Average Cost: Formula and Calculation

The average is obtained by dividing the summation of all the observations given by the total number of observations. Hence the average cost can be defined as the sum of the total cost divided by the number of observations. The average cost can be called the average price of goods and services.

How to Calculate an Average Cost?

All the firms use a parameter to understand how to price their commodities, this is where the concept of an average cost arises.

Let’s say a product’s total cost, i.e, the total amount of entire items to be sold is $50 and the quantity of output produced is 5. So, the average price or the unit cost will be =$\frac{50}{5}$ = 10

This means that the average cost measures how much a business has to spend on each unit or product of output produced. However, there are several factors that this formula holds, which give us the average cost of a product, we will discuss the same on this page.

Average Cost Formula

The formula for an average cost can be written mathematically in the following manner:

AC (average cost) = $\frac{\text{TC (Total cost)}}{\text{Q (Total output)}}$

In per unit cost of production, determining an average cost that includes all the fixed and variable costs is taken into the consideration. Thus, the average cost is also called Per Unit Total Cost.

Therefore, the average cost or AC = Average Variable Cost (AVC) + Average Fixed Cost (AFC).

The formula for calculating the average fixed cost is the Total Variable Cost (TVC) divided by the Total output (Q)

AVC = $\frac{\text{TVC}}{\text{Q}}$

Similarly, the average fixed cost is calculated by dividing the Total Fixed Cost (TFC) by the Total Quantity (Q).

Symbolically, AFC = $\frac{\text{TFC}}{\text{Q}}$

Point To Note:

Please note that The average cost pricing is greatly impacted by the time period of production that may be increasing or expanding the products in the short run might be quite expensive or impossible. Therefore, economists study both two types of costs to understand the average total cost, which is the short-run average cost and the long-run average cost to determine the production for a given period.

Now, let us understand the overall procedure in determining the average cost.

What do We Need to Include in an Average Cost?

Average costs incorporate fixed costs, similar to those fundamental for creation, that continue as before regardless of the output.

An illustration of a fixed cost is the building space and equipment used to assemble an item. Normal expense additionally incorporates variable expenses. Instances of variable costs are explicit parts expected to build an item, which may increment or lessening as per the output.

Now, let us understand how to calculate the average cost.

Average Cost - How to Calculate It?

In case you're hoping to allocate a value to an inventory, you'll ascertain the costs of merchandise ready for sale divided by the number of units for sale. This is the bit by bit guide you'll need to reference while figuring the average cost per unit:

Step 1: Find The Fixed Cost (FC) of Production

To track down the fixed cost of production, start by looking at a business’s profit and loss account normally found in its yearly financial reports. The fixed cost can incorporate insurance premiums, set up costs, ordinary benefits, devaluation, rent expenses, selling expenses, loan payments, etc.

Step 2: Determine The Variable Cost of Production

You can understand the variable cost of production by again referring to the profit and loss account. On a few occasions the variable cost of production incorporates things like crude materials, and manufacturing labour straightforwardly related to production, and packaging, and that's only the tip of the iceberg.

Step 3: Sum up The Total Fixed Cost and Total Variable Cost

After you have found the totals, you can calculate the average total cost of production by adding together the total fixed cost and total variable cost.

For instance, AC = Average Fixed Cost + Average Variable Cost

Step 4: Find The Number of Quantities Produced

You can find the number of quantities produced by referencing invoices, verifying with your accounting department, or calling the company that produced the units.

Step 5: The Final Step: Calculate The Average Total Cost of Production

Now you can find the average total cost of production. To calculate this cost by dividing the total cost of production that you computed in step 3 by the number of units that were produced (from step four). Here is an example of the equation:

ATC = $\frac{\text{Total cost of units}}{\text{Number of units}}$

Example for ATC:

Assume that Megha started an online business selling luxury coats for women. The total fixed and variable cost to produce these coats amounted to $6,000. However, Megha ended up producing 250 winter coats. Using the formula, your average cost per coat will be:

= $\frac{6000}{250}$= $24

So, the average cost per coat is $24.

