average cost
What is the average cost?
Average cost refers to the unit cost of production, which is calculated by dividing the total cost of production by the total number of units produced. In other words, it measures the amount of money the company has to spend to produce each unit of product. It is a fundamental part of supply and demand as it affects the supply curve It is also known as unit cost or average total cost. We can further divide the total cost of production into fixed and variable cost elements. In general, the component of total fixed cost does not change, and therefore the change in average cost is mainly due to a change in total variable cost. If the cost reaches the threshold, either increase the selling price or negotiate the variable cost share, otherwise, a loss of business will result.
We can calculate it by following these five steps:
Step 1: First, determine the fixed cost of production incurred during a given period, which may include salary, depreciation and depreciation, rent, marketing and advertising expenses, etc. . These cost heads do not change with the change in production volume.
Step 2: Next, determine the variable cost of production incurred over a given period, which may include the cost of raw materials, wages, electricity bills, etc. These cost elements mainly depend on the production volume.
Phase 3: Next, calculate the total production cost
by adding the fixed (phase 1) and variable (phase 2) production costs.
Total production cost = Fixed production cost + Variable production cost
Step 4: Now determine the number of units produced during the specified period.
Step 5: Finally, calculate the average production cost by dividing the total production cost (step 3) by the number of units produced (step 4) as shown below.
Formula for average cost = total production cost / number of units produced
Advantages
Significantly simplifies the costing and accounting process.
Automatically adjusts the impact of price volatility observed over a given period.
Makes it difficult to manipulate accounting data and therefore gives a true image of the company.
Disadvantages
Each time a new purchase occurs at a different pace from the previous one, it changes, resulting in frequent changes in the selling price.
The average cost may not reflect the prevailing market rate because it averages the price over the period.
