When average cost equals average profit, the firm's cash outlay will equal its expenses. As a result, the corporation will record no profit. Such a situation may arise under a variety of circumstances and is a hallmark of perfectly competitive markets.
If average cost includes all costs, as opposed to only variable costs, the firm will neither make any money nor record a loss when average cost equals average revenue. Under such conditions, the company will have no earnings left after paying its workers and suppliers and financing other overhead expenses such as rent of its stores, research and development costs and so on. Since there will be no profits, the firm cannot pay a dividend to its shareholders. If this is a temporary situation expected to improve soon, shareholders may hold on to the company stock. If, however, the lack of profitability is expected to continue for the foreseeable future, shareholders will likely sell their shares, resulting in a decline in stock price.
When every firm in an industry is operating at zero net profitability, the market they operate in is said to be perfectly competitive. Perfect competition is a theoretical ideal and very rarely, if ever, occurs in real life. In a perfectly competitive market, every manufacturer produces the exact same product, there are a large number of buyers as well as sellers, and buyers shop only on the basis of price, with complete disregard to such factors as brand name and advertising. Furthermore, the unit production costs of each firm are exactly the same, and new competitors can enter the market at any time. Naturally, such ideal conditions almost never materialize in the real world.
A more realistic scenario where average cost and revenue may be equal is when a firm accepts to sell products at no profit to maximize longer-term gains. A new entrant to an already established market, for instance, may follow such a tactic to familiarize consumers with its product. A new brand of soap may carry a "buy one, get second half off" promotion, thus bringing the average selling price per unit down to the level of average manufacturing costs. As consumers get to know and like the product, such promotions can be slowly phased out and the manufacturer can return to profitability.
A firm may also be forced to sell at cost because its manufacturing costs are simply too high. Especially if competitors sell far larger quantities and therefore enjoy lower production costs, a firm may simply be unable to sell at a profit. Other times, factors such as union labor contracts keep costs high despite high production volume.
In such instances, the firm will try to reduce costs by improving efficiency. If this proves impossible, the firm will probably stop manufacturing the unprofitable product, by either selling part of the business that manufactures the product line or shutting down that part of its operations.
Hunkar Ozyasar is the former high-yield bond strategist for Deutsche Bank. He has been quoted in publications including "Financial Times" and the "Wall Street Journal." His book, "When Time Management Fails," is published in 12 countries while Ozyasar’s finance articles are featured on Nikkei, Japan’s premier financial news service. He holds a Master of Business Administration from Kellogg Graduate School.