What is the Average Variable Cost?
The variable cost per unit of products or services is referred to as the average variable cost. The variable cost is the cost that fluctuates directly with output and is computed by dividing the total variable cost for the period by the number of units produced.
Total variable cost refers to all costs that change with output, such as direct labour and raw material. Looking at the result is the simplest way to detect if a cost is variable. When the output changes, the variable cost changes as well.
Formula:
TOTAL VARIABLE COST/UNITS PRODUCED.
Total Cost:
To calculate Total Variable cost, subtract the fixed cost from total cost incurred.
Total Cost comprises:
Variable Cost:
Variable costs are the sum of marginal costs for all units produced. These are expenses that fluctuate in response to variations in the quantity of a company’s product or service.
Raw materials and labour expenses are examples of variable costs that change over time and are often based on a company’s production volume.
Fixed Cost:
Regardless of how many goods the company produces, fixed costs remain constant. While smaller production volumes have a fixed cost, economies of scale in manufacturing allow costs to vary and decrease below that number. Rentals are a good example.
The sum total of Variable cost and fixed cost is the total cost incurred in production.
Calculating Average Variable Cost:
There are two approaches to calculate Average Variable Cost.
Method of Division
Average Variable Cost= Total Variable cost/ units produced
Under the Division Method, to arrive at an average variable cost, follow these steps.
Step 1: Calculate the number of Units Produced.
Step 2: Calculate the total variable cost of production for the units.
Step 3: Divide Total Variable cost by the Total number of units produced.
The resulting number is the average variable cost.
Method of Subtraction:
Average Variable Cost = Average Total Cost – Average Fixed Cost.
Under the Subtraction Method; to arrive at average variable cost, follow these steps.
Step 1: Calculate Average total cost of production
Average Total cost= Total Cost/ Units Produced.
Step 2: Calculate Average Fixed Cost.
Average Fixed Cost= Fixed Cost/ Units Produced.
Step 3: Subtract Average Fixed cost from Average Total Cost.
The resulting number will be the Average Variable Cost.
Understanding the Application
- Companies can use the Average Variable Costs to maximise profits by calculating when production should be temporarily halted.
- If they get a higher price for the good than the Average Variable Cost for the output they produce, they are at least covering all variable expenses and some fixed costs.
- Fixed costs are expenses that do not change in response to output; they are set at a fixed price regardless of the quantity generated.
- Rent on the space utilised to create the product or supply the service is the finest illustration.
- Regardless of how many units are manufactured or how many customers are supplied, the fixed cost will be the same.
- As a result, you will be accountable for the fixed expenses even if you produce nothing, as you would if you shut down manufacturing.
- If the price is more than the Average Variable Cost and covers some fixed expenses, you should keep producing.
- If the price falls below the AVC, the corporation may decide to suspend production temporarily because the price no longer covers any fixed or variable costs.
- As a result, the Company would rather not incur any variable costs and instead concentrate on paying fixed expenses.
Limitations of Average variable costs:
Multiple Product Lines: More often than not, Firms have multiple products in their product portfolio. Under such circumstances, attributing a fixed cost proportion to an individual product produced, with the same fixed cost incurred on a portfolio of Products, can be highly complicated. With this factor under consideration, it becomes difficult to identify efficient and Inefficient products, in terms of average variable cost, for profitability optimization.
Duration: To compute average variable costs, all expenses must be reduced to the same denominator in terms of length or time period. The duration, which might be weekly, monthly, or annually, is the time period for which the average variable cost must be estimated. All costs should be changed in the same proportion as time for these calculations, and then the computation should be completed.
Dynamic nature of Costs: While average variable cost might be helpful in making profit-maximising decisions, it should only be one of several variables to examine. When deciding on products or services based on average variable costs, keep in mind that variable costs are frequently easier to modify than fixed expenses. When a company relocates, it may be able to find a more cost-effective building, obtain more cost-effective raw materials by switching suppliers, or pay slightly more incentive to retain personnel and minimise hiring costs by paying slightly higher compensation.
Conclusion:
Average Variable Costs can be helpful in obtaining a picture of the efficiency of production of units or delivering any services. While taking decisions on the basis of average variable costs, it should be seen in tandem with other factors and industry expectations.
