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.