nbsp; You say yes! YES! YES!&nbsp; After you hang up the phone, you do the happy dance.&nbsp; Then the following morning, as you begin contacting your suppliers to purchase the materials, it occurs to you, how much is that going to increase the expenses?&nbsp; Did it really matter that you agreed to a 10% price reduction for the bulk order?&nbsp; Will you be giving those pet rocks away?&nbsp;</p> <p>This budget calculation can be complicated, but if you break it down piece by piece it can figured out.</p> <p>First is the Marginal Revenue which is the amount revenue from selling one additional unit.&nbsp; So in this case, the Marginal Revenue is the ninety percent of the normal selling price.&nbsp; Not too hard to calculate, so let&rsquo;s move onto Marginal Cost.</p> <p>Marginal Cost is the tricky part of the equation.&nbsp; It is the cost to produce one more additional unit.&nbsp; Sounds like fancy CPA talk?&nbsp; Doesn&rsquo;t it?&nbsp; &nbsp;Let&rsquo;s break it down into its components.</p> <p>Marginal Costs are made up of Fixed and Variable Costs.&nbsp; Increases in Fixed Costs are often responsible for most of the red ink, so let&rsquo;s start with that.</p> <p>Fixed costs are typically things like Rent, Copier rentals, maintenance agreements, salaried employees, and their payroll taxes, etc.&nbsp; Normally, these items do not vary from month to month. &nbsp;&nbsp;For example, the rent on your small studio is $500.00 per month.&nbsp; If you produce 100 pet rocks that month, how much more would it cost to produce unit number 101?&nbsp; Zero.&nbsp; &nbsp;The studio will have the necessary space to manufacture that unit.</p> <p>Remember the definition above, the increase in cost to produce one more additional unit. &nbsp;&nbsp;What if at unit number 150 additional space is needed?&nbsp; You negotiate a good price with your neighbor.&nbsp; You can use their studio for $200.00.&nbsp; Therefore, at unit # 150, there is an increase of $4.00 per unit. ($200/50 Units = $4.00/unit)&nbsp;</p> <p>Marginal Variable costs increase incrementally with increased production.&nbsp; Examples of variable costs are direct materials, hourly labor, payroll taxes, supplies, and electricity.</p> <p>An example is an employee who takes one hour to complete one pet rock. &nbsp;&nbsp;If you produce 4 pet rocks, he works for four hours.&nbsp; If you produce 12 units, he works for 12 hours.&nbsp; (To keep it simple, let&rsquo;s assume that the one hour per pet rock includes all coffee breaks and lunches.) &nbsp;After he works 8 hours, he is entitled to overtime.&nbsp; He is willing to work an extra 4 hours that day.&nbsp; So the variable labor costs for those extra four units are 1.5 times the normal hourly rate. &nbsp;&nbsp;Those four pet rocks with have a higher Margin Variable Cost due to the extra overtime and payroll tax expense.</p> <p>Variable costs also include direct materials.&nbsp; It requires one rock, paint, glue, and two googly eyes to create one Pet Rock.&nbsp; It also requires cleaning fluid, scrubbing brushes, and other supplies to prepare the rock for painting.&nbsp; Some types of direct material are pretty consistent on a per unit basis, so will require less examination.&nbsp; But, be careful to consider the available supply of direct materials.&nbsp; For instance, if it is required to overnight most of the rocks from the quarry, it would increase the direct material cost.&nbsp;</p> <p>Are you still with me? Good!&nbsp; The next part is easier in a spreadsheet.&nbsp; I like envelopes too, but you may run out of room for this.</p> <p>The first time that you do this, it is easier to label rows one to one hundred in the first column.&nbsp; In the second column enter the Marginal Revenue.&nbsp; In the third column enter the increases in Fixed Marginal Costs.&nbsp; If we use the previous example, enter $4.00 per unit starting at unit #150.&nbsp;&nbsp; Do you know your normal variable cost?&nbsp; Good!&nbsp; Enter that in the fourth column.&nbsp; In only those units with higher variable costs, in the fifth column enter the increase in variable costs, such as overtime and any associated payroll taxes, etc.&nbsp;</p> <p>Calculate the Marginal Profit for each unit by subtracting all of the costs from the Marginal Revenue.&nbsp; Did you notice something?&nbsp; Typically in a large production increase, the last units are the most expensive to manufacture.&nbsp; The trick is to know when the Marginal Profit turns negative, so you can effectively plan a strategy to ramp up production. &nbsp;This type of analysis will help keep you from being between a rock and a hard place, when you receive the next boffo box office order.</p> 2009-08-10T23:06:56Z -4.0156 308 5874 true 10 36154 budget-large-sales-increases-with-marginal-revenue-and-marginal-cost 1 2009-08-13T15:27:09Z 2009-08-13T22:27:27Z

Rock solid financial planning includes a good understanding of Marginal Cost. It can turn that boffo box office sale into the dead weight that drags the net income into the dreaded red ink zone.

1 2009-08-13T22:27:28Z