Average Variable Costs

EconomicsArticles / Tutorial Titles

Introduction

It is important for companies to find the variable costs to check whether the products are earning a profit. Fixed costs of products do not change and they are straightforward to calculate. However, variable costs differ widely from one another and hence keeping an eye on variable costs is very important. Average variable costs allow an individual to compare the cost to make a single unit to the price at which it is sold. So, one can see whether it is worthwhile to produce.

What is Average Variable Cost?

Average variable cost is the average of all variable expenses in creating a product. Variable costs keep changing and they are often related to factors, such as volume, materials, and labor. Fixed costs usually do not change no matter how many items have been produced. However, variable costs depend on factors like volume. The variable cost is usually fixed at lower production numbers but economies of scale may reduce the variable costs palpably.

In general, total variable cost includes all variable costs in a production run while average variable cost implies the variable cost associated with each unit of product. The average variable cost is different from the total variable cost as in the short run, at least one variable is fixed. On the other hand, in the long run, all variables are flexible.

Importance of Average Variable Cost

Average variable cost is an important factor for companies to see whether their products are earning profit and whether they should keep producing them. When the average variable cost is lower than the product price in the market, the company is earning a profit by producing that product. So, it may continue producing and selling it.

However, if the market price of a product is less than the variable price, the company is incurring a loss in selling the product. So, it is making a loss and should not continue producing the product.

In other words, the average variable cost also indicates the lowest amount at which a product should be sold in the market. Below this threshold, the company makes a loss. So, the price of the product should always be more than the average variable cost to earn a profit and continue running the product in the market.

So, the average variable cost is important because it shows the minimum price at which the company can earn a profit and stay competitive in the market.

Calculating Average Variable Cost

There are two main methods for calculating the average variable costs depending on the information one has at his hand.

They are −

  • Division Method
  • Subtraction Method

Division Method

To find the average variable cost using the division method, two total numbers must be available. These are the total variable costs and the output number.

The steps involved in the division method are −

  • Finding the total variable cost.
  • Finding the total output number
  • Dividing the total variable cost by the total output number.

Example

Suppose Pentonic, a pen manufacturer wants to know whether their new line of pens would be profitable for them. They sell each pen at the price of Rs 10, while the total variable cost of 2000 pens is Rs 18,000 in total.

Here, the total variable cost is Rs 18,000

Average Variable cost will be $\frac{18000}{2000}$ = Rs 9.

Since the average variable cost is less than the selling price, Pentonic is making a profit. So, they may continue producing the pen.

Subtraction Method

In the subtraction method, the average variable cost is determined by the formula −

For calculating average variable cost in the subtraction method, two other average costs must be known. These are average total costs and average fixed costs.

The steps involved in calculating average variable cost by subtraction method are −

  • Finding the average total cost, (total cost divided by the output)
  • Finding the average fixed cost, (fixed cost divided by the output)
  • Subtracting the average fixed cost from the average total cost

Pentonic is calculating the average variable cost for their new range of pens. They made 100,000 pens last month the total costs of which were Rs 1,000,000. The fixed costs of the company were Rs 100,000.

Here, we must find the average total cost first which is $\frac{1000000}{100000}$  = Rs 10

Then, we must find the average fixed cost = $\frac{1000000}{1000000}$ = Rs 1

Hence, the average variable cost = 𝑅𝑠 10 − 𝑅𝑠 1 = 𝑅𝑠 9 .

Key Features of Average Variable Costs Calculation

  • For companies that produce more than one product in multiple product lines, it may be tricky to calculate the average variable cost for one single item or product.
  • For example, a company may have one fixed cost but several variable costs for different items. In such situations, using the division method may be useful because it requires the output of a specific item and variable cost for the given item.
  • It is important to pay attention to the time period. If monthly average variable costs are calculated, the data must be associated with the particular month. Using monthly data for one factor and yearly one for another may lead to erroneous results.
  • It is also important to remember that variable costs keep changing. Therefore, in various instances, it is important to keep an eye on the overall outcome. Relocating for cheaper rent may be expensive and suppliers can be switched for cheaper raw materials.
  • Similarly, a slight hike in wages may stop employee attrition rates leading to lower hiring costs. The average variable cost may help in making these decisions but it is among a host of factors that should be considered while making such decisions.

Conclusion

Average variable cost is an indispensable factor in deciding the financial health of a company because it shows the measure of profitability from sales. When the average variable cost is subtracted from the sale price of a product, profitability can be estimated. Since profitability is the number one priority of companies, they are heavily interested to know whether their firms are on the right path using the average variable cost formula.

It is also important to track variable costs because too much variable expenditure may lead to huge losses for firms. Knowing the limits of variable costs is, therefore, necessary for all companies, and the companies pay attention to average variable costs while continuing their operations profitably.

Since the average variable cost is determined from total variable costs, it can indicate the overall variable expenditure of a company. Most companies have limits to such costs and they want to contain the total variable costs within set limits. They can do so by limiting the average valuable costs. So, average variable cost is an important factor for all types of businesses.

FAQs

Qns 1. How is the average variable cost calculated when total variable cost and total output are available?

Ans. The average variables cost in the division method is calculated by dividing the total variable cost by total output.

Qns 2. Mention some factors with which average variable costs are associated.

Ans. Factors, such as volume, raw materials costs, and labor affect the average variable costs.

Qns 3. Which are the two methods of calculating average variable costs?

Ans. Average variable costs can be calculated using division and subtraction methods.

raja
Updated on 13-Oct-2022 11:19:47

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