Average Cost: Cost per Unit of Output
Breaking Down the Average Cost Formula
The basic formula for average cost is simple. It tells you the cost of a single unit. We write it as:
But total cost is made of two parts: fixed costs and variable costs. So, we can also write it as:
For example, imagine you run a small bakery. Your rent (fixed cost) is $200 per day, and the flour, sugar, and labor (variable costs) for 100 loaves of bread is $300. Your total cost is $500. The average cost per loaf is $500 / 100 = $5.00. This means each loaf costs you $5.00 to make.
Fixed vs. Variable Costs: A Closer Look
To understand average cost, you must understand its two main ingredients. Fixed costs are like the foundation of your businessāthey exist even if you produce nothing. Variable costs are the ingredients that grow with your production.
| Cost Type | Definition | Real-Life Example |
|---|---|---|
| Fixed Costs (FC) | Costs that stay the same no matter how much you produce. | Monthly rent for a factory, annual insurance, salaries of permanent managers. |
| Variable Costs (VC) | Costs that change directly with the number of units produced. | Raw materials (wood for chairs), hourly wages for workers, electricity for machines. |
How Average Cost Changes with Scale
Imagine you have a lemonade stand. Your fixed cost is a $10 sign. Your variable cost is $1 per cup for lemons and sugar. Look at how the average cost changes as you sell more cups:
| Cups Sold (Q) | Fixed Cost (FC) | Variable Cost (VC) | Total Cost (TC) | Average Cost (AC) |
|---|---|---|---|---|
| 1 | $10 | $1 | $11 | $11.00 |
| 5 | $10 | $5 | $15 | $3.00 |
| 10 | $10 | $10 | $20 | $2.00 |
As you sell more, the fixed cost of the sign is spread out over more cups. This is called spreading overhead. The average cost drops from $11.00 to $2.00!
Real-World Example: The Smartphone Factory
A smartphone company, TechPulse, wants to launch a new phone. They spend $1,000,000 on research, design, and the factory building (fixed costs). Making each phone costs $200 for parts and labor (variable cost).
- If they make 1,000 phones: $AC = \frac{\$1,000,000 + (1,000 \times \$200)}{1,000} = \frac{\$1,200,000}{1,000} = \$1,200 per phone.
- If they make 100,000 phones: $AC = \frac{\$1,000,000 + (100,000 \times \$200)}{100,000} = \frac{\$21,000,000}{100,000} = \$210 per phone.
By producing 100 times more phones, the average cost dropped dramatically because the huge fixed cost was shared across many units. This is why big companies can often sell products for lower prices than small onesāthey benefit from economies of scale.
Important Questions
Average cost is the break-even price. If you sell an item for less than its average cost, you lose money on each sale. Businesses use average cost to set a profitable selling price. If our bakery's average cost per loaf is $5.00, they must sell it for more than $5.00 to make a profit.
Average cost is the cost of all units so far, averaged out. Marginal cost is the cost of producing just one more unit. In our lemonade stand, the average cost for 5 cups was $3.00. The marginal cost (cost to make the 5th cup) was just the $1.00 for ingredients. When marginal cost is below average cost, it pulls the average cost down.
Yes. If a factory gets too crowded with workers and machines, they might start getting in each other's way, leading to inefficiency. This is called diseconomies of scale. For example, if our bakery tries to bake 1,000 loaves in a tiny oven, the variable costs (like overtime pay) could rise so fast that the average cost per loaf starts to increase again.
Footnote
- [1] Economies of Scale: A situation where the average cost of production falls as the quantity of output increases.
- [2] Diseconomies of Scale: A situation where the average cost of production rises as the quantity of output increases.
- [3] Marginal Cost: The change in total cost that comes from making or producing one additional item.