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 purchasing 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.
Within these restrictions, then, the cost per unit calculation is:
(Total fixed costs + Total variable costs) / Total units produced
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.
For example, 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