Principle in Brief
Marginal analysis is an important element in good economic thinking that can greatly improve business decisions. It is an effective tool to help us eliminate waste, innovate and discover profitable opportunities.
Marginal analysis asks, “What is the profitability of additional units of production, of one more or less plant, or of a larger versus a more modest investment?” It looks at the benefits and costs associated with a specific change. We call it marginal not because it is unimportant, but because it is incremental, occurring at the margin. This makes it a much more powerful tool than working with averages or totals.
We make most decisions using marginal analysis, which requires understanding the difference between costs and benefits that are incremental and those that are not, such as sunk costs. Only by making decisions on the appropriate margin will a business consistently enhance its profitability and eliminate waste.
When used properly, marginal analysis is an indispensable management tool. For example:
- If we wanted to add a team member, we would determine what more could be accomplished for the incremental cost. If a team member were to leave, we would determine whether the savings of not replacing the employee would exceed the value foregone.
- In a plant with excess capacity, the marginal cost up to full utilization would simply be the incremental cost incurred (which may vary significantly from the average cost), plus any effect on the market. The marginal cost of producing an amount exceeding the capacity would also include the necessary investment.
- In deciding what to do with a poorly performing plant, we use marginal analysis to compare the net present value of continuing to operate with that of shutting it down or selling.
- In considering an innovative new feature or technology, we estimate the remaining resources, risks, time and opportunity cost involved in realizing the benefits. We then determine whether the risk-adjusted potential is high enough to sufficiently overcome these cost factors.
Marginal analysis requires establishing an optimized base case that can be compared to alternatives. An OBC includes known, incremental low-cost improvements. It is essential that the base case be realistic.
Effective marginal analysis requires good knowledge systems. Traditional accounting practices tend to rely on historical transactions, totals and averages, causing unprofitable assets or activities to be hidden or subsidized by those that are profitable – leading to poor decisions. In contrast, when we apply marginal analysis with the appropriate data focused on the profitability of individual customers, products, services, plants, offices, staffing and other assets, we greatly improve decision making.
Understand It Better
The Problem with Averages - Unscripted
De-averaging helps us understand reality and apply marginal analysis so we can achieve superior results.
Marginal Contribution: A Specific Application of Marginal Analysis
An employee’s marginal contribution is the contribution ABOVE OR BELOW that expected of a typical contributor.
A typical contributor is someone who performs at the median of all peers doing similar work.
Marginal Contribution is an application of marginal analysis used during compensation reviews to help assess an employee’s total contribution. Using a typical contributor as the base case, here are some questions to assess an employee’s marginal contribution:
- What would a typical contributor in this role do for the team?
- If this person wasn’t here and a typical contributor was in the role instead, what would be the difference in outcomes this year (including contributions to culture)?
What is Marginal Contribution?
This special application of marginal analysis helps us evaluate how an individual is contributing.
Examples
Marginal analysis helps us better understand reality. Here are some examples to provide a sense of the variety of ways this principle can be applied.
- Hiring
- Analyzing Customer Requests
- Understanding Problems
- Optimizing Production
Sofie’s team has been overworked for months, so she is starting the hiring process. When the recruiter asks if she should hire two or three people instead of one, Sofie evaluates the additional (marginal) costs of adding a second and third person and the potential value they could bring (marginal benefits). She determines that hiring two people makes sense, but hiring three does not.
Mariah is responsible for preparing customer estimates and contracts. When Customer X requested a custom-built feature for their database management system, Mariah initially bundled it into the original estimate. However, she realized that separating the base system cost from the cost of the custom feature—including estimates of how much time the customer would need to spend with their technical team gathering requirements and testing—would help the customer perform marginal cost/benefit analysis for this feature.
Paula is concerned about the increasing amount of overtime at her facility. Reports indicate that average monthly overtime is rising and higher than at other facilities. Paula requests a report that breaks down the overtime data by department and by days of the week. She discovers that much of the overtime is coming from the maintenance department on weekends. Working with others, Paula learns that weekend crews lack the experience to identify and prevent issues, requiring maintenance to be called in most weekends. This knowledge gap isn’t as noticeable during the week when maintenance is readily available. By de-averaging, they understand the root causes and can work to close the gaps.
Harper is reworking facility data to identify each manufacturing line's labor costs, capital, raw materials and revenue (marginal costs and benefits). Harper is surprised to learn that while one line is profitable overall, it is highly profitable when running for two customers but loses money when running for another. The total profit was masking this loss. Harper shares this analysis with the sales and engineering teams so they can work toward making every line and every customer profitable.
Give It a Try
The power of these principles happens through application. There’s no substitute for learning as you apply.
- Identify areas where you or your team looks at averages. How is this useful? What might you be missing by focusing on averages? Brainstorm different margins you might look at instead.
- Identify areas where you or your team look at totals. How is this useful? What might you be missing by focusing on totals? Brainstorm different margins you might look at instead.
- Reflect: Think about a recent decision you made. Did you consider the marginal cost and benefit of the additional time you would spend on it? If not, how can you make this a habit?
- Reflect: Who in your area of work is good at marginal analysis? What are some questions you might ask them to help you improve your skills?
- How deliberate are we about applying marginal analysis to our work? What upcoming decisions would benefit from better applying it?
- In our work, where might averages differ a lot from marginal data? Where are we overly relying on averages or totals to evaluate our performance or make decisions?
- What are some questions that can help us better identify the margins that matter?
- How can we help one another be better at marginal analysis?
- Who are the people we work closely with that can help us better apply marginal analysis?