What do you mean by average cost?

By Indeed Editorial TeamUpdated February 22, 2021 | Published February 25, 2020Updated February 22, 2021Published February 25, 2020The Indeed Editorial Team comprises a diverse and

What do you mean by average cost?

By Indeed Editorial Team

Updated February 22, 2021 | Published February 25, 2020

Updated February 22, 2021

Published February 25, 2020

The Indeed Editorial Team comprises a diverse and talented team of writers, researchers and subject matter experts equipped with Indeed's data and insights to deliver useful tips to help guide your career journey.

In the world of economics, there are many terms associated with production and costs. When most people hear the term average cost, its meaning may seem a bit vague at first. People may wonder which cost is being questioned and how to calculate it. When professionals speak about average cost, it's generally about production costs. In this article, we discuss the key elements of average cost, how to calculate it, the difference between average cost and marginal cost, and why it's important.

What is average cost?

Average cost is the total amount of all production costs divided by the quantity of output produced. This number is also known as average total cost or unit cost. In simpler terms, it measures how much a business has to spend on each unit or product of output produced. You can determine the ATC with a simple equation:

Average Total Cost = Total Cost of Production / Quantity of Units Produced

Related: Economic Demand: Definition, Determinants and Types

What to include in average cost

Average cost includes fixed costs, like those necessary for production, that remain the same no matter the output. An example of a fixed cost is the building space and equipment used to assemble a product. Average cost also includes variable costs. Examples of variable costs are specific parts needed to build a product, which may increase or decrease according to output.

How to calculate average cost

If you're looking to assign a value to inventory, you'll calculate the cost of goods available for sale divided by the number of units available for sale. This is the step-by-step guide you'll want to reference when calculating the average cost per unit:

1. Determine the fixed cost of production

To find the fixed cost of production, start by looking at a business's profit and loss account typically found in its annual financial reports. Fixed cost can include insurance premiums, setup costs, normal profit, depreciation, rent expense, selling expense, loan payments and more.

2. Find the variable cost of production

You can learn the variable cost of production by again referencing the profit and loss account. Some instances of the variable cost of production include things like raw materials, manufacturing labor directly related to production, packaging and more.

3. Add the total fixed cost and total variable cost

Now that you've found these totals, you can determine the average total cost of production by adding together the total fixed cost and total variable cost. For example:

Average Total Cost = Average Fixed Cost + Average Variable Cost

4. Determine the quantity of units produced

Once you've reached this step, you're ready to determine the quantity of units produced. You can find this number by referencing invoices, checking with your accounting department or calling the company that produced the units.

5. Calculate the average total cost of production

Now you're ready to find the average total cost of production. Calculate this cost by dividing the total cost of production that you computed in step three by the number of units that were produced (learned in step four). You will do this with the following average cost formula:

Average Total Cost = Total Cost of Production / Quantity of Units Produced

Example of ATC

Let's check out an example of the average total cost formula:

Pretend that you have started an online business selling luxury winter hats for women. The total fixed and variable cost to produce these hats amounted to $5,000. You ended up producing 300 winter hats. Using the formula, your average cost per hat is $16.67. Of course, you'd want to sell those hats for much more than it cost to produce them to make money. And you would not want to sell them for less than that, or you'd be losing money. Here is an example of the equation:

$16.67 cost per unit = $5,000 production cost / 300 winter hats

Average Cost Per Unit = Total Production Cost / Number of Units Produced

Related: The Value of Increasing Your Business Vocabulary

Average cost vs. marginal cost

Average cost differs from marginal cost in one key way. Average cost is all about the total cost per unit of output, whereas marginal cost concerns the cost involved in producing an additional unit of a product or service. Marginal cost is often known as the cost of the last unit and can be calculated in three basic steps:

1. Calculate change in cost

The level of output typically causes a cost increase or decrease. When you're subject to a higher output, you can expect higher costs. Similarly, a lower output results in a lower cost, which necessitates the presence of variable costs. As we mentioned, these variable costs are related to the output level directly and correspond with an increase or decrease in levels. Step one's fixed costs can increase this number too if a certain output level is attained. To calculate the change in cost, you follow this simple formula:

Change in cost = new cost - old cost

2. Determine change in quantity

To get this calculation, all you must do is follow the same formula. That's because it works in the same way. When the output levels increase, the supply increases. Just deduct the old quantity from the new quantity to get the change in quantity. This is the simple formula:

Change in quantity = new quantity - old quantity

3. Divide change in cost by change in quantity

When you're selling units of something, your marginal cost will vary depending on the output. The marginal cost of selling 16 sunglasses instead of 15 will likely differ from the marginal cost of selling 201 units instead of 200. This is the final formula for determining marginal cost:

Marginal cost = change in cost / change in quantity

Related: 6 Essential Accounting Skills

Why is average cost important?

Knowing ATC is critical when making pricing decisions because any prices below ATC will result in a financial loss. Understanding the importance of average cost will also help you understand how it works for long periods of time. For example, cost fluctuates depending on seasonal demand and production efficiency. When you calculate the average cost, it normalizes or levels out the cost per unit of production overall.

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