If you ever find yourself making big decisions at a company that makes a product — whether it's your own company or someone else's — you'll need to be familiar with the factors that determine your production costs. Average variable cost is one that might keep you up at night.
Fixed and Variable Costs
You can break the cost of producing just about anything into two parts: fixed costs and variable costs. Fixed costs are those that stay the same regardless of how much you produce. A good example is rent on your company's building. It doesn't matter whether your production line is running 24/7 or you have the whole line shut down all month, your rent is the same. Rent is thus a fixed cost. Variable costs are those that change — vary — as you increase or decrease production. Raw materials are a classic example of a variable cost. If your company makes bowling balls, then your variable costs rise with each ball you make, because you need more of whatever material it is that they make bowling balls out of (usually plastic, urethane or resin).
Companies are actually less interested in the total cost involved in a production run than they are in the average cost for each item in the run. Average cost for a product has two parts: average fixed cost and average variable cost. You get these figures by taking the total fixed cost and the total variable cost of the production run and dividing each by the number of items produced. Average fixed cost always gets smaller as you increase production, since the same cost is spread over more items. But average variable cost actually "changes direction," which is why companies are more interested in tracking average variable cost.
Average Variable Costs
As production increases, average variable costs begin to decrease as the company takes advantage of unused capacity, worker productivity and other factors. Essentially, its total variable costs are rising at a slower rate than production, so the average variable cost is falling. Eventually, though, if the company wants to continue increasing production, it's going to have to do things that produce a greater increase in total variable costs, such as hiring more workers, paying overtime or running additional equipment. When total variable costs rise at a faster rate than production, average variable cost rises. It's up to the company's decision-makers — you, maybe — to determine what level of average variable cost produces the greatest profit given whatever price is being charged for a product.
Congratulations. You're the new production manager at Titlebaum's Toilet Brush Co. You've got two variable costs: labor, for which you pay $10 per worker per hour, and materials, for which you pay $2 per brush. If you produce one toilet brush per hour, you only need one worker. Your total variable cost is $12 ($10 for labor, $2 for materials), and the average variable cost is $12 per brush. Make two brushes, and the total is $14, so the average drops to $7 per brush. Three brushes, the figures are $16 and $5.33. Four brushes, $18 and $4.50. Five brushes, $20 and $4. The average is falling, although the rate of decrease is shrinking. But one worker can only make five brushes per hour. If you want to make more brushes, you have to add a second worker. At six brushes per hour, you have $20 in labor for two workers, and $12 in materials. Total variable cost is $32 — and average variable cost is rising again, to $5.67 a brush.
- "Microeconomics," Third Edition; Paul Krugman and Ronin Wells; 2012
- AmosWEB: Average Variable Cost
Cam Merritt is a writer and editor specializing in business, personal finance and home design. He has contributed to USA Today, The Des Moines Register and Better Homes and Gardens"publications. Merritt has a journalism degree from Drake University and is pursuing an MBA from the University of Iowa.