What is the true average cost? How to Calculate average cost?

Economics and How To Calculate Average Cost

February 22, 2021


In the world of business, there are many expressions linked with the costs of  production. When many people acknowledge the expression average cost, its meaning may appear a bit abstract at the beginning. Many imagine which cost is being identified and the methods to calculate it. When the pros mention average cost, it’s loosely concerning the cost of making the product. In this essay, 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

ATC = TCP / QUP

What to use in average cost

Average cost includes fixed costs, like those important for making the products, that include the identical ingredients no matter the material result. A sample representation of a fixed cost is the location overhead and machinery used to build an item. Average cost also includes variable costs. Sample representatives of variable costs are particular items necessary to assemble goods, which can raise or sink according to final 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. Identify the fixed cost of manufacturing

To discover the fixed cost of manufactured output, begin by peering at a business’s profit and loss statement generally located in its annual accounting reports. Fixed cost can include insurance premiums, setup costs, normal profit, depreciation, rent expense, selling expense, loan payments and more.

2. Locate the variable cost of  manufacturing

You can locate the variable cost of  manufacturing by again gazing upon the profit and loss statement. Particular examples of the variable cost of manufacturing include things like raw materials, manufacturing labor directly related to production, packaging and more.

3. Combine the total fixed cost and total variable cost

Now that you’ve notated these totals, you can deduce the average total cost of manufacturing by combining the numbers that include the total fixed cost and total variable cost. As a sample:

Average Total Cost = Average Fixed Cost + Average Variable Cost

ATC = AFC + AVC

4. Predetermine the quantity of units made

Once you’ve breached this calculation you’re prepared to pinpoint the vastness of units created. You can pinpoint this calculation by referencing the paper trail, inquiring with your accounting department or communicating with the company that built the items.

5. Determine the average total cost of manufacturing

Now you’re looking to locate the average total cost of  manufacturing. Lockdown  this cost by dividing the total cost of production that you noted in step three by the number of units that were made (concluded in step four). You will accomplish this with the following average cost formula:

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

ATC=TCP/QUP

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 coats for women. The total fixed and variable cost to produce these hats amounted to $60,000. You ended up producing 300 winter coats. Using the formula, your average cost per coat is $200.00. 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:

$200.00 cost per unit = $60,000 production cost / 300 winter hats

ACU = TPC/NUP

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

Average cost vs. marginal cost

Average cost is unlike marginal cost in one important way. Average cost is all primarily the total value per units made, whereas marginal cost focuses the income invested in creating an extra unit of a product or service. Marginal cost is often listed as the cost of the next to last unit and can be calculated in three basic steps:

1. Determine the change in cost

The rise of output normally  creates a cost rise or fall. When you’re a slave to a higher  volumes, you can conclude greater expenses. Similarly, a lower volume results in a lower expense, which creates the need for the inclusions of variable costs. As we concluded, these variable costs are tied to the production level attached and are tied with an rise or fall in levels. Step one’s fixed expenses can balloon this number too if a particular production level is realized. To calculate the variance in cost, you follow this simple formula:

Change in cost = new cost – old cost

C = NC  + OC

2. Determine change in quantity

To get this determination, all you have to do is follow the identical formula. That’s because it works in the same way. When the production levels rise, the supply rise. 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 marketing items of  anything, your marginal cost will change with on the manufacturing volume. The marginal cost of selling 36 sunglasses instead of 45 will likely differ from the marginal cost of selling 301 units instead of 300. The final formula for calculating marginal cost:

Marginal cost = change in cost / change in quantity

MC= CC / CQ  ( usually the Delta Sign or triangle is written as the first c in CC )

Why is average cost important?

Knowing ATC is important when making sales price decisions because any prices under ATC will conclude in a profit loss. Realizing the value of average cost will also provide understanding of how it will function for future periods in time. For example, cost changes because of  winter vs. summer demand and manufacturing efficiency. When you calculate the average cost, it rationalizes or bottom lines the cost per item of manufacturing overall.