Average cost is the cost of making one unit of a product. It is important in economics because it helps decide the price of a product and how much a company is willing to supply. This cost affects the supply curve and plays a big role in how demand and supply balance in the market. The total cost of making goods includes both the direct cost of materials and labor (called prime cost) and other costs like rent and bills (called supplementary cost). There are five main types of production costs: fixed, variable, total, average, and marginal.

What is Average Cost?

Average cost is defined as per unit cost of production, which is the ratio of the total cost of production to the total number of units produced. It can also be defined as the sum of average variable cost and average fixed cost.

Average cost of production can vary depending on the units produced by a company. It is inversely proportional to the number of units produced and directly proportional to the total variable cost, i.e, if the number of units produced by a firm increases then its total average cost would decline and vice versa.

In simple words, Average cost is the amount of money a firm or a business has to spend to produce a single unit of output.

Cost of Production: Assuming a very simple model for a given company, production is instantaneous. In order to acquire inputs a firm has to pay for them, this is known as the Cost of Production. Once the output has been produced the firm sells it in the market and earns the revenue, the difference between the revenue and cost is called the firm’s profit.

Production cost includes factors such as raw materials, land, labour and capital required for the process of production.

For example: Consider a vehicle, so its production cost would include rubber needed for the tyres, labour costs paid, raw materials and manufacturing supplies needed to assemble that vehicle.

There are 3 types of Cost of Production:

1. Variable Cost
2. Fixed Cost
3. Total Cost

Variable Cost: Variable Cost is the type of cost which changes with any changes in the level of production.

They are directly proportional to the production volume.

If the production volume of a commodity increases then its variable cost will also increase.

Variable costs include factors like: commissions from sales, labour costs, raw materials and utility costs.

For example, let us consider an ice cream factory, the variable cost will include: labour cost and the cost of raw materials required.

If the cost of raw materials and labour cost incurred in the production of a single unit of ice cream is ₹70 and the company produces 2000 such units, then the total variable cost is ₹1,40,000.

Fixed Cost: Fixed Cost does not change irrespective of the volume of output produced, it remains fixed.

Fixed costs are generally time limited.

A fixed cost does not change even if the company has reached its maximum output capacity.

Fixed costs may include rent, electricity bills, salaries and leases, this does not change irrespective of the number of customers a company may have.

Total Cost: Total Cost is the sum of both fixed and variable costs.

All costs included right from production and manufacturing to delivery and services are covered under total cost.

Example: In an ice cream factory, the cost of raw materials and labour cost incurred in the production of a single unit of ice cream is ₹70 and if the company produces 2000 such units, then the total variable cost is ₹1,40,000. It also pays a rent of ₹60000 per month and utility bills of ₹7000.

Hence the total cost of the ice cream factory is variable cost + fixed cost = ₹1,40,000 + ₹67000 = ₹2,07,000

What is Average Cost of Production?

Average Cost of Production is equal to the per unit cost of production divided by the total cost of the total output product. Average Cost of Production is also known as the Average Total Cost and it is the cost per output unit.

Average Cost Formula 

Average Cost Formula is given by,

\(AC=\frac{TC}{Q}\)

where,

AC = Average Cost

TC = Total Cost

Q = Total quantity of goods produced

How to Calculate Average Cost 

To find the average cost, we simply add up all the costs and then divide the total by the number of items.

Let’s understand this with an easy example.

Example:

You bought 10 books, and the prices of each book are:

Rs. 300, Rs. 320, Rs. 310, Rs. 280, Rs. 290, Rs. 330, Rs. 340, Rs. 310, Rs. 300, and Rs. 320

Step-by-step Solution:

First, add the prices of all 10 books:

300 + 320 + 310 + 280 + 290 + 330 + 340 + 310 + 300 + 320 = 3100

Now, divide the total cost by the number of books:

Average Cost = Total Cost / Number of Items
Average Cost = 3100 / 10 = Rs. 310

Final Answer: The average cost of the 10 books is Rs. 310.

Types of Average Cost

In this article we are going to discuss 4 types of average costs:

1. Average Fixed Cost
2. Average Variable cost
3. Short run Average costs
4. Long run Average costs

Average Fixed Cost: Average Fixed Cost can be defined as the fixed production expenses of the company per unit of goods produced by it.

