How to calculate cost per unit
/Cost per unit information is needed in order to set prices high enough to generate a profit. The cost per unit is derived from the variable costs and fixed costs incurred by a production process, divided by the number of units produced. Variable costs, such as direct materials, vary roughly in proportion to the number of units produced, though this cost should decline somewhat as unit volumes increase, due to greater volume discounts. Fixed costs, such as building rent, should remain unchanged no matter how many units are produced, though they can increase as the result of additional capacity being needed (known as a step cost, where the cost suddenly steps up to a higher level once a specific unit volume is reached). Examples of step costs are adding a new production facility or production equipment, adding a forklift, or adding a second or third shift. When a step cost is incurred, the total fixed cost will now incorporate the new step cost, which will increase the cost per unit. Depending on the size of the step cost increase, a manager may want to leave capacity where it is and instead outsource additional production, thereby avoiding the additional fixed cost. This is a prudent choice when the need for increased capacity is not clear.
Formula for the Cost per Unit
Within the restrictions just noted, the cost per unit calculation is to add together the total fixed costs and total variable costs for the measurement period, and then divide by the total number of units produced during the same period. The calculation is as follows:
(Total fixed costs + Total variable costs) ÷ Total units produced = Cost per unit
The cost per unit should decline as the number of units produced increases, primarily because the total fixed costs will be spread over a larger number of units (subject to the step costing issue noted above). Thus, the cost per unit is not constant.
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Example of the Cost per Unit
ABC Company has total variable costs of $50,000 and total fixed costs of $30,000 in May, which it incurred while producing 10,000 widgets. The cost per unit is:
($30,000 Fixed costs + $50,000 variable costs) ÷ 10,000 units = $8 cost per unit
In the following month, ABC produces 5,000 units at a variable cost of $25,000 and the same fixed cost of $30,000. The cost per unit is:
($30,000 Fixed costs + $25,000 variable costs) ÷ 5,000 units = $11/unit