As a business grows, its revenue typically follows suit. However, further growth results in diminishing returns at a certain point.
In order to continue growing, the company must identify new sources of revenue or find ways to produce and sell their products or services more efficiently. This is where it becomes important to understand marginal revenue and how to calculate it.
By understanding and taking advantage of marginal revenue, businesses can continue growing while maximizing profits. Below you will find all you need to know about marginal revenue and how to calculate it.
Marginal Revenue Definition
Marginal revenue is the increase in total revenue generated by selling one more unit of a product or service. It can be helpful for businesses to identify which products or services offer the highest marginal revenue, as these are likely to be the most profitable items in their portfolio.
Those in the field of microeconomics use the term marginal revenue to show the change in total revenue resulting from producing one more unit of a good or service.
This metric is calculated by dividing the change in total revenue by the change in quantity produced. Here’s the formula for marginal revenue:
Marginal Revenue = Change in Revenue / Change in Quantity
Let’s say a subscription box typically sells 50 boxes a month for $2,000 at a price of $40 per box. And since it costs the business $20 to produce a box, the company earns $20 per box.
Now, suppose the company runs a 30% off promotion to acquire new customers. This offer enables the company to sell 70 units and earns a revenue of $1,400.
To calculate marginal revenue, we’ll take the change in revenue and divide it by the change in quantity:
Marginal Revenue = 1,400 / 70 = $20
In this instance, each unit sold adds $20 to the company’s revenue—which is the same as the revenue added when they’re not running a promotion. The subscription business takes this insight and decides not to run the same promotion in the future, because it doesn’t add significant value to the bottom line.
Why It’s Important to Track Marginal Revenue
Understanding marginal revenue helps businesses make more sound decisions about pricing and production. With this information accurately tracked, businesses can forecast the potential gains of making more products or adding additional merchandise or services. It also helps to determine how much can be charged for a product without losing customers.
You can approach additional revenue streams with peace of mind through your marginal revenue calculations. To sell additional items, you need to confirm those items will be profitable and under what conditions.
Marginal Revenue vs. Average Revenue
With all the terms, it can be confusing to understand what each refers to. But there are distinct differences between marginal revenue and average revenue.
Marginal revenue is what you earn from selling an additional unit of product (or service). Average revenue is how much money you make, on average, for each unit you sell.
Say, for example, you have a lemonade stand and sell 100 cups of lemonade. Your marginal revenue is what you make from selling the 101st cup. If that yields $2, then your marginal revenue is $2. Average revenue is what you make from all 100 cups of lemonade. So if each cup cost $1 and you made a total of $100, then your average revenue would be $1 per cup.
Marginal Revenue vs. Total Revenue
Total revenue is the amount of money you make from selling all the products that you have.
For example, if you sell ten products at $10 a pop, your total revenue will be $100. We understand now that marginal revenue is the amount of money you make from selling one more unit of a product.
To increase your total revenue, you could do one of two things: sell more products and/or sell products at a higher price.
Marginal Revenue vs. Marginal Cost
Marginal cost is how much it costs you to produce one more unit of whatever it is that you’re selling. Marginal revenue, as we know, is what you earn from selling one more unit of your product or service.
Assuming that your business is selling a product, marginal revenue is calculated by finding the difference in total revenue when one more unit of the product is sold. This can be done by looking at the sales data from previous periods and observing what happens to total revenue when an extra unit is sold.
On the other hand, marginal cost is calculated by finding the difference in total cost when one more unit of the product is produced. This can be done by looking at the cost data from previous periods and observing what happens to total cost when the number of units is increased.
Where marginal revenue is greater than marginal cost, it’s optimal to produce and sell another unit of the product since this will increase total revenue and, hopefully, profits.
If marginal revenue is less than marginal cost, then it doesn’t make sense to increase your level of output and sell another unit of the product since this will only increase losses. In this case, it might be better to stop selling the product altogether.
If marginal revenue equals marginal cost, producing more would have a negligible effect on profit maximization efforts.
How to Get Marginal Revenue Increase
Marginal revenue can be improved by increasing consumer demand for the good or service and/or decreasing the cost of production. A few examples include:
- Offering discounts or promotions to increase demand
- Improving production efficiency to reduce additional costs
Both of these methods may increase marginal revenue. However, in order to decide which method would be most effective, other factors would need to be considered. For example, if demand for the good or service is relatively inelastic, then decreasing production costs would be more effective in increasing marginal revenue.
Other methods of improving marginal revenue exist. The most appropriate one depends on the specific context within which the business operates. For example, in perfectly competitive markets, marginal revenue is equal to the price. This is because when a new seller enters the market, they can’t raise prices since all of the other sellers would also sell at that higher price.
Accounting and Recognize Marginal Revenue
As with all business metrics, proper tracking and reporting of your marginal revenue is critical. For businesses that sell products that immediately land on their customers’ hands (e.g., retailers), recognizing revenue (including marginal revenue) is pretty straightforward since the transfer of goods happens at the time that the revenue is earned.
On the other hand, SaaS companies and subscription businesses may find it a bit trickier to recognize revenue, as these entities must comply with ASC 606—an accounting standard that stipulates that income can only be recognized as revenue when the product or service’s value is received by the consumer.
Revenue recognition doesn’t happen until after the company’s contractual obligations are fulfilled. And in the case of SaaS and subscription businesses, this typically happens at the end of the customer’s billing cycle, once their subscription has been used up.
Tools such as Stax Bill can make revenue recognition much easier. As the only fully ASC 606 compliant platform, Stax Bill streamlines your billing and accounting processes by ensuring revenue is only recognized once your contractual obligations are met.
With Stax Bill, you can rest easy knowing that your business fully complies with ASC 606 and your accounting practices are always in check.
The Bottom Line
All the world’s leading businesses use marginal revenue calculations to understand their business and market and how they can react quickly to changes. Tracking and monitoring this financial data lets you see the present and the future. With that, you can better plan for a competitive advantage.
For payment processing software that helps you gather quality sales data, get in touch with the team at Stax. We support growing businesses with the tools they need to monitor, measure and improve their profitability.