Average fixed cost is defined as the ratio of total fixed cost with respect to its output.

\(AFC=\frac{TFC}{\text output}\)

AFC = Average Fixed Cost

TFC = Total Fixed Cost

or the difference between average total cost and average variable cost.

\(AFC=ATC-AVC \)

AFC = Average Fixed Cost

ATC = Average Total Cost

AVC = Average Variable Cost

Example:

Average Variable Cost (AVC): It is the total variable cost per unit of output.

Average Variable Cost is the ratio of total variable cost to the total output.

Average Variable Cost determines at what point should a company stop production of a particular product.

If the price falls below the AVC the company may stop production and if the price is above the AVC then the company may continue its production.

A cost varies only if the output of the company changes.

\(AVC=\frac{TVC}{Q} \)

AVC = Average Variable Cost

TVC = Total Variable Cost

Q = Volume

Example:

Short Run Average Costs: The Short Run Average Cost incurred by the firm is defined as the Short Run Total Cost per unit of output.

\(SAC=\frac{TC}{Q} \)

SAC = Short Run Average Costs

TC = Short Run Total Cost

Q = Output

Long Run Average Costs: In the long run all inputs are variable, there are no fixed costs.

Hence the total cost and the total variable cost will coincide in the long term.

Therefore, Long Run Average Cost is defined as the Long Run Total Cost divided by the total output.

\(LRAC=\frac{TC}{Q} \)

LRAC = Long Run Average Cost

TC = Long run Total Cost

Q = Output

What is Average Cost Curve?

Average Cost is the total cost divided by the quantity of output. Refer to the diagram below representing the average cost curve.

Consider a factory, serving 40 coffee cups at 320$.

The average total cost of producing each of 40 coffee cups is 320$ / 40 = 8$ per coffee.

The average cost curve is generally a U shaped curve, where the Average Total Cost is relatively high, because at a low level of outputs total costs are more than the fixed costs.

Average total cost declines as the total fixed costs are more than increasing output quantity.

In the average cost curve, initially the rise in the numerator of total costs is small as compared to the rise in denominator of the output.

As output increases the average cost also begins to rise but diminishing returns kick in as the total costs begin to rise.

How to Find Average Cost of Production?

We will discuss the key concepts to find the average cost of production in steps.

Average Cost Formula is given by \(AC=\frac{TC}{Q}\)

where

AC = Average Cost

TC = Total Cost

Q = Total quantity of goods produced

The average cost includes both fixed and variable costs required for production.

Let’s look at the steps required to calculate the average cost per unit.

• Find the Fixed Cost Production 

The fixed cost of production includes insurance, loan payments, rent, salaries, bills etc.

• Find the Variable Cost Production 

Variable Cost of Production includes raw materials, labor costs, packaging etc.

• Add Fixed Cost and Variable Cost 

• Find the Quantity of Units Produced

The quantity of units produced can be determined by the company accounts.

• Calculate the total Average Cost of Production

The average cost of production = total cost of production/quantity of units produced.

Let us calculate the average cost of production.

Consider a company producing aviator sunglasses, the total fixed cost and the total variable cost of them is 5000$, total number of production of the aviators is 300.

By the formula,

The average cost of production = total cost of production/quantity of units produced.

The average cost of production = 5000 / 300 = 16.67$

The average cost of production of aviator sunglasses is 16.67$

What is Marginal Cost?

Marginal cost is the change in the total cost of production from producing a single unit.

The marginal cost is the ratio between change in production cost with respect to the change in quantity.

Marginal cost is used to optimise maximum profits of a company.

If the marginal cost of production is less than the selling price of a single unit, then the company gains profit.

The formula for Marginal Cost is given by Marginal Cost = Change in the Total Expenses / Change in Quantity of the Units Produced.

It is basically the cost needed to produce one incremental unit.

One must remember that the Marginal Cost includes all costs that vary with the level of production.

Relationship between Average Cost and Marginal Cost

The average cost is the total cost of manufacturing per unit and marginal cost is the cost required to produce one incremental unit.

Average Cost and Marginal Cost impact each other as production fluctuates.

The graph above represents the average total cost, marginal cost and marginal revenue.

• When the average cost increases the marginal cost is always greater than the average cost.
• When the average cost decreases the marginal cost becomes less than the average cost.

Hence average cost and the marginal cost are directly proportional to each other.

