This article explains the concept of average total cost, its significance, and the way it is calculated. Read on to know more.
For any commerce or economics student, accounting is the core subject of study. Concepts like cost, revenue, taxes, assets, liabilities, etc., are significant to make them understand the cost and pricing structure of a company. The concept of average total cost (ATC) helps in determining the profit and loss structure, variables affected, distribution and marketing strategies, and hence, the money to be spent on them. Any change in the ATC has a bearing on all these factors.
Average total cost is the cost incurred per unit quantity produced. For instance, if the total cost of producing 1000 units for an XYZ company is USD 10,000, then the average total cost is USD 10 per unit. ATC is made up of two variables, namely, average fixed cost (AFC) and average variable cost (AVC). Also, there's another major concept called marginal cost (MC), which we'll see in the later part of the article. Average fixed cost is the fixed cost per unit quantity, which is the total of money spent on rent, salaries, electricity, water, insurance, etc. AFC never changes even if there is a rise or fall in production. On the other hand, average variable cost is the variable cost per unit quantity, which is the dynamic spending on overtime pays, marketing, advertising, maintenance of machinery, labor and tools, raw materials, transportation, etc. This cost undergoes a change every day, and hence, it can have a major bearing on the profit margin.
The best way of deriving profit is to calculate the difference between the average total cost and selling price of the product. For instance, if a company manufactures a shirt at the ATC of USD 50 and sells it to a garment store for USD 70, it makes a profit of USD 20 per shirt. If the ATC goes up, the profit will lower and vice versa, assuming there is no change in the sale price. Thus, it has a lasting effect on the revenues of the business.
For determining the ATC, first we'll need to find out the total fixed cost and total variable cost:
Average fixed cost = Total fixed cost / Quantity of output produced
Average variable cost = Total variable cost / Quantity of output produced
Average total cost = Average fixed cost + Average variable cost
Or, it can be simply calculated as, Total cost / Quantity of output produced. Now, when we plot the curve on a graph with the quantity of output produced on the x-axis and average total cost on the y-axis, we get a U-shaped curve. It decreases exponentially as the quantity produced increases, until it reaches the lowest point and intersects the marginal cost curve. Marginal cost is the cost required to produce one more unit of output and calculated as dTC / dQ, where dTC is the change in total cost and dQ represents change in output. It tells us the required cost to produce the next unit, and the point where the MC and ATC curves intersect denotes the 'capacity', which is the quantity which minimizes average total cost. At this point, the company is at the most efficient level of production, and therefore, can gain maximum profits. After this point in the graph, the law of diminishing returns takes over and each quantity produced after that has a higher per unit cost. Thus, the negatively sloped portion denotes decreasing ATC and increasing marginal returns, and the positively sloped curve denotes the exact opposite.
Average total cost and marginal cost curves, thus, help a company in deriving the profit-loss analysis, once they have a detailed idea of demand and supply. It paves a way to ascertain the future strategy to optimize the company's efficiency and maximize profits.