Marginal Revenue Product (MRP)

What is Marginal Revenue Product (MRP)?

Marginal Revenue Product (MRP) is an economic and financial term that describes the additional revenue a company receives from employing one additional unit of a factor, i.e., one additional worker, machine, or labor hour.

In simple terms, it's the additional income a company receives when it employs one additional "unit" of its production system with other inputs remaining constant.

How Marginal Revenue Product (MRP) is Calculated?

MRP is the product of two factors:

• Marginal Product (MP): The extra output generated due to the introduction of an additional unit of a factor (an additional worker who makes 5 additional widgets).
• Marginal Revenue (MR): The extra revenue from selling an additional unit of product (an additional $10 per unit).

Marginal Revenue Product (MRP) - Formula

MRP = Marginal Product × Marginal Revenue

For instance, suppose one more worker produces 10 more units of a commodity and each one can be sold at $5. Then MRP of such an employee will be 10 × $5 = $50.

Why It Matters?

MRP assists businesses in making informed decisions regarding the utilization of resources. A business will generally employ labor or invest in a resource as long as the MRP for the resource is greater than its cost (e.g., worker salary or leasing charge for a machine). If MRP is below cost, the use of the resource would reduce profits.

Applications in Finance and Business

• Labor Hiring Decisions: Companies make personnel decisions about the number of workers to employ on the basis of comparing the MRP of the worker and his or her pay. If the MRP of the worker is $30/hour but he or she has a wage of $25/hour, then the company should employ the worker.
• Investments in Capital Assets: Companies make decisions about investing in a machine on the basis of approximating the MRP of the machine or its cost.
• Resource Allocation: MRP guides decisions on how to best allocate resources, e.g., whether to invest more in labor, technology, or raw materials.

Limitations

• Makes Constant Conditions Assumption: MRP calculations assume other things (like prices or productivity) don't change, which isn't always the case.
• Diminishing Returns: As increasingly more units of a resource are being used, the marginal product begins to decrease (i.e., too many units of a particular worker creates inefficiency), decreasing MRP.
• Market Forces: External influences such as competition or variability in demand can influence marginal revenue, making it more difficult to estimate MRP.

Example

Suppose that a bakery is considering the employment of an additional baker. The new baker has the capacity to make 20 additional loaves of bread per day, and each loaf costs $4. The MRP is 20 × $4 = $80 per day. If the bakery pays $60 per day to employ the baker, then it is worthwhile to employ the baker since the MRP ($80) is higher than the cost ($60).