Businesses use many financial indicators to monitor profitability. Of these, the marginal rate of return is one of the most valuable tools for a company to determine the most profitable level of production. Relatively simple to calculate and to understand, the indicator conveys a wealth of knowledge in one easy number.
The marginal rate of return refers to how much revenue per extra item a company can expect to gain for each extra dollar more it spends on its production costs.
Defining Marginal Rate of Return
Technically, the marginal rate of return is the marginal return, or the amount of revenue per additional item, divided by marginal cost (the cost per additional item produced). In other words, it's the amount of additional revenue that a business can expect to earn per each additional dollar that it spends on production. Using marginal rate of return, a company can determine whether or not its operations are profitable.
Calculating Marginal Rate of Return
First, calculate the marginal return, or the additional revenue brought in from one additional unit of production. In most cases, the marginal return (or marginal revenue) is equal to the selling price of the item. A company receives the dollar amount of the price in new revenue by producing that one item.
Second, calculate the marginal cost, or what a company must spend to produce an additional unit. The marginal cost would include all the variable expenses that go into producing that additional unit, such as extra materials or hours or labor.
Finally, divide the marginal revenue by the marginal cost to get your marginal rate of return. For instance, if a good has a price, or marginal revenue, of $50, and a marginal cost to produce of $10, then the marginal rate of return is five ($50/$10).
Using This Decision-Making Tool
Marginal rate of return becomes most powerful when it's used as a decision-making tool. As long as a marginal rate of return is greater than one, a company can make a profit by producing one additional unit. Because marginal rate of return tends to decrease as more and more units are produced, a company will maximize its profits by expanding production until its marginal rate is one.
Basically, this is where marginal revenue equals marginal cost. If a company produces beyond this point, the marginal rate of return drops below one, and the company will be spending more per each additional item than it is bringing in in revenue.
Exploring Individual Applications
Marginal rate of return is not only applicable to business decisions; it's also a valuable tool in any individual's decision-making process. For instance, you could use marginal rate of return to determine the best investments for your retirement savings. Also, marginal rate of return doesn't always have to be expressed in dollars or some other currency. For example, you could use a rough calculation of marginal rate of return to determine how to best spend your free time: What activity brings you the most enjoyment at the least cost?