Average Cost

What is an Average Cost?

Definition: The Average Cost is the per unit cost of production obtained by dividing the total cost (TC) by the total output (Q). By per unit cost of production, we mean that all the fixed and variable cost is taken into the consideration for calculating the average cost. Thus, it is also called as Per Unit Total Cost.

Symbolically, the average cost is expressed as:

AC = TC / Q

Also,

AC = Average Variable cost (AVC) + Average Fixed cost (AFC)

Where,

Average variable cost = Total Variable Cost (TVC) / Total output (Q)
Average fixed cost = Total Fixed Cost (TFC) / Total output (Q)

Average cost is a cost accounting term that is sometimes referred to as unit cost or weighted average cost. Average cost can refer to either average cost of inventory or the average cost of units produced.

These two categories are similar in nature. Retailers usually don’t produce any of their inventory; they buy it from manufacturers or wholesalers. Manufacturers, on the other hand, produce their own inventory. Retailers need to know the cost of what they paid for the inventory, while manufacturers need to know how much it costs them to produce the inventory.

What Does Average Cost Mean?

Average is extremely easy to calculate. A retailer would calculate the average cost of inventory using the weighted average inventory method. In other words, they would divide the total dollar amount paid for the inventory by the total number of units of inventory on hand. Obviously, the total inventory must be made up the same type of units.

Businesses that sell products to customers have to deal with inventory, which is either bought from a separate manufacturer or produced by the company itself. Items previously in inventory that are sold off are recorded on a company’s income statement as cost of goods sold (COGS). The COGS is an important figure for businesses, investors, and analysts as it is subtracted from sales revenue to determine gross margin on the income statement. To calculate the total cost of goods sold to consumers during a period, different companies use one of three inventory cost methods—first in first out (FIFO), last in first out (LIFO), or average cost method.

The average cost method uses a simple average of all similar items in inventory, regardless of purchase date, followed by a count of final inventory items at the end of an accounting period. Multiplying the average cost per item by the final inventory count gives the company a figure for the cost of goods available for sale at that point. The same average cost is also applied to the number of items sold in the previous accounting period to determine the cost of goods sold.

Example

If a retailer averaged $20 shirts in with $100 shoes, the inventory average per unit would be a little skewed. Each type of inventory should be separately averaged. Here’s what the average cost formula looks like:

Average cost of inventory = Total cost of inventory / Total number of inventory units

A manufacturer’s calculation of average unit costs is just as simple as the retailers’. Take the total dollar amount spend on manufacturing a group of products and divide it by the total amount of units produced. Here is the average units equation:

Average unit cost = Total manufacturing cost of inventory/ Total number of units produced

Minimization

A company producing goods wants to minimize the average cost of production. The company also wants to determine the cost-minimizing mix and the minimum efficient scale. Companies with a lower average cost per unit of production are better able to defend against aggressive price-cutting among industry competitors than companies with a higher average cost per unit of production.

The cost-minimizing mix is the lowest cost input-output production mix, or the point at which a company can produce the most output for the least cost. This mix occurs at the point of tangency between the isoquant and isocost lines. In economics terminology, the isoquant line is the line that represents all different combinations of production inputs that produce the same quantity of output. In addition, the isocost line represents all possible combinations of production variables that add up to the same level of cost. The point of intersection between the isoquant and isocost lines is the point of cost minimization.

The minimum efficient scale is scale of production at which average cost of production reaches its minimum point. Up to a certain point, more production volume reduces the cost per unit of production. This is economies of scale. The more output that is produced, the more thinly spread the fixed costs of production across the units of output are. This ends up lowering the cost per unit. Furthermore, production economies of scale can lower the threat of new entrants (competitors) into the industry.

Accounting

In accounting, to find the average cost, divide the sum of variable costs and fixed costs by the quantity of units produced. It is also a method for valuing inventory. In this sense, compute it as cost of goods available for sale divided by the number of units available for sale. This will give you the average per-unit value of the inventory of goods available for sale.

Short-run Average Cost

Short-run costs are those that vary with almost no time lagging. Labor cost and the cost of raw materials are short-run costs, but physical capital is not.

An average cost curve can be plotted with cost on the vertical axis and quantity on the horizontal axis. Marginal costs are often also shown on these graphs, with marginal cost representing the cost of the last unit produced at each point; marginal costs in the short run are the slope of the variable cost curve (and hence the first derivative of variable cost).

A typical average cost curve has a U-shape, because fixed costs are all incurred before any production takes place and marginal costs are typically increasing, because of diminishing marginal productivity. In this “typical” case, for low levels of production marginal costs are below average costs, so average costs are decreasing as quantity increases. An increasing marginal cost curve intersects a U-shaped average cost curve at the latter’s minimum, after which the average cost curve begins to slope upward. For further increases in production beyond this minimum, marginal cost is above average costs, so average costs are increasing as quantity increases. For example: for a factory designed to produce a specific quantity of widgets per period—below a certain production level, average cost is higher due to under-used equipment, and above that level, production bottlenecks increase average cost.

Three Averages

Short-run production analysis makes use of three average cost measures–average total cost, average fixed cost, and average variable cost. Each is derived from a corresponding total–total cost, total fixed cost, and total variable cost.

  • Average Total Cost: This is per unit total cost, or total cost divided by the quantity of output produced. Average total cost is also the sum of average fixed cost and average variable cost.
  • Average Fixed Cost: This is per unit total fixed cost, or total fixed cost divided by the quantity of output produced. Because fixed cost does not vary with output, average fixed cost declines with larger quantities of production.
  • Average Variable Cost: This is per unit total variable cost, or total variable cost divided by the quantity of output produced. Average variable cost is influenced by short-run marginal returns, decreasing for small quantities, then increasing for larger quantities.