Of course, Megha would desire to sell those coats for much more than it cost to produce them to gain money. And she would not want to sell them for less than that, or she'd be losing money. Below is an example of the equation:

24 (average price) = \[\frac{\text{6000 production cost}}{\text{250 winter coats}}\]

Or,

Average Cost Per Unit = \[\frac{\text{Total production cost}}{\text{Number of coats produced}}\]

Average Cost and Marginal Cost

Now, if we were to find the difference between Average Cost vs Marginal cost, then average cost discussed the total cost per unit of output, while the marginal cost considers the cost involved in generating an additional unit of a product or service. Often, marginal cost is called the cost of the last unit, which can be calculated in three basic steps:

Step 1: Change in Cost

The level of output decides a cost increase or decrease. When you're subject to a higher yield, the cost goes high. Similarly, a lower output results in a lower cost, which hints at the presence of variable costs. As we know these variable costs are directly associated with the output level and correspond to an increase or decrease in levels.

Therefore, the change in cost = New cost - Old cost

Step 2: Determine The Variation in Quantity

To get the calculation on a change in quantity, all you need to do is, follow the above formula because the current formula works in the same way. When the output levels increment, the supply increases. Now, deduct the old quantity from the new quantity to get the variation in quantity. The simple formula is a Change in quantity = new quantity - old quantity.

Step 3: Divide The Change in Cost by The Change in Quantity

While selling units of something, your marginal cost varies depending on the output. The marginal cost of selling 16 notebooks instead of 15 will likely differ from the marginal cost of selling 306 units instead of 305. Below is the final formula for calculating marginal cost:

Marginal cost = change in cost divided by the change in quantity

For instance, a firm produces 8 units at a total cost of Rs. 400. For some reason, it has to produce 10 units instead of 8, and the total cost changes to Rs. 360. Therefore, the marginal cost becomes Rs. 400 - Rs. 360 = Rs. 40.

Now, an average cost can be categorized into two types, viz: Short-run average cost and long-run average cost.

Short Run Average Cost

Let us go through an example to understand the concept of Short-run average cost:

Assume that the TFC of a firm is Rs. 3,500. If the output is 200 units, the average fixed cost is:

AFC =$\frac{\text{TFC}}{\text{Q}}$ = $\frac{3500}{200}$ = Rs. 17.5

Now, if the output is increased to 350 units, then the Short-run AC is:

= $\frac{3500}{200}$ = Rs. 10

Here, we notice that the TFC is constant, while an increase in output decreases the AFC. Also, note that the AFC can become very small, but remains non-zero.

Long-Run Average Cost

LRATC is a business parameter that displays the average cost per unit of output over the long run, where all the inputs are assumed to be variable and the scale of production is also variable.

Solved Examples

1. A person sells various types of fabric where the prices are ranged from 250, 330, 480, 550, 670, and 890. What is the average cost of the fabrics sold by the person?

Solution: From the given, prices of fabrics are 250, 330, 480, 550, 670, and 890, from this, we can note that the total number of fabrics is 6.

Hence the average cost will be determined by,

$\frac{\text{Total of price of the fabrics}}{\text{Total number of prices}}$ = $\frac{3170}{6}$ = 528.3

Practise Questions

1. Average cost pricing is also called

1. Cost-plus pricing

2. Margin pricing

3. Both a & b

4. None of the above

Ans: Option c

2. Average cost is

1. total cost by marginal cost.

2. total cost by total output.

3. total output multiplied by cost per unit.

4. total output multiplied by marginal cost.

Ans: Option b

Conclusion

In the nutshell, we use the concept of average cost because it has strong implications for how companies will choose to price their products. Therefore, firms’ sale of commodities of a specific type is strictly linked with the size of a particular market and how the rivals would choose to act.