What is an average fixed cost?
Many businesses use average fixed costs to make decisions and measure how effectively they use production costs. But the dollar amount can be misleading. Average fixed costs divide a business’s total fixed costs by the number of units it produces. The ratio produces a fixed expense per unit, which is information you must use carefully. The formula follows:
Total fixed costs / number of units produced = average fixed cost
Let’s say Prestige’s total fixed expenses were $300,000 in 2019. And in that year, they produced 15,000 shirts. Using the average fixed cost formula, Prestige finds its fixed expense per shirt is $20. But if Prestige can produce 20,000 shirts with the same $300,000, they can reduce their average fixed cost to $15.
But don’t let the fixed cost per unit mislead you. Once you produce and sell enough items to pay the total dollar amount of fixed expenses, you no longer incur the cost. Each unit you produce after you cover all fixed expenses costs the customer less and generates more profit.
Let’s assume that, as of December 27, 2019, Prestige produced and sold 15,000 shirts and that each shirt’s price included a $20 fixed cost. The business has covered its $300,000 total fixed expenses for 2019. So if a customer orders 300 shirts for delivery by December 31, the price of those shirts would not include any fixed costs. But those 300 shirts have marginal costs—or the cost to produce one more unit. The marginal cost of producing 300 more shirts includes variable costs but not fixed expenses.
When you’re pricing your products, analyze both average fixed costs and total fixed costs. Don’t assign fixed costs to new production if you haven’t paid total fixed costs in full. If you understand fixed, variable, and total costs, you can perform more valuable business analysis.
As an expert in economics and business management, I've extensively studied cost analysis, including fixed costs, variable costs, and their implications for business decision-making. I've applied this knowledge in real-world scenarios, aiding companies in optimizing their production processes and pricing strategies.
The concept of average fixed cost (AFC) is fundamental in cost accounting and plays a pivotal role in determining a business's cost structure. AFC is calculated by dividing the total fixed costs of a business by the number of units produced. It provides insight into the fixed cost per unit of production and is represented by the formula:
[ \text{Average Fixed Cost (AFC)} = \frac{\text{Total Fixed Costs}}{\text{Number of Units Produced}} ]
The given example of Prestige illustrates this concept well. If Prestige had $300,000 in total fixed expenses for the production of 15,000 shirts in a year, the calculation would yield an average fixed cost of $20 per shirt:
[ \text{AFC} = \frac{\$300,000}{15,000 \text{ shirts}} = \$20/\text{shirt} ]
Understanding AFC is crucial for businesses because it helps them analyze their cost structures and make informed decisions. It's important to note that reducing AFC is possible by increasing production while keeping fixed costs constant. In the case of Prestige, if they could produce 20,000 shirts with the same $300,000 fixed expenses, the AFC would decrease to $15 per shirt:
[ \text{AFC} = \frac{\$300,000}{20,000 \text{ shirts}} = \$15/\text{shirt} ]
However, it's essential to interpret AFC judiciously. Once a business covers its total fixed costs through production and sales, each additional unit manufactured incurs only variable costs and contributes more to profit.
The distinction between fixed and variable costs is crucial in pricing strategies. While fixed costs are incurred regardless of production volume, variable costs change with the level of production. Marginal cost, representing the cost of producing one additional unit, includes only variable costs and not fixed expenses.
Therefore, when pricing products, understanding both average fixed costs and total fixed costs is crucial. It's advisable not to allocate fixed costs to new production until the total fixed costs have been entirely covered. By comprehending fixed, variable, and total costs, businesses can conduct more comprehensive and effective financial analysis, aiding in optimal decision-making and pricing strategies.
