An important concept to understand when running or analyzing a business is the difference between Marginal and Full Costs. It is impossible to make good decisions on setting prices for goods and services without taking into account what it costs to make them.

Defining Full Costs

All products and services are made up of many components. In order to calculate the full cost of an item, all the inputs must be included:

• Raw materials
• Cost of employees creating the product or performing the service
• Employee benefits if applicable
• Building costs, including rent, mortgage interest, depreciation, and property taxes, etc.
• Income and sales taxes
• Overhead costs, including legal fees, personnel costs, management and accounting

All costs are then divided by the number of units produced to obtain an average full cost. The company needs to generate enough from sales to cover the full cost; therefore the average price should be set high enough to accomplish this.

If, for competitive reasons, the average price cannot be set high enough, then some costs must be reduced, or the company should discontinue the product or service.

Defining Marginal Costs

Marginal cost is identified as the additional cost to create one more unit of a product or service. The term comes from the fact that these costs are on the margin, or after direct costs are covered.

From the above list, raw materials and the cost of employees are usually included in both marginal and full cost. The other items are generally considered fixed, and are not included in marginal cost.

An extra hour of overtime to build one more car adds salary expense, but would not create additional benefits. It rarely requires additional space to make one more pizza in a pizzeria, so rent is usually not figured into marginal cost.

The equation for cost is as follows:

Marginal Cost + Overhead Costs = Full or Total Cost.

Why Is Marginal Cost Important?

Though all companies have to generate enough revenue to cover full costs and a profit margin, once this level is achieved, marginal costing is important to assist in the ability to supply additional profit.
A common example is in the airline industry. Once a plane is in the air, the additional cost to fill one more seat is fairly small. It is advantageous to sell any remaining unfilled seats at any price above marginal cost.

Hotels rooms and cruises work in a similar fashion. It is one reason hotels can offer deals to websites like Priceline or Hotwire. Selling rooms at a discount is only viable after overhead costs are covered, and only at rates higher than marginal cost.

Knowing how companies work gives the consumer an advantage in negotiating lower prices, whether it is for a berth on a cruise ship or the last seat on an airplane.