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.
TL;DR
- 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.
- The formula for how to calculate marginal revenue is: Marginal Revenue = Change in Revenue / Change in Quantity
- You can improve marginal revenue by increasing consumer demand for the good or service and/or decreasing the cost of production.
What is Marginal Revenue?
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.
To get academic, this is known as the marginal revenue curve. Key characteristics of the marginal revenue curve include:
- The slope of the curve reflects the rate at which total revenue changes as output increases. In competitive markets with perfect competition, the marginal revenue curve is typically downward-sloping due to diminishing returns and the need to lower prices to sell additional units. In monopolistic markets, the shape of the curve may vary based on factors such as market power, demand elasticity, and pricing strategies.
- The marginal revenue curve is closely related to the demand curve for a product or service. In competitive markets, the marginal revenue curve is often below the demand curve because firms must lower prices to sell additional units, leading to diminishing marginal revenue. In monopolistic markets, the marginal revenue curve may coincide with or intersect the demand curve at various points depending on factors such as pricing power and market structure.
- The marginal revenue curve is used to determine the level of output that maximizes profit. Profit maximization occurs where marginal revenue equals marginal cost (MR = MC). You should continue producing additional units as long as marginal revenue exceeds marginal cost, but will stop when marginal revenue equals marginal cost.
- The elasticity of demand influences the shape and slope of the marginal revenue curve. Inelastic demand results in a steeper curve, indicating that small changes in quantity sold lead to larger changes in total revenue. Conversely, elastic demand results in a flatter curve, indicating that changes in quantity have a smaller impact on total revenue.
- Changes in market conditions, such as shifts in demand, can cause the marginal revenue curve to shift. For example, an increase in demand for a firm’s product will shift the demand curve to the right, leading to higher marginal revenue at each level of output.
How Do You Calculate Marginal Revenue?
Marginal revenue is calculated by dividing the change in total revenue by the change in quantity produced. Here’s the marginal revenue formula:
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.
For calculating 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 profit 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
Before you implement anything, you’ll need to start with your data. Analyze customer behavior, purchase patterns, and market trends to identify potential areas for growth. Understanding your customers’ preferences and pain points allows you to identify gaps in your marketing and product offering.
Now let’s talk about actionable strategies for your business to increase marginal revenue.
Optimizing your pricing strategy
Pricing is a powerful lever for increasing marginal revenue. Three common pricing strategies that can increase marginal revenue are:
- Dynamic pricing (sometimes called surge pricing or market demand-based pricing) is a strategy of adjusting prices in real-time based on various factors such as demand, supply, and customer behavior. Uber is a great example of a company that uses dynamic pricing. Employing dynamic price changes often entails using algorithms to adjust prices in response to market conditions and customer dynamics. However, not all dynamic pricing strategies need to be so technologically driven. Restaurants, for instance, often offer meat and fish dishes at “market price”, which changes with how much the cut of meat costs them that day and requires no additional technology (beyond perhaps an excel sheet) to set.
- Value-based pricing is a strategy where product prices are determined based on the perceived value they deliver to customers rather than solely on production costs or market benchmarks. By highlighting the unique value propositions and positioning them as superior solutions, you can justify premium pricing.
- Segmented pricing is a strategy where businesses set different selling prices based on various customer segments, demographics, or purchasing behaviors. This approach recognizes that different customers may have different levels of willingness to pay and allows businesses to capture additional value from each segment.
Improve your customer retention
Acquiring new customers is important, but retaining existing ones can be even more lucrative. 84% of companies that invest in customer experience see an uplift in revenue. Loyal customers tend to spend more over time. Invest in building strong relationships with your customer base through personalized communication, exceptional customer service, and loyalty programs.
One tried-and-true way to increase customer retention is simply to improve your communication with previous customers. Email and SMS marketing offer highly scalable and effective options to communicate with your customers.
Expand your product line
Diversifying your offerings allows you to capture additional revenue streams. Identify complementary products or services that cater to unmet customer needs. Launching new products or variations can entice existing customers to make additional purchases while attracting new ones who may be interested in your expanded portfolio.
An example of this is how many makeup brands have added skincare lines over the past few years as skincare has seen a boom. Adding an additional category allows these brands to remain relevant as trends change, but it also enables them to increase sales with existing makeup customers and reach a new set of customers who don’t wear makeup at all.
Common Challenges with Increasing Marginal Revenue
Increasing marginal revenue, while crucial for business growth, is not without its challenges. Here are some common hurdles businesses may face:
Common external challenges
Market saturation can be an issue for companies looking to expand their product offerings. In highly competitive markets, finding new growth opportunities can be challenging. Existing brands may already have a strong foothold, making it difficult for new companies to break out and differentiate themselves.
Price sensitivity is an issue that companies looking to optimize their pricing strategy face. In many markets where alternatives are readily available, customers are highly price-sensitive. Increasing prices to boost revenue may lead to resistance from customers, potentially resulting in decreased sales volume or market share. This is a common problem that any eCommerce business faces thanks to Amazon’s ability to undercut almost any price.
The solution for both of these challenges is the ability to differentiate your offering with any of these:
- A better quality product than competitors
- An incredible customer experience customers can’t get elsewhere
- An innovation – even a small one – on the product
Common internal challenges
Resource constraints are a challenge for nearly any business, but especially small businesses. Limited resources can hinder efforts to expand operations, develop new products, or invest in marketing initiatives aimed at increasing revenue.
Generally, solutions for resource constraints come down to creativity, but a few specific to-dos include:
- Prioritizing investments. Assess the potential return on investment (ROI) for various initiatives and prioritize those that offer the greatest impact on revenue growth with the resources available. Focus on high-impact projects that align with strategic objectives and have the potential to generate significant returns in the short to medium term.
- Outsourcing. Identify non-core functions or activities that can be outsourced to cheaper third-party providers.
- Invest in technology. There are many software solutions today that can streamline time-intensive manual activities, freeing up your people to focus on tasks that will actually grow your revenue.
Inefficient internal processes can also seriously impede efforts to reduce costs, limiting the potential for revenue growth. The most basic solve for this is to invest in a third-party audit of your processes so that you can confirm what’s working (or not working) and then leverage their expertise to improve the process.
Accounting and Recognizing 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.
FAQs about How to Calculate Marginal Revenue
Q: What is marginal revenue?
Marginal revenue is the additional income generated from selling one more unit of a good or service. It’s a critical metric in economics and business, helping firms determine how changes in production and sales affect their overall revenue.
Q: How do you calculate marginal revenue?
You can calculate marginal revenue by using this formula: Marginal Revenue = Change in Revenue / Change in Quantity
Q: What is considered a good marginal revenue?
A “good” marginal revenue is context-dependent and varies by industry and market conditions. Generally, it’s positive, meaning that selling an additional unit is profitable. It should at least cover the marginal cost of producing one more unit to sustain business operations.
Q: How can businesses improve their marginal revenue?
Businesses can improve their marginal revenue through various strategies such as optimizing pricing, enhancing product quality, diversifying product lines, and targeting the right market segments. Effective cost management and increasing operational efficiency are also crucial.
