How to Calculate the Average Cost of Production

bizfluent article image

factory image by cico from Fotolia.com

Owners and managers of businesses that manufacture goods or provide services are always conscious of the amount of money it takes to produce their products. This is essentially what the average cost of production measures. Calculating the average cost of production or average unit cost is a straightforward procedure, but it is also very useful. Unit cost is a number that allows business people to make informed decisions about product pricing or the profitability of product lines. Analysis of unit costs can help identify opportunities for reducing costs.

The Concept of Average Unit Cost

The average production cost formula, also called the unit cost formula, is total production costs for the year or other accounting period divided by the number of units produced. Total cost is the aggregate sum of all fixed and variable costs of production for the accounting period. For instance, if 1,000 units are produced at a total cost of $50,000, the average production cost per unit is $50.

Don't confuse unit cost and marginal cost. They are not the same. The marginal cost is the expense of producing one more unit over the current production level. To illustrate, suppose ABC Company produces 10 units at a cost of $525. The unit cost is $52.50. However, if the firm produces one more unit, only the variable costs increase. Fixed costs normally remain unchanged. If the marginal cost is $25 and ABC Company produces one additional unit, total costs increase to $550. This results in a lower unit cost of $50. This is good news for stakeholders because it means more money is left over at a given price level, so the profit margin increases.

The Components of Production Cost

When you calculate and analyze average production cost per unit, it is useful to categorize expenditures as either variable costs or fixed costs. Variable costs are those that change with the level of production. For instance, outlays for raw materials go up when you increase production. In addition to raw materials, variable costs include direct production labor, commissions and shipping costs. Fixed costs tend to remain constant. Rent payments for factory space, for example, remain constant for the duration of the lease even if production is shut down for some reason. Some other fixed costs are insurance, interest and some salaries.

The Significance of Average Production Cost

One reason to track the average unit cost is that it is essential for setting product prices. Without this information, it isn't possible to know if your prices are too low to cover costs and allow for a profit margin. Calculating the average unit price over a time interval such as a year also gives you a more accurate assessment of production costs because it smooths out short-term fluctuations such as changes in seasonal demand. Accurate unit cost figures are also essential to valuing inventory correctly.

Average production cost is also useful for decision-making. Suppose you sell an item for $50 per unit and a competitor cuts his price for the product to $40. Your unit price figures will form the basis for choosing a pricing strategy to counter this threat. On the other hand, the analysis of unit costs will give you key information to decide how much you can cut prices in order to implement an aggressive marketing strategy.

Sample Average Production Cost Calculation

Businesses typically use a cost of production calculator or other accounting software to determine the unit cost. However, tracing a simple example helps you understand the concept and use it effectively to inform decision making. Suppose XYZ Widgets has $1.2 million in fixed expenses and $1.8 million in variable expenses one year, bring the total cost of production to $3 million. Checking the records, you find the company produced 75,000 widgets during the year. Divide $3 million by 75,000 and you get an average production cost per unit of $40.