Average total cost definition
/What is Average Total Cost?
Average total cost is the aggregate of all costs incurred to produce a batch, divided by the number of units produced. The outcome includes a combination of all fixed costs and variable costs incurred to produce the units, and so is considered the most comprehensive costing compilation for a production run. This information is commonly used to set the minimum value at which a price point should be set. Any price set below the average total cost will not allow a business to recover its costs, resulting in losses. It is also useful to track this cost on a trend line, to see how it is changing over time.
The average total cost concept may be examined during the budget formulation process, since an organization can only be profitable when its average net sales per unit exceed its average total cost over the long term. If this is not the case, then management will need to budget for either higher prices or lower average total costs.
How to Calculate Average Total Cost
To calculate average total cost, add together total fixed and variable costs, and then divide by the number of units produced. The formula is as follows:
(Total fixed costs + Total variable costs) ÷ Number of units produced = Average total cost
Fixed costs are those costs that will be incurred, irrespective of the production level. The amount of variable costs incurred will vary directly with the number of units produced. For example, the rent on a production facility is classified as a fixed cost, while the cost of the direct materials that goes into a product is classified as a variable cost.
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Example of Average Total Cost
A business manufactures widgets. During the last month, it incurred $50,000 of fixed costs and $100,000 of variable costs, while producing 75,000 widgets. Based on this information, the average total cost for each unit produced was $2. If the accountant had only been interested in the average variable cost, this would have been calculated as $1.33 per unit (calculated as $100,000 variable costs divided by 75,000 units).
Disadvantages of Average Total Cost
A problem with the average total cost concept is that, as production volumes increase, the incremental cost to produce a unit declines, so the cost of the last unit produced may be much lower than the cost of the first unit produced. This disparity is hidden in the average total cost calculation. When this is the case, the reported average cost of a batch may be higher than is really the case; this can be a problem when the same product will be manufactured again, since management will be operating from the incorrect average cost figure, rather than the cost of the last unit produced.
Average Total Cost vs. Marginal Cost
Marginal cost is the cost incurred to produce one additional unit, which is the variable cost per unit. Marginal cost information is used to set the minimum price that can be charged to sell one more unit of output, usually when there is some excess capacity available for the fulfillment of a few additional customer orders. Conversely, average total cost includes all costs per unit, and so is used to set the minimum long-term price that a business should offer in order to generate a profit over the long term.