Average cost

Average cost is defined as the total cost divided by the number of units produced. It is the average cost of each unit produced.

Average cost

Average cost is a cost control measure of a company or organization that seeks to reflect the average cost per unit of production. It is calculated by applying the following formula:

Average cost types

Average costs can be divided into two large groups: Fixed average cost and variable average cost:

Average fixed cost (CMeF)

Average fixed cost (CMeF) is calculated as the division between total fixed costs and the number of units produced. Since fixed costs are constant (independent of the level of production) when more units are produced, the CMeF will decrease. The foregoing reflects the fact that the more units the producer manages to manufacture, then the better it will be able to face high fixed costs since these are redistributed in a greater number of units.

The fixed average cost formula is as follows:

CMeF = Total fixed cost / Quantity

A good example is the case of the services of a doctor. Suppose the doctor needs to buy a surgical machine whose cost reaches 50,000 euros. The more patients the doctor has, the easier it will be for him to finance his investment. If the doctor only manages to sell 5 services a month, his fixed average costs will be 10,000 euros. However, if he manages to sell 100 services per month, his average fixed costs will be 500 euros, making it much easier for him to face this expense.

The Variable Average Cost (CMeV)

The moving average cost is calculated as the division between the variable costs and the number of units produced. Average variable costs do not necessarily decrease with the number of units produced as they vary with the volume of production.

The average variable cost formula is as follows:

CMeV = Total variable cost / Quantity = CVT / Q = CMeV

Let’s look at an example. A baker decides to increase his production of bread from 100 to 200 units. Its variable costs correspond to 500 when it produces 100 units, the average variable cost in this case is 5 euros. When you increase your production to 200, your total variable costs are 800 euros, in this case, your average variable cost is 4 euros.

Shape of the average cost curve

In general, the average cost curve is U-shaped. At first it gradually descends until it reaches a minimum where it begins to rise slowly.

Average Cost Curve

The relationship between the total cost curve, average cost, and marginal cost

The average cost curve is derived from the total cost curve, since it is the total cost curve divided by the number of units.

Regarding the relationship between the average cost curve and the marginal cost curve, when the marginal cost is less than the average cost, the average cost curve falls. On the contrary, when the marginal cost curve is greater than the average cost curve, the latter grows. When marginal cost equals average cost, it is at its lowest point and therefore the CMe curve will be flat at that point.

Below we see a graph that presents the relationship between both cost concepts: