What is the Average Fixed Cost?
Definition: Average fixed cost is defined as the amount it costs to a business for producing a unit of its product. AFC is determined by dividing the total fixed cost by the output level. In a business, two costs are essential for running a business; they include variable cost and fixed cost.
The average fixed cost (AFC) is the fixed cost per unit. Fixed cost is the cost that does not change with the change in the number of units produced. Generally, companies recalculate their fixed costs to ensure that the goods and services make profits for the business.
It is the fixed production expenses of a company for producing per unit of goods or services. By increasing the quantity of output produced, the average fixed cost would decrease as fixed cost remains the same while the number of output will increase.
Variable cost changes with the change in the number of quantities produced, but the fixed cost does not change. A cost will be considered variable or fixed depending on whether it is for the short-run or long-run. The average fixed cost is relevant for the short run only. The example of fixed costs includes the mortgage payment on plant and machinery, rent paid on a non-cancellable lease, and more.
Calculation of Average Fixed Cost
An average fixed cost can be calculated with two methods, i.e., Division Method and Subtraction Method.
In the division method of calculating average fixed cost, the total fixed costs are divided by the number of production units over a fixed period. This method helps determine that how the fixed costs can affect the fixed cost per unit. To calculate the average fixed cost of a product, follow these steps:
1. Select a period
Fixed costs are calculated for some time. This helps the companies to determine when they are reaching the break-even point and making a profit. While determining average fixed cost, an accountant must ensure that the total fixed cost must be accrued when the number of units was produced.
2. Determine total fixed cost
The next step is to determine the total fixed cost of the business. Total fixed cost means all the costs that do not change no matter how many units are produced.
3. Determine the total number of units produced
To calculate the average fixed cost, the next step is to determine the total quantity of goods produced in the same period in which the fixed costs were accrued.
4. Divide the obtained figures
Now, to know the average fixed cost, divide the total fixed cost by the quantity produced.
Therefore, here the formula is
Average Fixed cost = Fixed cost / Quantity produced
In the subtraction method, the total cost is determined by including both variable and fixed costs. In this method, the average total cost and average variable cost are determined, and then the latter is subtracted from the initial one. This method is useful if a company wants to know how the fixed costs and variable costs compare. To calculate the average fixed costs using the subtraction method, follow these steps:
1. Determine the total cost
To determine the total cost of a business, all the costs that accrue from producing a certain quantity over a period are considered. Total cost includes both fixed cost and variable cost. Variable costs are the cost that changes with the change in the number of quantities produced. This includes utilities, materials, and production labor.
2. Determine the average total cost
The next step is to divide this total cost by the quantity produced over the specified period. Here, a company will get the total cost per unit produced.
3. Determine the average variable cost
The average variable cost can be calculated by dividing the total variable cost by the quantity produced.
4. Subtract the average variable cost from the average total cost
Now, for determining the average fixed cost, subtract the average variable cost from the average total cost.
Therefore, the formula here is:
Average Fixed cost= Average Total Cost – Average Variable cost
Example of Average Fixed cost
Suppose a company is engaged in cultivating sugar cane. They have hired three workers against a contract of one year. The contract is non-cancelable.
The annual salary of each employee is INR 500,000. The company also purchased farming equipment for which they are paying INR 600,000 rent per annum for cultivation. The depreciation charged on farm building and fencing amounts to INR 100,000 per annum. The total output produced here is 1200 tons of sugar cane. Here, the average fixed cost will be:
Average Fixed cost = Total Fixed cost / Number of units
= (15,00,000 (500,000 x 3) + 600,000 + 100,000) / 1200
= INR 1833.33 per ton
On the concluding note, it is clear that average fixed cost is derived from fixed costs which are the costs that never change.
Therefore, companies generally calculate average fixed costs periodically to keep on making profits from their produced goods. Businesses also use average fixed costs for measuring breakeven and analyzing expenses.
After understanding the whole concept, what will your definition of an average fixed cost?