The total cost formula is used to derive the combined variable and fixed costs of a batch of goods or services. The formula is the average fixed cost per unit plus the average variable cost per unit, multiplied by the number of units. The calculation is:
(Average fixed cost + Average variable cost) x Number of units = Total cost
For example, a company is incurring $10,000 of fixed costs to produce 1,000 units (for an average fixed cost per unit of $10), and its variable cost per unit is $3. At the 1,000-unit production level, the total cost of the production is:
($10 Average fixed cost + $3 Average variable cost) x 1,000 Units = $13,000 Total cost
There are several problems with the total cost formula, which are as follows:
Limited range for average fixed cost. The definition of a fixed cost is a cost that does not vary with volume, so the average fixed cost part of the formula only applies within a very narrow volume range. Actually, the same fixed cost will probably apply across a broad range of unit volumes, so the average fixed cost figure could vary wildly.
Variable purchasing costs are volume-based. When buying raw materials and sub-assemblies for the production process, the per-unit cost will vary based on volume discounts. Thus, the more units ordered, the lower the variable cost per unit will be.
Direct labor is actually fixed. There are few cases in which direct labor actually varies directly with production volume. Instead, a fixed number of people are needed to staff a production line, and that group can handle a fairly wide range of unit volumes. Thus, direct labor should usually be considered a fixed cost.
To correct for these issues, it is necessary to recalculate the total cost whenever the unit volume changes by a material amount.