What is Average Fixed Cost?
Definition: Average fixed costs are a production cost that remains the same regardless of the amount of goods and services produced. Such costs do not vary with changes in output.
Businesses and companies incur a wide array of costs in the production of goods and services. The incurred expenses vary depending on how they influence the production process. While some costs change over time, some remain fixed. Average fixed cost is one of the costs that businesses incur in the production process.
However, such costs are only relevant in the short run, given that inputs are variable in the long term. Likewise, very few costs are fixed in the long run.
Average fixed costs are mostly made up of expenses that a company must pay independent of any underlying business activities. Combined with variable costs, fixed costs make up the total cost structure of any company or business. The two costs influence the overall profitability of any business.
How to Find Average Fixed Cost?
The fact that fixed costs don’t change means most of them are established by way or binding contract agreements and schedules. Once established, the costs don’t change throughout the life of a contract or agreement. For instance, a new business may begin with fixed costs in the form of rent and management salaries.
Fixed costs are allocated throughout an income statement and are typically negotiated for a specified period. While such costs don’t change with production levels, they can decrease on a per unit basis when associated with the direct cost portion of the income statement.
The more the fixed costs in an income statement, the more the amount of revenue a company would need to break even. It is because the costs would occur regularly and rarely change.
Likewise, whenever a company produces lower units, the average fixed costs would increase significantly, taking a toll on profitability. The impact of average fixed costs on the balance sheet would most of the time depend on the units produced.
Fixed costs can change after a given period, especially on the expiry of an underlying contract agreement. While the change in fixed costs, in this case, may be associated with changes in contractual agreements, the same is never as a result of changes in production levels. Some of the best examples of average fixed costs include rental lease payments, salaries insurance, as well as interest expenses and property taxes.
Average Fixed Cost Formula
The average fixed cost is simply the fixed cost of production divided by the total output. Likewise, it is often referred to as the fixed cost per unit of output. The cost describes the sum of all expenses and costs that remain the same even as the output increases or decreases.
The average fixed cost formula is calculated by aggregating all fixed costs to find the total fixed costs then dividing by the total units produced.
Average Fixed Cost (AFC) = total fixed costs / quantity
Average fixed costs may also be computed by subtracting the average variable costs from the average total cost.
Example
Consider a car manufacturing company that produces 100 trucks every single month. Assuming that the company incurs two types of fixed costs in the form of $5,000 in monthly rent and $45,000 in employees’ wages, the total fixed cost will be $50,000.
The average Fixed Cost or the cost per unit output will be
Average Fixed Cost = $50,000 / 100 = $500
What this means is that for the company to produce 100 cars every month, it must incur $500 on each truck in the form of fixed costs.
Average Fixed Costs Importance
Average Fixed Cost is of great importance when it comes to making production decisions, as the costs must be incurred for any production to occur. Likewise, average fixed costs tend to decrease whenever the quantity of output increases.
Companies and businesses must always consider average fixed costs, and the change in output maximizes profits. Fixed costs also tend to contribute to economies of scale whenever costs decrease with the production of larger quantities.