Average Fixed Cost Definition
Average Fixed Cost is fixed production expenses of the company with respect to per unit of goods produced by it. With an increase in the quantity of output produced, this average cost reduces because the fixed cost remains the same while the number of output increases.
Example of the fixed cost includes the rent paid, salaries paid to the permanent employees, mortgage payments on the plant and machinery, etc. This cost remains the same, but as the total units of the produced increases, then the average fixed cost of the company decreases because the same amount of the fixed costs incurred by the company is getting spread over the more significant number of the units of output. It is different from the average variable cost, which remains the same, even when there is a change in the quantity of the goods produced by the company.
Average Fixed Cost Formula
It can also be calculated by subtracting the average variable cost of the company from the average total cost as the total cost of the firm can either be fixed or variable, and if the variable one is deducted from the total cost, then it will give the fixed cost as the resultant. Mathematically:
The following are examples in order to understand the concept in a better manner.
Company A ltd. is in the business of providing the telecom services to the customer. During the month of June-2019, the total fixed cost of the company was $ 100,000, and the output during the same period was $5,000. Calculate the average fixed cost of the company.
Calculation of the AFC
- = $ 100,000 / $5,000
- = $ 20 per unit
Thus the AFC of the company A ltd. is $ 20 per unit.
George Inc. is a factory manufacturing chocolates. It produces 2,500 units of chocolates. It incurs the following fixed costs annually:
- Annual rent of factory premises: $2,500
- Fixed annual salary of contract worker (per person): $1,500
- Annual property taxes: $2,000
- Other Fixed Costs: $1,000
Three contract workers are hired. Calculate the average fixed cost from the above information. Suppose 5,000 units are manufactured with the same total fixed costs. Will the AFC change?
2,500 units are produced
Salary of 3 contract workers = 3*$1,500 = $4,500
Calculation of Fixed Cost will be –
Total Fixed Costs = $2,500 + $4,500 + $2,000 + $1,000
Total Fixed Costs = $10,000
Calculation of AFC can be done as follows:
AFC = 10000 / 2500
AFC = $4
5,000 units are manufactured
Calculation of average fixed cost can be done as follows:
AFC = 10000 / 5000
AFC = $2
- It is simple to calculate, as the fixed cost for the enterprise when divided by the total output produced by the company; resultant will be the AFC.
- When there is an increase in the production of the company, then the AFC of the company falls. So, there is the advantage of the increase in the output, and the profit of the company, in that case, will be more.
- The number of the average fixed cost will help the company in determining the minimum amount of profit that it must earn per quantity of goods produced so that at least all the expenses of the company can be paid off.
- When there is a decrease in the production of the company, then the AFC of the company increases. So, there is a disadvantage of the decrease in the output.
- Sometimes the fixed cost is confused with the average fixed cost by the user of the value, which may not fulfill the purpose of the analysis.
- There are two ways to calculate the average fixed cost in the company, i.e., either by dividing the total fixed cost with the total output or by subtracting the average variable cost of the company from the average total cost of the company.
- With the increase in the production of the company, the AFC of the company falls, and the curve of the AFC will slope downwards continuously, from left to right.
- It is different from the average variable cost, as AFC changes whenever there is a change in the quantity of the goods produced by the company but in case of the average variable cost, it remains the same even when there is a change in the quantity of the goods produced by the company.
Thus the fixed cost refers to the fixed expenses per unit of production by the company. The curve of the AFC will slope downwards continuously, from left to right. When there is an increase in the production of the company, then the average fixed cost of the company falls. So, there is the advantage of the rise in the output, and the profit of the company, in that case, will be more. However, when there is a decrease in the production of the company, then the average fixed cost of the company increases, leading to a reduction in the profits of the company.
This has been a guide to what is Average Fixed Cost and its definition. Here we discuss how to calculate the average fixed cost using its formula along with examples, advantages, and disadvantages. You may learn more about finance from the following articles –