Properties of Average Cost (AC)

The Average Cost (AC) is the cost of producing one unit of a product. It is calculated by dividing the Total Cost (TC) by the number of units produced.

Formula:
AC = Total Cost / Number of Units Produced

Let’s now understand the main properties of Average Cost:

1. Average Cost is U-Shaped in the Short Run

In the short run, the Average Cost curve looks like a ‘U’.
This means:

• At first, the average cost decreases as more units are produced.
• After a point, the average cost starts increasing.

Why?
Because in the beginning, resources are used more efficiently. But later, adding more units leads to pressure on limited resources, which increases the cost per unit.

2. AC = AFC + AVC

Average Cost is the sum of:

• Average Fixed Cost (AFC): Cost that doesn't change with output (e.g., rent).
• Average Variable Cost (AVC): Cost that changes with output (e.g., raw materials).

So,
AC = AFC + AVC

As output increases, AFC keeps decreasing, while AVC may first decrease and then rise. This impacts the shape of the AC curve.

3. AC is Affected by Economies of Scale

In the long run, when production is increased:

• Average Cost falls due to economies of scale (benefits from large-scale production like bulk buying, efficient machinery, etc.).
• After a point, it may start rising due to diseconomies of scale (like management issues, wastage, etc.).

So, in the long run, AC can also be U-shaped.

4. AC is Minimum When MC = AC

MC = Marginal Cost (cost of producing one extra unit).

The Average Cost is lowest when Marginal Cost = Average Cost.
At this point, the firm is operating efficiently.

If:

• MC < AC → AC is falling
• MC > AC → AC is rising

5. Helps in Price Setting and Planning

Knowing the Average Cost helps businesses:

• Set the right selling price
• Decide how much to produce
• Plan future investments
• Control costs and improve profit

6. AC Reflects Efficiency

Lower average cost means:

• Better use of resources
• More efficiency
• Higher profit margins

If AC is too high, the business may need to check for waste, poor planning, or overuse of resources.

Key Points about AC, AVC, and AFC

1. AC is Always Above AVC:
   The Average Cost (AC) curve is always higher than the Average Variable Cost (AVC) curve. This is because AC includes both AVC and Average Fixed Cost (AFC). So, AC = AVC + AFC.
2. AVC Reaches Its Minimum Before AC:
   The AVC curve hits its lowest point (let’s call it point B) at a smaller output level compared to AC (point A). This happens because, even when AVC stops falling, AC can still decrease if AFC is getting smaller.
3. Gap Between AC and AVC Becomes Smaller:
   As more units are produced, the gap between the AC and AVC curves gets narrower. But they never meet. That’s because the difference between them is the AFC, which never becomes zero—even though it keeps decreasing.

Difference between Average Cost and Marginal Cost

Let us learn about the differences between the average cost and the marginal cost.

Solved Examples of Average Cost

Example 1: A person sells different types of shoes, he sells 5 pairs of shoes, costing 500, 600, 800, 1000 and 1200 rupees. What would be the average cost of the pair of shoes sold?

Solution: Given data,

Cost of 5 pairs of shoes is 500, 600, 800, 1000 and 1200 rupees.

The formula for average cost of production is given by,

Average cost of production = total cost of production/number of quantities produced.

Average cost of production = (500+600+800+1000+1200) / 5

= 820 rupees.

The average cost of production of 5 pairs of shoes is 820 rupees.

Example 2: The total fixed cost and total variable cost of production for a company is 3000$ and around 90 quantities produced. What would be the average cost of production?

Solution: Given data,

Total fixed cost and total variable cost of production (total cost) = 3000$

Total quantity produced = 90

According to the formula,

Average cost of production = total cost of production / total quantities produced.

Average cost of production = 3000 / 90 = 33.33$.

Hence the Average cost of production to produce a single unit is 33.33$.

Example 3: Long run total cost of production for a private firm is 10000$, whereas the total quantities produced are 650. What would be the Long Run Average Cost of the product?

Solution: Given data,

For a private firm,

Long run total cost of production = 10000$

Total number of quantities produced = 650.

By the formula,

Long Run Average Cost = Long Run Total Cost / Total number of quantities.

Long Run of Average Cost = 10000 / 650 = 15.38$

The Long Run Average Cost of a product is 15.38$.

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