Knowing when to up the price of your product or service is no easy feat. There are a lot of factors to take into account, including outgoing costs, financial performance, and market demand.
And if you make changes at the wrong time, you risk losing customers to competitors.
To make this process a little easier, you might want to try using the marginal revenue formula.
If you’re not familiar with it, don’t worry. In this article, we’ll look at the ins and outs of the marginal revenue formula and how you can use it to scale your business.
But before we get into the thick of it, let’s clarify what marginal revenue actually is.
What is marginal revenue?
Marginal revenue is the amount of revenue generated from selling extra units of a product or service. It’s used to calculate the financial benefits of producing a higher quantity of products.
Let’s use an example to demonstrate.
Imagine that you sell your first 50 units for $10 per product. You priced your products at $10 each based on your production costs and desired profit margin.
On top of the initial 50 units, you sell an additional 5 products for $10 each. This is the marginal revenue. With this information, you can make informed decisions about pricing and production costs.
Marginal revenue changes depending on the change of production price of the additional unit. To decide whether a production change is cost-effective, businesses will weigh up the revenue increase or decrease with the original output. This will then be compared with the new projected output.
For instance, if a business changes one or more parts of its production process, it can use the marginal revenue to determine the selling price.
Businesses can also use marginal revenue to determine when and how to incrementally up their sale price. This is often used to compensate for higher production costs without affecting the demand curve or the number of units sold. A lot of businesses do this in highly competitive markets.
What is the marginal revenue formula?
The marginal revenue formula (sometimes known as the sales revenue formula) divides the change in total revenue by the change in total output quantity.
Here’s how the formula is displayed:
Using this formula, businesses can accurately identify the marginal revenue.
Marginal revenue and marginal cost
Marginal cost is the additional cost required to produce an additional item.
So if you sold five additional units for $50, the marginal cost is the price paid to produce each additional unit.
As long as the marginal revenue is higher than the marginal cost, businesses will be making a profit. When the marginal cost is higher than the marginal revenue, the business should consider stopping production or sales or risk losing money.
What is the marginal revenue curve?
The marginal revenue curve represents the relation between marginal revenue (revenue generated by additional units sold) and the number of units sold.
You’ll need to produce the number of units found at the intersection between the marginal revenue curve and the marginal cost curve to maximize profit.
Various changes to the marketplace can cause the marginal revenue curve to shift, so it’s important to track it regularly. The curve will also change depending on whether you’re operating under perfect competition or imperfect competition.
Let’s look at this in more detail.
In this situation, multiple companies are operating in the same marketplace.
When a single company changes its supply, it doesn’t impact the total price in the market. Because there are so many companies operating in this marketplace, companies will always get the same price for every unit. To price too high would mean losing customers to fairly-priced competitors.
As a result, companies set their unit prices level to their marginal revenue.
Here’s an example of a marginal revenue curve under perfect competition.
As you can see, the marginal revenue is a straight, horizontal line that represents the standard market price.
Under imperfect competition (sometimes known as a monopoly), one company dominates the market. Changes in its product line and level of output can impact market prices and the industry as a whole.
Simply put, the price and number of units are determined by the monopolist. They’ll make their decision based on how best to maximize profits. In most markets, the monopolist will lower its price to increase output.
With a monopoly, the price of units lowers every time the company increases its output. Other companies will then need to lower their prices to sell more units, which can diminish the marginal revenue.
In this situation, the marginal revenue is on a downward slope. Here’s an example:
As you can see, the marginal revenue sits under the demand curve. The gain from selling more units is lower than the market price.
What is average revenue?
The average revenue per user (ARPU) is the average price a customer pays for one unit. You can calculate the average revenue by dividing your total revenue by the quantity sold:
Using the average revenue formula, businesses can estimate their profits and make informed business decisions. Here’s how it can help:
- It calculates the number of units a company should produce to maximize profits.
- It considers other expenses, such as sales and marketing budgets and the cost of materials.
- It identifies any areas where businesses are making a loss.
With all this information, businesses have a better understanding of their financial health and how to allocate their resources.
Marginal revenue vs. average revenue
Marginal revenue and average revenue are similar concepts. It’s for this reason that people often confuse the two formulas.
Figuring out which formula to use depends on what you want to measure.
Marginal revenue measures the relationship between change in total revenue and quantities sold. For this reason, it should be used to identify when it’s the best time to up your production efforts.
Average revenue doesn’t take changes into account and is a bit more rigid in its structure. If you want to determine how to price your products, use average revenue.
Why is marginal revenue important?
Now that we’ve covered a lot of ground and clarified what marginal revenue is, let’s look at some of its main advantages.
Maximize earnings and profit
To grow your business, you need to increase your revenue. Period. Without additional money coming in, you won’t have the resources you need to expand successfully .
This is where marginal revenue can help.
The marginal revenue formula measures the increase in revenue from selling more products. It allows businesses to analyze options to maximize earnings while preserving savings.
For example, if your marginal revenue is growing, you know that you need to think about upping your production and reviewing your prices. This is also known as a cost-benefit analysis.
But without marginal revenue, you might not be able to compare production costs with revenue so easily. This means you could miss an opportunity for growth and overlook increasing customer demand.
