Understanding the concept of average fixed costs is crucial to grasping the behavioral pattern of businesses and how they operate. Evaluating and calculating the costs incurred during production helps economic agents make better-informed decisions and identify opportunities for greater profitability.
Investors and business executives cannot assess and determine the performance of their companies by simply looking at the overall costs. Instead, they split the total costs into separate categories- fixed and variable costs- and inspect them Individually. Determining average fixed costs helps economic agents define the efficiency of their production, reduce their expenses, and increase the economies of scale.
Such cost classification and evaluation is vital for predicting cost behavior. Cost Behavior describes how changes in production activities influence costs, and it is essential for estimating profit margins.
By the end of this article, you will have a thorough understanding of what average fixed costs are and how they are calculated.
Cost Classification – Fixed and Variable Costs
Any economic activity that generates revenue simultaneously incurs expenses. The overall expenses acquired during production – total costs- can be broken down into total fixed cost (TFC) and total variable cost (TVC).
The distinction between these two categories can be established through cost behavior- how expenses react to changes in activity. Variable costs are directly associated with the production volume and output. They change proportionally to the variations in the level of activity.
Unlike variable costs, fixed costs are constant and operate separately from the production process – they occur regardless of whether the company is producing any output or not. Examples of such expenses are insurance, the salary of a permanent staff member, or the most common one–rent. Rent demands to be paid independent of any specific business activity.
Definition – Average Fixed costs
To put it in a nutshell, average fixed cost is the total fixed expenses incurred by the company per unit of output produced, which is calculated by dividing the total fixed cost by the total output produced.
Average fixed cost (AFC) = Total fixed cost (TFC) ÷ Total output (Q)
- Step 1: Determine the time during which the calculations are taking place.
- Step 2: Determine and add all the fixed costs in that time period (the costs that remain the same, even if the level of output changes) to find the total fixed costs.
- Step 3: Identify the total production output for that time frame.
- Step 4: Divide TFC by the Total output (Q).
There is also another approach to finding out AFC, which is nearly the same formula, however a bit more prolonged and broken down.
Average fixed cost = Average total cost – Average variable cost
- Step 1: Determine the time period for calculations.
- Step 2: Calculate the total costs by summing up all the given costs
- Step 3: Determine the total output. Afterwards, find average total costs by dividing the total cost by total output.
Average total cost = Total cost ÷ Total output
- Step 4: Calculate the average variable cost (Variable Costs can be direct labor, direct materials, etc. These are the costs that are related to the production and change corresponding to the output produced).
Average variable cost = Total variable cost ÷ Total output
- Step 5: Subtract average variable costs from average total costs to find average fixed costs.
Average fixed cost = Average total cost – Average variable cost
Now, in order to successfully grasp the formulas and the theory, we can consider several examples.
Example 1: Division Method
“Chunks of haven Inc. is a company that produces 100 units of chocolate bars per day. However, the company is having financial issues. Due to that, they want to decrease production to the lowest possible amount for the second quarter of the year (Q2). They have already calculated the average variable costs, now they need to know what the average fixed costs per unit will be. The quarterly fixed costs are given below:”
| Item | Cost ($) |
| Quarterly Rent | $ 9,000 |
| Quarterly Machinery costs | $ 25,000 |
| Quarterly Insurance | $ 2,600 |
| Quarterly Property Tax | $ 3,400 |
Calculations
Step 1
Determine the time. It has already been mentioned that determining the correct time period is very important while calculating fixed costs. Here, we are told we should calculate the second quarter, which means from April 1st–June 30th.
Step 2
Calculate the total fixed costs. The quarterly fixed costs are already given in the table above. To calculate TFC, we simply need to sum their costs up.
TFC = 9,422 + 25,000 + 2,600 + 3,400 =$ 40,422
Step 3
Calculate the total output for the selected time period. In order to do this, we need to know how many chocolate bar units were produced in the second quarter of the year. We already know that the company produces 100 Units per day. In order to find out the amount for the second quarter, we need to multiply Units per day x days per month for the selected months and sum the amounts up.
Total Output (Q2) = (100 x 30) + (100 x 31) + (100 x 30) = 9,100 units
Step 4
Divide the total fixed costs by the total output produced to find out the Average Fixed costs.
Average fixed cost = 40,422 ÷ 9,100 = $ 4.44
The Average fixed cost of Chunks of heaven inc. is $4.44 per unit of chocolate bar.
Example 2: Subtraction Method
“Unicorn Oasis needs to sort out its annual finances for the year 2019. They produce 225 units of unicorn onesies per day. The quarterly costs are given in the table below. What will be the average fixed cost per unit of unicorn onesie?”
| Item | Cost ($) |
| Quarterly Rent | $ 12,000 |
| Quarterly Machinery costs | $ 25,000 |
| Quarterly Insurance | $ 2,700 |
| Quarterly Property Tax | $ 3,400 |
| Direct Labor cost (monthly) | $ 4,000 |
| Direct Material costs (Monthly) | $ 3,000 |
Calculations [Subtraction Method]
Step 1
Determine the time frame. We were told in the instructions that the company is doing its annual calculations, meaning we will consider the entire year of 2019–12 months in total.
Step 2
Calculate the Total costs. In order to calculate the total costs, we need to sum up the total variable and total fixed costs. We already know that the first four items on the table are fixed costs. Direct labor and Direct Material costs are variable and depend on the volume of production. Considering we are calculating for the entire year, the fixed costs which are given in quarters need to be multiplied by four, and monthly costs need to be multiplied by 12.
Total cost = 4 x (12,000 + 25,000 + 2,700 + 3,400) + 12 x ( 4,000 + 3,000)
= 172,400 + 84,000 =$ 256,400
Step 3
Calculate the average total costs. To calculate ATC, we need to know the total output per year. Since the output per day is 225 units:
Total Output = 225 x 365 = 82,125 units
Average total costs = 256,400 ÷ 82,125 = $ 3.122 per unit
Step 4
Calculate Total variable cost and through that find average variable cost.
Total variable cost = 12 x (4,000 + 3,000) = 12 x 7,000 = $ 84,000
Average variable cost = 84,000 ÷ 82,125 = $ 1.023 per unicorn onesie
Step 5
Calculate the AFC by subtracting AVC from ATC:
Average fixed cost = ATC – AVC = 3.122 – 1.023 = $ 2.099 per unit
Additional Information and tips
Point 1
Fixed costs are used for calculating the breakeven point in the breakeven analysis. Break-even analysis is used to determine the levels of sales necessary to pay for the costs of the business. It determines a point at which the total revenue and total costs are equal.
Breakeven point = Total fixed cost / [(Sales price per unit) – (Variable cost per unit)]
Point 2
When plotted on a diagram, the total fixed cost will be a straight horizontal line since it is independent of the output produced. The average fixed cost is represented by a downward-sloping curve. This is because the same amount of costs is spread over a larger number of units as the output increases. AFC per unit decreases as the output increases.
Point 3
AFC is used by companies to determine the minimum amount of profit that they require per unit of the goods produced so that the expenses incurred can be paid off. It is also necessary for calculating the shut-down price. At the shut-down price, the firm can cover all of its AVC in the short run. Below this price, the firm is unable to cover not only their fixed costs but also their variable costs. Thus, they would be better off shutting down so they only lose the amount equal to fixed costs.
Point 4
When something is referred to as a “fixed cost” it is generally meant in the short-run (How the short-run period is defined can vary), in the long-run, the fixed costs turn into variable costs.
Point 5
TFC is the summation of expenses that will not change as production alternates, meaning it is often referred to as a sunk or unavoidable cost that a firm has to cover.
