Average Variable Cost

What is Average Variable Cost (AVC)?

Definition: The average variable cost represents the total variable cost per unit, including materials and labor, in short-term production calculated by dividing total variables costs by total output. Hence, a change in the output (Q) causes a change in the variable cost.

Variable costs are those costs which vary with the output level. Average variable cost formula:

Average variable cost = Variable cost / Quantity of output produced

What Does Average Variable Cost Mean?

As a rule of thumb, when the firm’s output is relatively small, the average cost decreases, whereas when the output starts increasing, the average cost increases too. Firms that seek to maximize their profits, use the average cost to determine the point that they should shut down production in the short term.

Therefore, if the price of a good is higher than the AVC of the good, it means that the firm is covering all the variable costs and a percentage of the fixed costs. In this case, firms continue production. On the contrary, if the price they receive for good is lower than the AVC, firms cease production to avoid additional variable costs.

Average Variable Cost
Average Variable Cost

A firm’s composition of variable costs depends on the time period being considered. Firms can change all their inputs, both labor and capital, in the long-run; but in the short-run, at least one of the inputs is fixed. It follows that in the short run, average variable cost is different from average total cost but in the long-run average variable cost and average total cost are effectively the same.

Average variable cost is important because it helps a firm in deciding whether it should continue operating in the short-run. It is feasible to operate only when the marginal revenue is higher than average variable cost.

Calculation of Average Variable Cost (Step by Step)

In order to calculate the average variable cost, use the following steps:

  • Step 1: Calculate the total variable cost
  • Step 2: Calculate the quantity of output produced
  • Step 3: Calculate the average variable cost using the equation
    • AVC = ATC – AFC
    • Where, AVC is an average variable cost, VC is variable cost and Q is the quantity of output produced

In certain cases, average total costs and average fixed costs are given. In such cases, follow the given steps

  • Step 1: Calculate the average total costs
  • Step 2: Calculate the average fixed costs
  • Step 3: Calculate the average variable costs using the equation
    • AVC = ATC – AFC
    • Where, AVC is Average Variable Cost, ATC is Average Total Cost and AFC is Average Fixed Cost

Example

Adam works as an accountant in a manufacturing firm, which produces equipment for tractors. He is asked to calculate the average variable cost formula of production so that the management decides whether they should go on or cease production after a given level of output.

Adam constructs a spreadsheet and calculates the AVC as follows:

Average Variable Cost Example
Average Variable Cost Example

After displaying all numbers, Adam gains an insight into the AVC. First, he notices that the AVC is relatively high for the first three inputs, and then declines until increasing again when the quantity is 10 units. This is consistent with the U-shaped pattern of the variable cost line. Secondly, the average cost is always higher than zero. The only possibility for the AVC to turn negative is if the total variable cost turns negative, which, in practice, makes no sense.

Given the level of price for each given level of output, the management can decide to cease production or continue in the short term.

Use of Average Variable Cost for Firms

Average variable cost is significant in that it is a crucial factor in a given firm’s choice about whether to continue operating. Specifically, the average variable cost should be lower than the marginal revenue in order for the firm to continue operating profitably over time.

In other words, this means that the price of a good should be higher than the average variable cost of the good–in this case, the firm is able to afford all of the variable costs as well as a portion of the fixed costs. And if a firm is selling its goods for lower than the average variable cost, a firm seeking to maximize their profits (as firms typically do) will halt production so as to prevent more variable costs from arising.

Leave a Reply

Your email address will not be published.