What is Average Variable Cost?
Definition: The average variable cost is simply a cost associated with the number of goods or services produced. The cost varies depending on the production volume. Similarly, whenever the production volume goes up, the average variable cost would also edge higher. Likewise, whenever production volume drops, the total average variable cost would most of the time edge lower.
Businesses and companies incur a wide array of costs in the process of producing goods and services. The expenses are broadly classified into two: variable and fixed costs, based on the impact they have on the total output as well as the bottom line.
Variable costs differ from average fixed costs on the fact that they vary with production volume. Likewise, AVC also varies from one industry to another. It is, therefore, not appropriate to compare variable costs between a company and business in one sector with another one in another sector.
Often referred to as the per-unit cost of production, the average variable cost is calculated by dividing the total variable cost by the total number of units produced in a production chain.
Average Variable Cost Formula Example
Production costs consist of two main components: Fixed Costs and Variable Costs. As fixed costs remain the same throughout the production process, variable costs vary depending on production volume. A good example of fixed costs includes property taxes as well as rent and insurances. Variable costs, on the other hand, include things like material costs production supplies as well as piece-rate labor.
Here is how to calculate the average variable cost formula.
Average Variable Cost = Total Variable Costs / Total Quantity
The total variable costs, in this case, are the total amount of cost that varies with changes in output.
Total variable costs are calculated by simply multiplying the total units produced by the variable cost per unit. For instance, if a company provides a pen at the cost of $2 a pen, then the total variable cost would be $1000 on producing 500 pens.
Likewise, should the company fail to produce any pen, it will not incur any variable cost. In contrast, a firm would always incur fixed costs as long as it is in operation, even on failing to produce anything.
The average variable cost function of a profitable firm appears typically as a u-shaped curve. At the start, the variable cost would decrease as output increases. However, upon reaching a low, the variable costs may start to increase because of the law of diminishing marginal returns.
The increase, in this case, maybe as a result of an increase in costs, needed to produce more units.
Understanding Average Variable Costs
Average variable costs provide insights to management styles. A firm is likely to incur losses whenever the price of an item is much less than the actual cost of production. Likewise, whenever the price of an item is more than the average variable cost, it could help cover some of the fixed costs, which would consequently minimize the total cost leading to profitability. Similarly, when the price of a good or service is less than its average variable cost, then a company or business could plunge into losses.
Profit oriented firms use average variable costs to ascertain when it is necessary to ramp up production to maximize profits as well as when to stop production in the short term. Whenever the price of a product or service is more than the average variable cost, then it means a firm is on the right trajectory to profitability.
Whenever the price of a service or good is above the average variable cost to the extent of coverage for fixed costs, a business is better off to continue production. Conversely, whenever the price is below the AVC, then a firm would be right to shut down production, until price rises above the AVC.