Average Cost

What is the Average Cost?

Average cost refers to the per-unit cost of production, which is calculated by dividing the total cost of production by the total number of units produced. In other words, it measures the amount of money that the business has to spend to produce each unit of output. It forms a fundamental component of demand and supply as it affects the supply curve.

It is also known as unit cost or average total cost. We can further break down the total cost of production into fixed and variable cost components. Generally, the total fixed costFixed CostFixed Cost refers to the cost or expense that is not affected by any decrease or increase in the number of units produced or sold over a short-term horizon. It is the type of cost which is not dependent on the business activity.read more component doesn’t change, and hence the change in average cost is primarily due to a change in total variable costTotal Variable CostTotal variable cost is the total of all variable costs that would change in proportion to the output or the production of units and helps analyze the company's overall costing and profitability. Total variable cost formula = number of units produced x variable cost per unit.read more. If the cost reaches the threshold, then it is advisable to either increase the selling price or negotiate the variable cost component, as otherwise, it will result in business loss.

How to Calculate Average Cost?

Average-Cost

You are free to use this image on your website, templates etc, Please provide us with an attribution linkHow to Provide Attribution?Article Link to be Hyperlinked
For eg:
Source: Average Cost (wallstreetmojo.com)

We can calculate it by following these five steps:

Step 1: Firstly, determine the fixed cost of production incurred during the given period, which may include salary, depreciation & amortisationAmortisationAmortization of Intangible Assets refers to the method by which the cost of the company's various intangible assets (such as trademarks, goodwill, and patents) is expensed over a specific time period. This time frame is typically the expected life of the asset.read more, lease rental, marketing & advertising expenses, etc. These cost heads don’t change with the change in production volume.

Step 2: Next, determine the variable cost of production incurred during the given period, which may include the cost of raw material, wages, electricity bill, etc. These cost heads are mainly dependent on the production volume.

Step 3: Next, calculate the total cost of productionCost Of ProductionProduction Cost is the total capital amount that a Company spends in producing finished goods or offering specific services. You can calculate it by adding Direct Material cost, Direct Labor Cost, & Manufacturing Overhead Cost. read more by adding up fixed (step 1) and variable cost of production (step 2).

Total Cost of Production = Fixed Cost of Production + Variable Cost of Production

Step 4: Now, determine the number of units produced during the given period.

Step 5: Finally, calculate the average cost of production by dividing the total cost of production (step 3) by the number of units produced (step 4) as shown below.

Average Cost Formula = Total Cost of Production / Number of Units Produced

Examples

You can download this Average Cost Excel Template here – Average Cost Excel Template

Example #1

Let us take the simple example of the manufacturing plant of ASF Inc., where the total fixed cost of production during the year was $100,000, and the variable cost of production was $20 per unit. Determine the average cost of production if the company manufactured 20,000 units during the year.

Given,

  • Variable cost per unit = $20
  • Number of units produced = 20,000
  • Total fixed cost of production = $100,000

Solution:

Calculation of Total variable cost of production will be –

The total variable cost of production = Variable cost per unit * Number of units produced

Example 1.0

Total variable cost of production = $20 * 20,000 = $400,000

Now, the calculation of the total cost of production is as follows:

Total cost of production = Total fixed cost + Total variable cost

Average Cost Example 1.1

Total cost of production = $100,000 + $400,000 = $500,000

Now, the calculation is as follows:

Average cost Formula = Total cost of production / Number of units produced

Example 1.2

 = $500,000 / 20,000 = $25 per unit

Example #2

If in the above example the number of units produced during the year increased to 25,000, then determine the average cost of production for the increased production.

Given,

  • Variable cost per unit = $20
  • Number of units produced = 25,000
  • Total fixed cost of production = $100,000

Solution:

The calculation of the total variable cost of production will be –

The total variable cost of production = Variable cost per unit * Number of units produced

Average Cost Example 2

The total variable cost of production = $20 * 25,000 = $500,000

Now, the calculation of the total cost of production is as follows:

Total cost of production = Total fixed cost + Total variable cost

Example 2.1

Total cost of production = $100,000 + $500,000 = $600,000

Now, the calculation is as follows:

Average Cost Formula = Total cost of production / Number of units produced

Example 2.2

= $600,000 / 25,000

= $24 per unit

Therefore, the new unit cost of production reduced from $25 to $24 per unit owing to the benefits of economies of scaleEconomies Of ScaleEconomies of scale are the cost advantage a business achieves due to large-scale production and higher efficiency. read more.

Average Cost Diagram

Typically, the average cost curve (blue line) results in a U-shape as can be seen in the above diagram.  It is primarily because of the average variable cost of production (grey line) that decreases with the increase in production initially and then starts increasing with the incremental production. On the other hand, the average fixed costs (orange line) continue to decrease significantly as the production volume increases.

Average Cost Diagram

The marginal costMarginal CostMarginal cost formula helps in calculating the value of increase or decrease of the total production cost of the company during the period under consideration if there is a change in output by one extra unit. It is calculated by dividing the change in the costs by the change in quantity.read more (yellow line) after initial decrease starts to increase due to diminishing marginal productivity and it intersects the curve at its lowest point (minimum), after which the curve also starts to slope upward. From this point onwards, the marginal cost curve is above the average cost curve, and hence an increase in production volume increases cost.

This concept is critical as it helps in determining the long-run price and supply of any commodity, and hence it influences profit significantly. For instance, if the selling price of a commodity is higher than its average cost (AC), then the company makes a profit. On the other hand, if the selling price is lower than the unit cost, then it is a loss-making proposition.

Advantages

  • It considerably simplifies the process of cost calculation and record keeping.
  • It automatically adjusts the impact of price volatility witnessed during the given period.
  • It makes manipulation of accounting figures difficult and hence provides an accurate picture of the business.

Disadvantages

  • Every time a new purchase happens at a rate different than the previous one, it changes, resulting in frequent changes in selling price as well.
  • The average cost may not be reflective of the prevailing market rate as it averages out the price across the period.

Recommended Articles

This article has been a guide on what is the average cost and its definition. Here we discuss how to calculate it along with practical examples. You can learn more about accounting from the following articles –