Short-run Production Analysis

Average cost is perhaps most important for short-run production analysis, especially when serious talk turns to the topic of profit. In terms of totals, profit is the difference between total revenue and total cost. However, profitability can also be identified per unit of output. In this case, a comparison between price (the revenue received for each unit sold) and average cost is highly informative. If price exceeds average total cost, then profit is received for each unit sold. If price is less than average total cost, then each unit is sold at a loss.

This price-average cost comparison is just the sort of thing that can keep a firm from bankruptcy. In fact, those firms that have some degree of control over price, frequently set prices based on average cost. The most common techniques used are mark-up pricing or cost-plus pricing, which ensure that firms cover cost and receive a profit on each unit sold.

Suppose, for example, that the average cost incurred by Waldo’s TexMex Taco World in the production of Super Deluxe TexMex Gargantuan Tacos is $3. If each Super Deluxe TexMex Gargantuan Taco sells for $3.50, then Waldo’s TexMex Taco World receives $0.50 per taco. In all likelihood, Waldo’s TexMex Taco World sets the price at $3.50 for their Super Deluxe TexMex Gargantuan Tacos by adding a “reasonable” fifty-cent per taco profit to the three dollar per taco cost.

Long-run Average Cost

Long-run average cost is the unit cost of producing a certain output when all inputs, even physical capital, are variable. The behavioral assumption is that the firm will choose that combination of inputs that produce the desired quantity at the lowest possible cost.

A long-run average cost curve is typically downward sloping at relatively low levels of output and upward or downward sloping at relatively high levels of output. Most commonly, the long-run average cost curve is U-shaped, by definition reflecting economies of scale where negatively sloped and diseconomies of scale where positively sloped.

If the firm is a perfect competitor in all input markets, and thus the per-unit prices of all its inputs are unaffected by how much of the inputs the firm purchases, then it can be shown that at a particular level of output, the firm has economies of scale (i.e., is operating in a downward sloping region of the long-run average cost curve) if and only if it has increasing returns to scale, the latter being exclusively a feature of the production function. Likewise, it has diseconomies of scale (is operating in an upward sloping region of the long-run average cost curve) if and only if it has decreasing returns to scale, and has neither economies nor diseconomies of scale if it has constant returns to scale. With perfect competition in the output market the long-run market equilibrium will involve all firms operating at the minimum point of their long-run average cost curves (i.e., at the borderline between economies and diseconomies of scale).

If, however, the firm is not a perfect competitor in the input markets, then the above conclusions are modified. For example, if there are increasing returns to scale in some range of output levels, but the firm is so big in one or more input markets that increasing its purchases of an input drives up the input’s per-unit cost, then the firm could have diseconomies of scale in that range of output levels. Conversely, if the firm is able to get bulk discounts of an input, then it could have economies of scale in some range of output levels even if it has decreasing returns in production in that output range.

In some industries, long-run average cost is always declining (economies of scale exist indefinitely). This means that the largest firm tends to have a cost advantage, and the industry tends naturally to become a monopoly, and hence is called a natural monopoly. Natural monopolies tend to exist in industries with high capital costs in relation to variable costs, such as water supply and electricity supply.

Relationship to marginal cost

When average cost is declining as output increases, marginal cost is less than average cost. When average cost is rising, marginal cost is greater than average cost. When average cost is neither rising nor falling (at a minimum or maximum), marginal cost equals average cost.

Other special cases for average cost and marginal cost appear frequently:

  • Constant marginal cost/high fixed costs: each additional unit of production is produced at constant additional expense per unit. The average cost curve slopes down continuously, approaching marginal cost. An example is hydroelectric generation, which has no fuel expense, limited maintenance expenses and a high up-front fixed cost (ignoring irregular maintenance costs or useful lifespan). Industries with fixed marginal costs, such as electrical transmission networks, may meet the conditions for a natural monopoly, because once capacity is built, the marginal cost to the incumbent of serving an additional customer is always lower than the average cost for a potential competitor. The high fixed capital costs are a barrier to entry.
  • Two popular pricing mechanisms are average cost pricing (or rate of return regulation) and marginal cost pricing. A monopoly produces where its average cost curve meets the market demand curve under average cost pricing, referred to as the average cost pricing equilibrium.
  • Minimum efficient scale: Marginal or average costs may be nonlinear, or have discontinuities. Average cost curves may therefore only be shown over a limited scale of production for a given technology. For example, a nuclear plant would be extremely inefficient (high average cost) for production in small quantities. Similarly, its maximum output for any given time period may essentially be fixed, and production above that level may be technically impossible, dangerous or extremely costly. The long run elasticity of supply are higher, as new plants could be built and brought on-line.
  • Zero fixed costs (long-run analysis) and constant marginal cost: since there are no economies of scale, average cost is equal to the constant marginal cost.

Benefits of the Average Cost Method

The average cost method requires minimal labor to apply and is, therefore, the least expensive of all the methods. In addition to the simplicity of applying the average cost method, income cannot be as easily manipulated as with the other inventory costing methods. Companies that sell products that are indistinguishable from each other or that find it difficult to find the cost associated with individual units will prefer to use the average cost method. This also helps when there are large volumes of similar items moving through inventory, making it time-consuming to track each individual item.