Average Fixed Cost

What is Average Fixed Cost?

Definition: Average fixed cost is a management accounting formula that measures the fixed production expenses per good produced by dividing total fixed-costs by number of units produced.

What Does Average Fixed Cost Mean?

Fixed costs are defined as the expenses that are independent of the number of goods or services a business produces. In other words, the company will have these expenses regardless the amount it produces or sells. If the company sells one unit or 200,000 units, these expenses will stay the same.

Managerial accountants use the average fixed cost formula to calculate how much costs should be allocated to each unit of production.

As the number of units produced becomes larger, the average fixed costs per unit becomes smaller, all else equal. Similarly if a business produces fewer units, the average cost would increase per unit.

Average fixed cost (AFC) is the fixed cost per unit of output. Fixed costs are such costs which do not vary with change in output. AFC is calculated by dividing total fixed cost by the output level.

Whether a cost is fixed or variable depends on whether we are considering a cost in short-run or long-run. Average fixed cost is relevant only in the short-run. Short-run is defined as a time period in which at least one of the inputs, typically capital, is fixed. Since all inputs are variable in the long-run, no costs are fixed in the long-run.

Typical examples of fixed costs include salaries of permanent employees, rent paid on non-cancellable lease, mortgage payments on plant and machinery, etc.

Formula

Average fixed cost (AFC) equals total fixed cost (FC) divided by output (Q):

AFC = FC / Q

Total cost (TC) of a firm are either fixed (FC) or variable (VC). This can be written mathematically as follows:

TC = FC + VC

If we divide both sides of the equation by output Q, we get:

(TC / Q) = (FC / Q) + (VC / Q)

It shows that average fixed cost can also be defined as the difference between average total cost and average variable cost:

AFC = ATC - AVC

Calculation of Average Fixed Cost (Step by Step)

In order to calculate the average fixed costs, the following steps are to be undertaken.

  • Step 1: Aggregate all the fixed costs to find out the total fixed costs.
  • Step 2: Find out the number of units produced.
  • Step 3: Use the formula for Average Fixed Cost = Fixed Cost / Quantity to find out the average fixed cost.

In certain cases, the total cost is given. The steps to calculate the average fixed cost in such a scenario are:

  • Step 1: Find out the total variable cost.
  • Step 2: Find out the number of units produced.
  • Step 3: Find out the average total cost using the equation. i.e Average Total Cost = Fixed Cost / Quantity
  • Step 4: Find out the average variable cost using the equation. i.e Average Variable Cost = Variable Cost / Quantity
  • Step 5: Find out the average fixed cost using the formula. i.e Average Fixed Cost = Average Total Cost – Average Variable Cost

Example

Let’s say an imaginary car manufacturer called Super Cars produces 100 pick-up trucks every month. For the sake of this example, we’ll assume that the company only has two types of fixed costs: rent and wages. More specifically, Super Cars has to pay USD 5,000 monthly rent for the factory building. In addition to that, the firm pays its employees a total of USD 45,000 in salaries per month. Thus, the total fixed costs per month add up to USD 50,000.

Now, to calculate AFC all we need to do is divide total fixed cost we just calculated above (i.e. USD 50,000) by the number of trucks produced (i.e. 100 trucks). This results in AFC of USD 500 per truck. Or in other words, when Super Cars produces 100 vehicles per month, it has to incur per-unit fixed costs of USD 500 for each truck it produces.

Why Average Fixed Cost Matter

AFC plays an important role when it comes to production decisions. As we know, fixed costs must be incurred regardless of the level of output produced. However, AFC decrease as the quantity of output increases. The reason for this is that the fixed costs can be spread across more units as output increases. Therefore, firms must always consider AFC and how they change as output changes if they want to maximize profit.

Relevance and Uses

  • In managerial economics, a graph of average fixed costs is prepared by the decision-makers. The graph of average fixed costs is plotted with quantity on the horizontal axis and costs on the vertical axis. Other variables like input prices and taxes are kept constant while making the graph. We have a constantly declining average fixed cost curve. It is negatively sloped.
  • As there is an increase in the production volume, the average fixed cost tends to reduce. The reason is that the fixed costs are spread over a larger quantity of output. This is known as economies of scale. Hence, in order to reduce per-unit costs, an organization should go for an increase in production volume. It is important to keep in mind the concept of economies of scale while determining pricing policies. It even finds its application in strategic planning.
  • Fixed costs remain constant in the short run. However, the management should try to reduce its fixed costs in the long run. For instance, let us assume rent for factory premises are incurred and are a significant portion of fixed costs. Does it make sense to shift the factory to another location outside the city to reduce costs? These are the kinds of decisions that will have a bearing on the average fixed costs in the long run.
  • While analyzing costs, the average fixed costs are calculated at different levels. The impact of carrying out production at different levels on average fixed costs has to be calculated.

Advantages

  • 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.

Disadvantages

  • 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.

Conclusion

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 the left to the 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 increase 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 decrease in the profits of the company.

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