Marginal profit definition
/What is Marginal Profit?
Marginal profit is the difference between the marginal revenue and marginal cost associated with a sale transaction. Thus, it is the incremental profit gained from generating one additional sale. Generally, a business should continue producing units as long as there is a marginal profit to be gained from each additional sale. As a business reaches the upper end of its available production capacity, it becomes more expensive to produce goods, since maintenance and overtime costs increase; this increase in costs typically minimizes the additional incremental sales volume that can be achieved.
A key management decision is whether to increase capacity when all available production volume has been used up; a key part of this decision is the amount of marginal profit expected to be earned from the additional capacity.
Example of Marginal Profit
Inscrutable Corporation’s managers are trying to decide whether to sell one additional unit of its Inscrutable Software, which is used to automate the interactions of its customers with their clients. A major customer wants to increase its seat license by one more seat, and is offering to do so at an incremental cost of $100. Inscrutable normally charges $1,000 for each incremental seat. In this case, the company incurs only $10 to record the extra seat license in its records - otherwise, there is no incremental cost associated with the proposed deal, so Inscrutable would generate a marginal profit of $90.
While this example shows that the seller will generate a marginal profit at almost any price point, a major concern is whether allowing such low pricing will damage the customer’s perception of what they are receiving. From a brand management perspective, it may make sense to keep the per-seat price relatively high.
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How to Improve Marginal Profit
There are a number of ways to improve the marginal profit of a business, including the following:
Optimize pricing strategies. If demand is relatively inelastic, raising prices can increase revenue without significantly reducing sales. Or, offer discounts selectively, targeting customers who are more price-sensitive, while maintaining higher prices for less price-sensitive segments.
Reduce marginal costs. Improve your production efficiency through process optimization, automation, or adopting lean manufacturing principles. In addition, work to secure lower costs for raw materials or negotiate better terms with suppliers.
Target high-margin products. Shift your focus to selling higher-margin products or services. For example, create bundles that combine high-margin products with lower-margin ones to increase overall profitability.
Adjust marketing strategies. Use data analytics to target marketing efforts more effectively, reducing acquisition costs and increasing conversions. Generally, focus on retaining existing customers, as it’s typically cheaper to keep a customer than acquire a new one.
Manage inventory and waste. Minimize overproduction and spoilage in the supply chain. In addition, implement inventory systems that reduce holding costs and ensure materials arrive as needed.
By implementing these strategies, businesses can improve their marginal profit, ensuring sustainable growth and a stronger competitive position.