Average cost definition
/What is Average Cost?
Average cost is the cost per unit manufactured in a production run. It represents the average amount of money spent to produce a product. This amount can vary, depending on the number of units produced. Generally, the average cost declines as the number of units produced increases, as the manufacturer takes advantage of increasing efficiencies. However, as the manufacturer approaches the theoretical capacity of its production facility, it becomes more expensive to produce each incremental unit, so the average cost starts to increase.
Average cost can be used as the basis for product pricing, where a standard margin is added to a product’s average cost in order to derive its price. This approach can be inefficient, since the prevailing market price may differ substantially from a price derived from the average cost.
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How to Calculate Average Cost
To calculate average cost, aggregate all fixed costs and variable costs associated with a production run, and divide by the number of units produced. This calculation does not include any administrative expenses. The average cost formula is:
(Fixed costs + Variable costs ) / Number of units produced = Average cost
Example of Average Cost
ABC International's manufacturing department completes a production run of 10,000 widgets. The fixed costs of the production run were $30,000, plus $2 of variable costs for each unit produced. The resulting calculation is:
($30,000 Fixed costs + $20,000 Variable costs) / 10,000 Units = $5 average cost
When to Use Average Cost
The average cost concept is most applicable to lengthy production runs, as may be found for highly standardized products that are produced and sold in large quantities. In these situations, a significant competitive advantage may exist when a business can reduce its average cost per unit, since this allows it to lower prices and gain market share from competitors.
When Not to Use Average Cost
The average cost concept has little application in a custom production shop or one that produces to order in small batches; in these situations, the competitive advantage is more likely to be associated with attentive service or fast turnaround time, rather than product cost.
Terms Similar to Average Cost
Average cost is also known as unit cost.