What is Average Variable Cost? (And How to Calculate It)
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Tracking maintenance and production costs is important as it can provide valuable data about an organization's profits and financial health. For most manufacturing businesses, average fixed costs like rent are straightforward, but as variable costs like labour and materials shift, it can be challenging to tell whether a product is profitable. Calculating average variable costs allows you to compare the cost per unit to the sales price and understand whether it's worthwhile to produce.
In this article, we explain what the average variable cost is, why it might be important, and which methods you can use to calculate it.
What is the average variable cost?
Average variable cost is the cost of all variable expenses involved in creating a product. This includes labour, materials, and other costs that may vary depending on how much a business produces. Variable costs change with production levels, so accurately calculating the average cost can show you the cost per unit.
Fixed costs remain the same no matter how many items the company produces and may include facility rent. Whether it's a fixed or variable cost is important to know when calculating the break-even point. It also helps to understand how much profit a company makes on each unit sold.
While the total variable costs include all variable costs for a production run, this cost makes it possible to understand how much these variable costs amount to each produced unit. The average variable cost differs from the average total cost in the short term because there's at least one fixed variable, while in the long term, all variables are flexible.
Factors that affect this cost
There are a few factors that can affect this cost, and it's important for businesses to be aware of them as they can influence the profitability of their products. Here are some things that can impact it:
Type of product: Products that require a lot of manual labour or specific materials may have higher variable costs than more automated products. For example, a product like a car has high variable costs because of the amount of manual labour involved in the assembly process.
Volume of production: The more products a company produces, the lower this cost may be as it can spread its fixed costs over more units. For example, if a business produces 1,000 widgets per day, the cost for each widget may be lower than if the business produces 10 widgets per day.
Location of the business: Businesses in areas with high labour or materials costs may have higher costs than businesses in other areas. For example, a business in Toronto may have higher labour costs than a business in a rural area because of the cost of living.
Quality of the product: If a business can produce a high-quality product, it can often charge a higher price and maintain a lower average variable cost than its competitors. This is because the higher quality product doesn't require as much customer service or warranty work.
Methods to calculate this cost
There are two ways to calculate this cost, depending on what information you have. Here are the two methods:
To use the division method, here's the formula you may use:
Average variable cost = total variable cost / output
This method is appropriate if you have two total numbers for your production: the total variable costs and the output number or product quantity. Here are the steps for the division method:
Find the total variable cost.
Find the output number.
Divide the total variable cost by the output.
Example: Flour Power Supplier is determining whether their new blue corn flour line is profitable, so they analyze their cost for each bag, which they sell for $5. The total of all variable costs to produce 2,000 bags of flour, including supplies and labour, is $11,000. They calculate the cost this way:
Average variable cost = $11,000 / 2,000
Average variable cost per bag of flour = $5.50
Since the cost to manufacture is above the selling price, their blue corn flour is unsustainable, so they might decide to stop producing it.
The formula for the subtraction method is:
Average variable cost = average total cost − average fixed cost
The subtraction method is appropriate if you already know two other average costs per unit: the average total and fixed costs. Here are the steps:
Find the average total cost, which is the total cost divided by the output.
Find the average fixed cost, which is the fixed cost divided by the output.
Subtract the average fixed cost from the average total cost.
Example: Flour Power Supplier is calculating their cost for their wheat flour mill. They made 100,000 bags of flour last month, and their total costs were $60,000. Their fixed costs, including rent and machine maintenance, were $10,000. First, the Flour Power Supplier accountant finds the average total cost:
$60,000 / 100,000 = $0.60
Then, they find the average fixed cost:
$10,000 / 100,000 = $0.10
Finally, they put those values into the formula:
$0.60 − $0.10 = $0.50
Tips for calculating this cost
Here are five tips for calculating this cost:
Put your costs in context
For companies with multiple products and product lines, calculating this cost for just one item is only part of the equation of profitability. For example, a company that makes cars and trucks may have different costs for each. To analyze single products in this situation, it may make more sense to use the division method, as it uses only the output and variable costs for that one item.
Be careful with the time frame you use
When calculating this cost, it's important to use the same time frame for all of your calculations. If you use a different time frame, it may make it challenging to see whether the product is profitable. For example, if you compare this month's cost against last month's cost, you're not getting an accurate idea of whether the product is doing well this month. It's a better idea to compare this month's cost against this month's average total costs to get a more accurate depiction of whether the product is profitable.
Use comparable data
When you calculate this cost, it's important to use comparable data. For example, if you're calculating the cost of manufacturing T-shirts, it may make more sense to use the number of shirts a manufacturer has produced of the total cost of supplies for all products. It's important to use the same unit of measurement for all of your calculations.
Remember that costs aren't permanent
If you're deciding about products or facilities based on costs, keep in mind that the variable costs may be easier to change than fixed costs. For example, while relocating to get cheaper rent may be expensive and take a while, a business might switch suppliers to spend less on raw materials or offer a slightly higher wage to increase workforce retention and lower hiring costs. While this cost can be useful information for making these decisions, it's only one of many factors to consider.
Consider all costs
When calculating this cost, it's important to consider all the costs associated with the product. This includes both the variable and fixed costs. For example, if you're looking at the cost of manufacturing T-shirts, you may include things like fabric and labour costs, along with rent and machine maintenance. This may give you a more accurate estimate of the average cost of producing each T-shirt.
Ways businesses can use this cost to their advantage
There are a few different ways businesses can use this cost to their advantage. Here are three of them:
Increase the output
If a business can increase the output while keeping the same variable costs, it may increase profits. They can do this by either increasing sales or reducing waste. For example, a bakery may produce more cookies if they make the baking process more efficient. It also might reduce the number of wasted ingredients if it uses leftover dough or frosting.
Reduce the cost of goods sold
Knowing this cost can help a business negotiate better prices with suppliers. For example, if a business can show that it's ordering a high volume of products, the supplier may give them a discount. Sometimes, businesses may even contact several suppliers to see who can offer the lowest price for the product.
Decrease the price
Businesses can also use this cost to decrease the price of their products. They can do this by reducing the number of materials they use in the product, negotiating a better price with suppliers, or taking on some fixed costs themselves. For example, a company might reduce the amount of plastic in a product to lower the cost or offer a subscription service instead of selling products one at a time.
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