How to Use the Formula for Marginal Revenue (With Examples)

By Indeed Editorial Team

Published 31 May 2022

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Financial experts can use marginal revenue to estimate the performance of a business. This metric can also enable businesses to identify when their total revenue increases. Understanding how to use the formula for marginal revenue can help you generate valuable insights into how a company's sales impacts its finances. In this article, we define what the marginal revenue formula is, provide steps on how to use it, explain when you can apply it and offer examples using the formula that you can reference.

What is the formula for marginal revenue?

The formula for marginal revenue is a technique that finance professionals can use to estimate the income a company generates for each additional unit of sale. Companies can use this information to balance the value of their output with production costs to help maximise income. The increase in marginal revenue is often lower as the output of a business increases.

For very competitive businesses, the marginal revenue can refer to the cost of continued production until the marginal revenue is equal to the marginal cost. The marginal cost is the change in production cost that an organisation experiences from producing one extra unit. You can define the marginal revenue formula using these two expressions:

Marginal revenue = Change in revenue / Change in quantity

Marginal revenue = (Current revenue - Initial revenue) / (Current product quantity - Initial product quantity)

How to use the marginal revenue formula

You can calculate the marginal revenue using the following steps:

1. Determine the total revenue

You can calculate a company's total revenue by estimating the number of products they sold within a specific time. Determining the average price of each product allows you to get the total sales value. You can get the total revenue by multiplying the average price per product with the number of products they sold. The formula to calculate a company's total revenue is:

Total revenue = Price of each product x Number of products sold

For example, a bakery sells loaves of bread for $100 each and sold 1,000 products in a certain year. The total revenue of the bakery is:

Total revenue = $100 x 1,000 = $100,000

Related: What Is Gross Margin? (Plus Steps for Calculating It)

2. Analyse the market

A market analysis can be a comprehensive evaluation of the market to determine the suitability of a product or service. Studying the market can determine a company's potential benefits and identify inherent risks of venturing into a target market. You can use a market evaluation to forecast how a company's product may perform compared to the products of competitors.

A business can precisely evaluate a market to determine the effect of using an alternate price for a product. This forecast can also include the impact of selling a different number of products to the same customers. Identifying the prices of competing items can also help a company identify a suitable product price range. If a business sells more of its commodities or services at a lower value, the demand for the product usually increases.

Related: Business Analyst Skills (With Examples and a Guide)

3. Find the alternate sales revenue

After analysing the market and determining the new price and sale quantity, you can use the figures to calculate the alternate revenue. The alternate income depends on the alternate product price and the alternate number of units the business may sell. You can express this potential revenue using this formula:

Alternate revenue = Alternate price x Alternate sales

For example, after conducting a market evaluation, the bakery sets an alternate price of its bread loaves to $80 and estimates selling 1,200 a year. The alternate revenue the business may generate in this situation is:

Alternate revenue = $80 x 1,500 = $120,000

4. Apply the expression for marginal revenue

A company's change in revenue is the difference between its previous revenue and the alternate revenue. The value difference between historical sales and alternate sales is the change in quantity. You can derive a company's marginal revenue by dividing the change in revenue by the change in quantity. The bakery's marginal revenue is:

Marginal revenue = ($120,000 - $100,000) / (1,500 - 1000) = $40

When can you use the marginal revenue formula?

You can apply the marginal revenue formula in the following situations:

Evaluating the income from each unit sale

Selling additional units of goods or services can increase total and marginal revenue. The company's revenue may increase, but the cost of production can also increase, which affects profit margins. Understanding marginal revenue can help measure the increase in total revenue compared to the rise in production cost. Organisations can use the marginal revenue formula to determine when an increase in additional sales units yields minimal benefit.

If a business makes more money from providing extra services, it can earn a profit when the marginal value is above the production cost. When the marginal revenue is equivalent to the marginal cost, there may be zero benefits in producing and selling more units.

Understanding customer demands

You can use the marginal revenue to understand how sales and market demand relate. This figure can also provide you with insight into the influence of competitors on the market. An increase in sales may result from a product satisfying a customer's needs. The emergence of new competitors or shifts in the needs of consumers may cause changes in demand. You can define a market's demand as how much interest consumers show in a product or service. In a market with perfect competition, the company may increase sales without decreasing a product's price.

In such a market, the marginal revenue can be equal to the product price because there's enough demand. Monopolistic markets may require a decrease in the item price to generate more sales. The drop in the product value may arise from the inability of new organisations to compete with the significant demand held by a company with a monopoly. This unfair competition often results in lower profit for companies competing against established monopolies.

Maximising profit

Businesses can generate more profits by producing more goods or services. This profit creation can occur if the company is certain that the value of producing and selling additional units doesn't result in an excessive increase in costs. By analysing the marginal income and expenditure, organisations can determine the maximum amount of profit they can achieve with a product. Profit maximisation occurs when the marginal revenue is equal to the marginal cost, so a company's goal can be to increase production and sales until the income and expenses from additional products are equivalent.

Related: What Is a Profit and Loss Statement? (With Types and Steps)

Examples of marginal revenue calculation

Here are examples you can refer to when calculating marginal revenue:

Restaurant

Here's an example of a restaurant calculating its marginal revenue:

A restaurant increased the number of its private catering services by 50 in the past year. The cumulative revenue from the increase was $4,000. The marginal revenue is:

4,000 / 50 = $80.

Bike store

Here's an example of a bike store calculating its marginal revenue:

A children's bike shop assembles 300 bicycles every year and sells them at $100 per bike. This sale gives the store a total revenue of:

300 x 100 = $30,000

After noticing a change in the market demand, the shop owner estimates they can sell over 300 bicycles by dropping the price to $90. You can express the change in revenue as

400 x $90 – 300 x $100 = $6,000

The change in sales is

400 – 300 = 100

The marginal revenue of using the new price is $6,000 / 100 = $60.

Marginal revenue vs. other business metrics

Here are comparisons between marginal revenue and related metrics that you can use to estimate a company's performance:

Marginal revenue vs. total revenue

Marginal revenue represents the increment of increased income in selling more of a company's goods, while the total income is the total sales of products. A company's total earnings can include revenue from sales, interests, dividends and investments. Marginal revenue relates to the total revenue as it measures how much the cumulative earnings changes by selling one extra product.

Marginal revenue vs. marginal cost

Marginal cost relates to the expense a company incurs when producing and selling an additional product. If the marginal revenue is lower than the marginal cost, a business may experience losses from increasing its production and sales. If the two metrics are equal, a company is theoretically generating maximum profits from their target market within the context of existing economic conditions.

Related: What Is Fixed Cost and What Is Its Business Application?

Marginal revenue vs. average revenue

Average revenue is the average sale price of a company's products. A company can estimate its average revenue by dividing its total returns for a year by the total products it sold in the same year. When the marginal revenue equals the average revenue, it may show that an organisation's product price is the same regardless of production and sales numbers.

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