Make informed decisions about production
Understanding your marginal revenue helps you make informed business decisions.
Think about it. When you’re tracking the marginal revenue, you’re measuring the increase in revenue from selling more units. With this information, you can make informed pricing and production decisions that help your business succeed.
Without this information, your business decisions could lack alignment and direction. Somewhere down the line, this could result in a pretty sticky financial situation for your company.
Meet consumer demand
Using the marginal revenue formula, you can identify if and how it's financially viable to offer products that meet consumer demand.
But why is it important to meet consumer demand?
Understanding consumer demand allows you to provide customers with the products and services they’re looking for. It keeps them happy and helps your business grow.
If you’re giving customers what they want, they’ll have a good perception of your brand. And when a customer has a good relationship with your brand, they’re more likely to buy from you. 71% of consumers will buy from a brand they trust.
By understanding your marginal revenue, you can see when consumer demand is growing and prepare your business to meet customer needs. In doing so, you’re building a rapport with your target market and encouraging them to buy from you.
How to reduce production costs to increase the marginal revenue and grow your business
You know what marginal revenue is and how to use it. Now, it’s time to think about how you can put the marginal revenue into action and grow your business.
A good place to start is by reviewing your production processes and costs.
Because with lower production costs, you’re far more likely to see an increase in the marginal revenue. And when the marginal revenue starts to increase, you can look at increasing your output and upping your prices — both of which will help your business grow and succeed.
So keep reading to familiarize yourself with some efficient ways you can reduce your production costs and increase your marginal revenue.
Review your current production process
We’ll start by looking inward and optimizing your existing processes. This is a great way to reduce your costs and streamline your production process.
To get yourself started, here’s what we’d suggest:
- Review your current process as a whole. Spend some time reviewing how your production process works. Look at how many people are involved, how long it takes, the systems and materials that are used throughout — all of this information will give you a clear picture of how things move from A to B.
- Identify areas of improvement. Now that you’ve got a handle on the process, you can identify areas of improvement. Perhaps there’s part of the process that could be automated or an area where you can cut costs on materials? This is your chance to find out where you can reduce costs.
- Get feedback from your team. When you’ve figured out what you’d like to change to bring costs down, get feedback from your colleagues — both managerial staff and other team members. You’ll need people who work in the production process to agree that your changes will work, and you might need a high-level manager to sign off on the idea.
- Implement changes. When you’ve got the green light, it’s time to roll out your new changes to the production process. Make sure you notify everyone involved, so they’re prepared for any changes. Once it’s live, make sure to monitor progress continually. If things aren’t going to plan, you’ll need to step in and put things right.
Upgrade or change your existing software
In a world where almost 27% of businesses are predicted to work remotely, technology plays a pretty important role in the day-to-day running of business operations.
But how cost-efficient is your technology?
It’s not uncommon to stick with a piece of software because you’re used to it. You get comfortable and forget that there might be other options better suited to your needs and budget.
So spend some time looking at the software you’re currently using and compare it with what else is out there. In doing so, you might find something that saves you money and provides you with a better service.
Negotiate with your suppliers
If you can reduce your outgoing costs for materials or services, you might see an increase in marginal revenue.
Negotiating prices can be tricky, especially with suppliers that already feel they’re giving you a good deal.
Here’s some advice for trying to negotiate:
- Ask for bulk discounts. If you don’t already have a bulk discount with your suppliers, ask for it. It makes sense for both of you in the long run: You’ll get a cheaper deal per item, and the supplier has a guaranteed sales volume. This gives them more time to focus on selling their product to other customers, as well as the ability to plan their storage options more effectively.
- Sign up for a long-term contract. Show that you're serious about sticking around for the long haul and sign up for a long-term contract. That way, your supplier knows that they’ll get a regular, steady income from you (even if it is at a slightly discounted rate).
- Talk to various suppliers. Don’t feel obligated to your existing supplier. Spend some time shopping around and see what else is out there. You might find yourself a better deal simply by looking. And if you do, you can always return to your existing supplier with better rates and see if they’ll match it.
Attract more customers
As we already know, marginal revenue increases when the revenue received from an additional unit of sale grows faster than the cost of production.
Getting more consumers to purchase can help you reach that extra unit sale and increase your marginal revenue.
But reaching new customers is easier said than done. Not to mention, the best way to attract new customers varies from business to business. What works well for one company might not be the best bet for you.
Ultimately, it’s up to you to figure out how best to reach your target audience and encourage them to make a purchase.
Whether you offer unique deals and discounts with promo codes for new customers or use promotional marketing to reach more customers — only you’ll know the best way to attract your target audience.
Put your marginal revenue knowledge into action
Using the marginal revenue formula is never a linear process. Unless your prices never change and the marketplace stays the same, your marginal revenue will fluctuate. Depending on how it looks at any given time will determine where your focus needs to be.
If marginal revenue is high, take a look at expanding your production efforts. If it’s low, think about what you can do to increase it.
At this stage, you should have a pretty sound knowledge of the marginal revenue formula and how to use it. Now, it’s time to review your marginal revenue and figure out where your business stands.
If things are looking good and you want to attract more customers, take a look at the discounts other companies are offering on the CouponFollow website. You might find some inspiration for your own deals and offers.