Blog 4 (Average Cost)

Jeffrey Williams

Average Cost

So you want to learn about average cost?  Let’s start off with the definition of average cost, average cost is (fixed cost plus variable cost) divided by units produced.  Mathematically, the fixed cost plus variable cost is the cost function which can be represented by the notation C(q) with q being number of units. Since average cost is the cost function divided by the number of units, the formula for average cost is C(q)/q.   We can demonstrate this with a very simple example, suppose that:

Fixed Costs = 10,000

Variable cost per unit = 10

Units produced = 100

So if the cost function is fixed cost + variable cost = cost function (C(q)), then

C(q) = 10,000 + 1,000* = 11,000/10 = 1,100 per unit.

*1,000 is calculated as by taking the variable cost per unit and multiplying it by the units produced to produce total variable cost. Ex: 100 x 10 = 1,000.  

A graph showing average cost compared to the cost function.
 Note how the both graphs eventually meet at 11,000 at 100 units

Okay, so you've learned how to calculated average cost, but why should you need to now this. That's a very good point, the reason why average cost is important is that it allows companies to measure the total cost to produce each unit.  But, isn't variable cost the cost to produce each unit? Well, yes and no; Variable cost is the marginal cost or the cost to produce each unit, but variable costs aren't the only costs that businesses have. Fixed costs are the cost that the business has simply for keeping its doors open. So, even if the business produces zero units it still has a certain amount of costs.  Thus the importance of average cost is it allows businesses to measure the true cost (fixed costs plus variable costs) of each unit it produces. This helps the company determine the profitability of and cost of making more units.  If the marginal or variable cost is less than average cost (MC<AC) then each unit produced become less expensive since the fixed costs of the company are spread out of more units so the cost of each unit decrease.  This decrease in cost increases the business' profits.  The reverse is when marginal cost is greater than average cost (MC<AC) then each unit produced increase cost since each unit cost more produce then the amount it reduces foxed cost per unit.  This increase in cost causes the company to loss money on each unit produced.  To wrap it all up, the cost function and average cost function both measure the same thing (the total cost of a business), the difference between them is how they go about measuring costs.  In the end, you can see in the graph above, they each end at the same amount.