Understanding the concept of “Average Variable Cost” is extremely important to maintain the sustainability of any business. It can help companies and businesses with budgeting and production planning. And if you are interested in learning this concept then you are in the right place.
In order to make a profit, businesses have to sell their products and services at a price so that they can recover their variable and fixed costs of production. And by learning how to calculate the average variable cost, you will be able to effectively manage the variable cost of production which in turn will help you to maximize profit.
This article will give you the definition of average variable cost and show you the formula for calculating it. The article also contains a step-by-step guide along with examples explaining the average variable cost calculation process. This article will also give you an idea about why calculating it can be very beneficial to your business.
Average Variable Cost Formula
The formula for computing average variable cost (AVC) can be derived by finding out the total variable cost first and then dividing the result by the quantity of the output.
The mathematical expression of the average variable cost formula is given below,
AVC = (Total Variable Cost) ÷ (Quantity of the Produced Units)
Here, the total variable cost is calculated by adding all the variable costs of manufacturing together.
You can also calculate the average variable cost using the following formula,
AVC = (Average Total Cost) – (Average Fixed Cost)
Average Variable Cost Definition
To put it in simple words, the term “Average Variable Cost (AVC)” refers to the variable cost per unit production.
In economics, variable costs are those that change with the amount of the produced output. Such costs include raw materials, some forms of labor cost, fuel, etc. Fixed costs are the opposite of it. The quantity of the output doesn’t affect this type of cost at all.
Some examples of fixed costs include insurance, rents, advertising costs, depreciation, etc.
How to Calculate Average Variable Cost?
To calculate the average variable cost, follow the step-by-step guide given below:
Method 1
The following step-by-step process is for calculating the average variable cost using the first formula mentioned above.
Step 1: First of all, identify all the variable costs of manufacturing. These costs change with the quantity of the output. Cost of materials, labor costs that are directly involved in the manufacturing processes are considered variable costs. Figure out these costs for a given time span.
Also, find out the variable manufacturing overhead of the company. This cost includes the rest of the variable costs.
Step 2: In this step, figure out the total variable cost of manufacturing. To do that, just add all the variable costs together.
Total Variable Cost = (Variable Manufacturing Overhead + Raw Material Cost + Direct Labor Cost)
Step 3: Now, figure out the quantity of the produced units during the time span.
Step 4: Lastly, put the values from “Step 3” and “Step 4” into the first formula mentioned above. This will give you the average variable cost of manufacturing.
Method 2
The following step-by-step process is for calculating the average variable cost using the second formula mentioned above.
Step 1: First, identify the total cost of production.
Step 2: Secondly, figure out the total fixed cost of manufacturing.
Step 3: Next, find out the quantity of the manufactured units.
Step 4: In this step, figure out the average total cost of production using the following formula,
Average Total Cost = (Total Cost) ÷ (Quantity of Produced Units)
Step 5: Calculate the average fixed cost of production using the formula given below,
Average Fixed Cost = (Total Fixed Cost) ÷ (Quantity of Produced Units)
Step 6: Finally, put the values from “Step 4” and “Step 5” into the second formula for the average variable cost mentioned above to get the result.
Practical Examples
Down here, I’ve provided several examples showing how to calculate the average variable cost in different scenarios. Take a look at them to understand the concept better.
Example 1
Let’s start with a simple example. Consider the case of a hypothetical company named “Herbert Inc.” It is a display panel manufacturing company based in North Carolina. The following table shows the cost information that was published in the annual financial report published for the fiscal year 2020.
| Total Raw Material Cost | $1,000,000 |
| Labor Cost | $15/Hour |
| Total Variable Manufacturing Overhead | $500,000 |
| Number Required Work-Hour | $700,000 Hours |
| Quantity of Produced Display Panels | 100,000 |
Now find out the average variable cost of manufacturing for Herbert Inc. using the above information.
Here, the total raw material cost and the total manufacturing overhead are given directly. To calculate the total variable cost, we will have to figure out the direct labor cost in this example.
Direct labor cost is calculated using the following formula,
Direct Labor Cost = (Per Hour Labor Cost) × (Number of Work-Hours)
= ($15/Hour) × (700,000 Hours)
= $10,500,000
So, the total variable cost is going to be,
Total Variable Cost = (Variable Manufacturing Overhead + Raw Material Cost + Direct Labor Cost)
= ($500,000 + $1,000,000 + $10,500,000)
= $12,000,000
Finally, the average variable cost is going to be,
AVC = (Total Variable Cost) ÷ (Quantity of the Produced Units)
= $12,000,000 ÷ 100,000
= $120/Unit
So, in the case of Herbert Inc., the average variable cost is $120 per unit production for the fiscal year 2020.
Example 2
Let’s consider another company that goes by the name “Regal Inc.”. According to their annual financial report for the fiscal year 2020, the total cost of manufacturing was $100,000. The quantity of the produced units was 7,500 and the total fixed cost was $49,000. Find out the average variable cost for the companies by using these pieces of information.
Here, the total cost of the company was $100,000 for the fiscal year 2020. So, the average total cost will be,
Average Total Cost = (Total Cost) ÷ (Quantity of Produced Units)
= ($100,000) ÷ (7,500 Units)
= $13.33/Unit
And the total fixed cost was $49,000. Therefore, the average fixed cost of production in this example is going to be,
Average Fixed Cost = (Total Fixed Cost) ÷ (Quantity of Produced Units)
= ($49,000) ÷ (7,500 Units)
= $6.53/Unit
So, the average variable cost of production is going to be,
AVC = (Average Total Cost) – (Average Fixed Cost)
= ($13.33/Unit) – ($6.53/Unit)
= $6.8/Unit
Therefore, the average variable cost of production for “Regal Inc.” is $6.8/unit for the fiscal year 2020.
Importance of Average Variable Cost
Understanding the concept of “Average Variable Cost (AVC)” is extremely important in order to maintain the profitability of a company. One of the main goals of every business is to increase their sales and profit numbers as much as possible. And companies typically do that by effectively managing the variable cost of production.
Keep in mind that average variable cost is subjected to the law of diminishing marginal returns. It gradually decreases up to a certain level with the increase in output volume. Once that level is crossed, the average variable cost keeps increasing with the increase in the quantity of the manufactured units.
It is logical for companies to increase their output until the average variable cost is lower than the selling price of their product in order to make a profit. This is why it is essential to calculate the average variable cost in any business as it can help companies with their production plan.
Conclusion
In this article, I’ve discussed how to calculate the average variable cost along with examples. Hopefully, this article was enough to clear all your confusion regarding this topic. Thanks a lot for going through the entire article. Have a great day!