How to Calculate Total Cost (With Formulas and Examples)
Updated September 30, 2022
Determining the average total cost is important for pricing products and services, as it ensures companies are pricing their products high enough to generate a profit. Considering the fixed and variable costs associated with production in relation to the total number of goods you're producing can help you evaluate the average total cost. Understanding how to calculate this value can help you evaluate cost structures, create plans, and implement profitable production budgets. In this article, we define the average total cost, explain the steps for calculating it, explore the differences between other types of production costs, and provide an example.
What is the average total cost?
The average total cost is the per-unit cost of the number of products that are made. Business and financial managers might use this information to make decisions on product pricing. In order for a company to be profitable, businesses price products above the average total cost. Production managers use the average total cost to evaluate which level of production can increase profitability. The average total cost measures the total cost of production per each unit produced, considering both fixed and variable costs.
Fixed costs are those that are necessary for production and remain constant regardless of the number of goods produced. This includes the facility costs and manufacturing equipment purchased, often under the title of plant, property, and equipment (PPE) assets. Variable costs might increase or decrease based on the output, including items such as direct labour or the cost of materials used to create products. Since the total fixed cost doesn't change, the change in average variable cost influences the change in average total cost. Here's the formula for calculating the average total cost:
Average total cost = (Total fixed costs + Total variable costs) / Number of units produced
How to calculate total cost
Here are the steps that outline how to calculate total cost:
1. Identify fixed costs
You can determine a company's fixed costs by evaluating the profit and loss account or business balance sheets. Combine the fixed costs, such as rent expenses, equipment costs, insurance, salaries, and utilities. Here's an example of identifying fixed costs:
A manufacturing company's accountant reviews its profit and loss account to determine it has $150,000 in equipment leases, $37,000 in property taxes, and $157,000 in rent and utilities. The accountant combines these values to determine total fixed costs of $344,000.
2. Determine variable costs
You can identify the variable costs by reviewing the same financial documents. Combine all variable costs, such as the cost of raw materials, direct labour, sales commissions, and shipping charges. Here's a continuation of the above example to show how you can determine variable costs:
The manufacturing company's accountant reviews its financial documents to determine it has $52,000 in raw materials, $124,000 in direct labour costs, and $21,000 in shipping charges. The accountant combines these values to determine the total variable costs of $197,000.
Read more: How to Calculate Variable Cost with Examples
3. Calculate total cost of production
To calculate the total cost of production, you can add the total fixed and variable costs. Here's an example to demonstrate how you can calculate this value, followed by the formula:
The manufacturing company's accountant adds the total fixed costs of $344,000 and the total variable costs of $197,000. They determine the total cost of production is $541,000.
Total cost of production = Total fixed costs + Total variable costs
4. Determine the quantity of units
Determine the total number of units that the business has manufactured. Depending on the number of products produced, you might add various values to determine the total number. Here's a continuation of the manufacturing example above:
The accountant reviews the financial documents to determine the company manufactured 125,000 products in the time frame they're evaluating.
5. Calculate the average total cost
You can determine the average total cost by dividing the total cost of production by the number of units that the company manufactured. This value shows the average manufacturing costs per unit. You can use this value to determine the consumer price per item. Here's an example, followed by the formula:
The manufacturing company's accountant divides $541,000 by 125,000 to determine an average total cost of $4.33 per unit.
Average total cost = Total cost of production / Number of units produced
Average total cost vs. average variable cost
Average variable cost (AVC) refers to the total variable per-unit cost. Unlike average total cost, AVC doesn't consider fixed costs. This calculation only considers costs that change with output, such as the costs of direct labour, sales commissions, and raw materials. As output increases from zero to normal capacity, the average variable cost usually falls. When you move beyond normal capacity output, the AVC may accelerate due to the operation of diminishing returns. This means that when you add a factor of production, you might observe a smaller increase in output. You can calculate the AVC with the following formula:
Average variable cost = Variable cost / Quantity of output produced
Alternatively, if you know the average total cost and the average fixed cost, you can determine the average variable cost using this formula:
Average variable cost = Average total cost - Average fixed cost
Average total cost vs. marginal cost
Whereas the average total cost is the per-unit cost of the goods produced, the marginal cost is the incremental extra cost a business might incur when it manufactures extra units. Businesses use the average total cost to evaluate how the total per-unit cost changes with output. Conversely, businesses use marginal costs to determine if it's beneficial to manufacture more of a particular good or service. You can follow these steps to calculate the marginal cost:
1. Determine the change in cost
Changes in cost may occur when a business increases or decreases the level of output. Whereas higher output levels result in higher variable costs, lower output results in lower variable costs. Here's the formula you can use to determine changes in cost:
Change in cost = New cost - Old cost
2. Calculate the change in quantity
The change in quantity refers to when the quantity of a good or service increases or decreases. You can determine the change in quantity in the same way that you calculate the change in cost. Here's the formula for calculating the change in quantity:
Change in quantity = New quantity - Old quantity
3. Calculate marginal cost
You can calculate the marginal cost by dividing the change in cost by the change in quantity. This value shows the cost of producing one additional unit. A business may analyze the marginal cost to determine the point at which it can optimize production and operations. When the marginal cost is lower than the per-unit price, the business may increase profitability. Here's the formula for calculating the marginal cost:
Marginal cost = Change in cost / Change in quantity
Example of average total cost
Here are some examples of how businesses may evaluate their average total cost:
Example of a restaurant calculating average total cost
A new burger restaurant wants to determine the average total cost per burger to determine how to price their menu items. The managers have a goal of selling 1,000 burgers in their first opening month, so they evaluate the total costs of production to determine the average total cost. They review their financial documents to determine their total fixed costs are rent of $2,500 per month, including utilities. The variable costs include employee wages and ingredients needed to make the burgers, including buns, patties, toppings, and fries. They determine the variable costs to make 1,000 burgers add up to $3,000.
The managers combine the fixed and variable costs to determine the total cost of production is $5,500. They input this value into the average total cost formula to determine the average cost of each burger is $5.50. To run a profitable business, the managers know to price their menu items higher than $5.50 each.
Example of an auto parts manufacturer using the average total cost calculations
An auto parts manufacturer wants to increase its output and engages its accountant to calculate the average total cost to determine the amount they're able to increase production. The accountant reviews the financial statements to determine the manufacturer's total fixed cost is $12,000 per period, with an average variable cost of $10 per unit produced. They analyze various quantities of units produced up to a maximum of 5,000 units to provide options to the business managers to help with their decision.
The accountant uses the average total cost formula to determine that the total average cost of producing 1,000 units is $22 per unit. They apply the formula again to determine the cost of producing 3,000 units is $14 per unit and the cost of 5,000 units is $12.40 per unit. The business managers use this information to determine which value fits within their budget and capabilities to secure enough raw materials required for the different levels of production.
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