In the world of economics, knowing how to calculate average total cost is one of the basic skills you need to have. Calculating this is relatively an easy process but many often find it very complicated. This is mainly because the guides that they are following do not go in-depth about the topic. They only cover the basics which are not enough in most cases.
Calculating average total cost can help business owners make better pricing decisions that will benefit them financially. On top of that, it can help them optimize their production so that they can utilize the available resources much more efficiently.
This article will show you the average total cost formula, how you can calculate it, and teach you how you can apply this formula in the real world through multiple examples.
Average Total Cost Formula
Divide the total cost by the number of units produced to calculate the average total cost (ATC) of production. This formula shows how much a firm has to spend on each unit of output it manufactures.
The formula for calculating the average total cost is expressed as,
ATC = Total Cost of Production ÷ Quantity of Produced Goods
In this formula, the total cost includes all the costs that are necessary to produce the goods. That means, the total cost includes both the variable cost (cost for producing per unit of the good which can change based on the output) and the fixed cost (a one-time cost that doesn’t change with the output and is necessary to manufacture the products).
Therefore,
Total Cost = Total Variable Cost + Fixed Cost
The average total cost can also be calculated by using the following formula:
ATC = Average Variable Cost + Average Fixed Cost
Where,
Average Variable Cost = Total Variable Cost ÷ Number of Produced Goods
And,
Average Fixed Cost = Total Fixed Cost ÷ Number of Produced Goods
How to Calculate Average Total Cost
To calculate the ATC, use the following steps:
Step 1: First of all, identify the total fixed cost of production. You can get this information from the profit & loss statement of the company. Fixed costs of production include rent expenses, depreciation costs, selling expenses, etc.
Step 2: Now find out the total variable cost of production. You can get this information the same way as mentioned in “Step 1”. Variable costs of production include labor cost, raw material cost, etc.
Step 3: In this step, calculate the total cost of production. You can do that by adding up the values from “Step 1” and “Step 2”.
Step 4: Next, find out the number of goods that have been produced.
Step 5: Finally, divide the total cost of production calculated in “Step 3” by the number of goods produced determined in “Step 4”. This will give you the average total cost of production.
Examples
Take a look at the following examples to get a clear idea of how to calculate the average total cost using the formula mentioned above:
Example 1
Consider a hypothetical example where the variable cost of production of a LED bulb manufacturing company is $5 per unit. At the same time, the total fixed cost of the product is 2,000 USD. Assume. Find out the ATC when the number of units manufactured is:
- 400 units
- 600 units
- 800 units
For the first instance when the quantity of produced LED bulb is 400 units, the data required for calculating the average total cost is shown in the following table:
Let’s calculate the total variable cost for 400 units of LED bulbs first,
Total Variable Cost = Variable Cost (Per Unit) × Number of Units Produced
= $5 × 400
= $2,000
Therefore,
Total Cost = Total Variable Cost + Total Fixed Cost
= $2,000 + $2,000
= $ 4,000
Finally, for 400 units of LED light bulbs, the average total cost (ATC) is calculated as:
ATC = Total Cost of Production ÷ Quantity of Produced Goods
= $4,000 ÷ 400
= $10
So, at 400 units, the average total cost is $10 per unit.
Now, let’s calculate the average total cost for the second case, i.e for 600 units of LED bulb production.
Here, the total variable cost of production will be,
Total Variable Cost = $5 × 600
= $3,000
So, the total cost can be calculated as:
Total Cost = Total Variable Cost + Total Fixed Cost
= $3,000 + $2,000
= $ 5,000
Therefore,
Average total cost of production at 1,500 units = $5,000 ÷ 600 = $8.33
Now, let’s calculate the ATC for the final case, i.e for manufacturing 800 units of the LED light bulbs.
Similar to the previous cases, let’s start by calculating the total variable cost.
Total Variable Cost = $5 × 800 = $4,000
Now calculate the total cost.
Here,
Total Cost = $4,000 + $2,000 = $6,000
Finally, find out the average total cost by dividing the total cost by the quantity of produced LED light bulbs.
So, at 800 unit, the average total cost is = $6,000 ÷ 800 = $7.50
In this example, you can notice that the ATC is decreasing as the quantity of production is increasing. But that will not always be the case.
Example 2
In this example, consider another hypothetical situation where a LED bulb manufacturing company has a total fixed cost of $2,500. But here, the variable cost per unit production is going to change with the number of the product produced. Find out the ATC for 400, 600, and 800 units of production of LED light bulbs when:
- The variable cost of production is $4.00 per unit from 0-400 units
- The variable cost of production is $5.00 per unit from 401-600 units
- The variable cost of production is $9.50 per unit from 601-800 units
Here, the total cost at 400 units of LED bulb = Total Variable Cost + Total Fixed Cost
= $4 × 400 + $ 2,500 = $4,100
So, at 400 units, the average total cost is going to be,
Average Total Cost = Total Cost ÷ Number of Units Produced
= $4,100 ÷ 400
= $10.25
Similarly, let’s find out the average total cost at 600 and 800 units of LED light bulb production.
At 600 units, the total cost will be = $4 × 400 + $5.00 × 200 + $2,500 = $5,100
So, the average total cost in this case = $5,100 ÷ 600 = $8.5
And for 800 units of LED light bulb production, the total cost will be
Total Cost = $4 × 400 + $5 × 200 + $9.5 × 200 + $2,500 = $7,000
Therefore, at 800 units, the average total cost will be = $7,000 ÷ 800 = $8.75
As you can see from this example, the ATC keeps decreasing with the increase in production level at first. This trend continues until the quantity of produced goods reaches 600 units. But when the production quantity hits 800 units, this trend takes a 180-degree turn.
This happens because the average variable cost starts increasing at this level of production. This results in a “U” shaped curve which is discussed in-depth later in this article.
The Average Total Cost Curve
From example 2, you can see that the decreasing average total cost trend reverses at a certain level of production. This happens because of the theory of diminishing marginal return.
This theory states that after a certain level, adding an additional factor of production is going to result in a smaller increase in output. And because of that, the ATC curve is shaped like the letter “U”.
Let’s take a look at the table given below. This table contains brief calculations of example 2 that I’ve discussed previously in this article. From there, you can clearly see how the average total cost changes with the change in production level.
To calculate the ATC for each number of produced units, put the following formula in cell G2:
= D2/A2
Now, copy the formula down column D.
This will give you the ATC for each case.
The following chart shows the change in average total cost, average fixed cost, and average variable cost of production with respect to the change in production quantity.
Use and Relevance of Average Total Cost Formula
The concept of ATC (average total cost) gives companies an idea about what the per-unit cost of a product is going to be for producing a specific number of goods. From the above examples, we’ve seen that as the production increases, the total cost is going to decrease as the fixed cost is going to remain the same no matter how many products you are going to manufacture.
On the other hand, the variable cost is going to increase after the production hits a certain level. This happens due to a decrease in margin productivity and at the same time, a return of the additional resources that you are adding.
Using the average total cost formula, companies can calculate an optimal point for which their total cost of production per unit will be minimum. Plus, if their fixed cost increases due to an increase in demand, companies can calculate what their production quantity should be.
On top of that, companies can utilize the average total cost formula to optimize their production quantity, so that they can utilize their resources much more efficiently.
Conclusion
In this article, I’ve discussed how to calculate average total cost in detail with the help of several practical examples. Hopefully, I was able to clear all your confusion. Thanks a lot for stopping by. Have a great day!
