Work out Average Fixed Cost

Fixed costs are the costs associated with a product's production that do not change, regardless of the number of units produced. For example, if your business produces curtains, then your fixed cost list will include things like the building lease, sewing machines, storage bins, overhead lighting fixtures and sewing chairs. Average fixed cost (AFC) is the fixed cost amount per unit of product produced. There are two methods for calculating the AFC, depending on what type of information you are working with. Follow these instructions for how to work out and use average fixed cost.

Steps

Using the Division Method

1. Choose a time period to measure. You'll want to choose a distinct time period for your calculation. This will help you align your costs to your production and properly calculate fixed cost. In general, it's easiest to use one month or a number of months because you can easily determine fixed costs over this time period. You can also approach this from the other end and use the amount of time it takes to produce a certain amount of units.
   • For example, you could recognize that you produce 10,000 units every two months and use that time constraint to figure out your fixed costs.
2. Combine total fixed costs. Fixed costs are those costs that don't change based on how many products you produce. This includes things like the rent on the building used to produce or sell the good, the cost of buying or maintaining manufacturing equipment, property taxes, and insurance. This can also include the cost of payroll for employees not directly involved in the manufacturing process. Sum these costs to determine total fixed costs.
   • Going with our previous example, manufacturing 10,000 units in two months, let's say you spend $4,000 per month on rent for your manufacturing space, pay $800 per month in property taxes, $200 in insurance, $5,000 in non-manufacturing (administrative) wages, and $1,000 in depreciation expense on your machinery. This would total $11,000 per month in fixed expenses. Because you're measuring for two months, simply double this number to get $22,000 in total fixed costs.
   • For more information, see how to calculate fixed cost.
   • Keep in mind that this does not include any variable costs, or costs incurred based upon how many products you produce. Variable costs can be materials used in production, utilities, labor costs from manufacturing employees, and packaging expenses.
3. Determine the quantity of units produced. Simply use your figures for goods produced within the period you are measuring. Be sure that the production time period matches the time period from which you collected the information for fixed cost expenses.
   • In our example, this would be the 10,000 units produced in the two months we are measuring.
4. Divide the total fixed costs by the quantity of units produced. This gives you the average fixed cost. To complete our example, we would now divide the $22,000 in total fixed cost over our two month period by the 10,000 units produced in that period. This gives us an average fixed cost of $2.20 per unit.

Using the Subtraction Method

1. Calculate the total cost. This is the total amount of money it costs to produce a product, equal to the total fixed cost plus the total variable cost. Every element of production must be factored into the total cost, including labor, commissions, utilities, marketing, administrative costs, office supplies, shipping and handling, materials, interest and any other cost that pertains to the specific product. It is the sum of total fixed cost and total variable cost.
2. Figure out the average total cost (ATC). The ATC is the total cost, divided by the number of units.
   • Going with our previous example from method 1, if the total cost is $35,000 over the two months when 10,000 units are produced, then the ATC will be $3.50 per unit.
3. Determine the total variable cost amount. Variable costs change according to the quantity of product produced, increasing as production goes up and decreasing as production goes down. For example, the two most predominant variable costs are manufacturing labor and materials. Variable costs also include utilities that vary with production, like the electricity and gas used in manufacturing, for example.
   • Continuing with the same example, imagine the total variable cost is comprised of $2,000 in materials, $3,000 in utilities ($1,500 per month for two months), and $10,000 ($5,000 per month for two months) in manufacturing wages. Add these numbers up to get a total variable cost of $15,000 for your two month period.
   • For more information, see how to calculate variable costs
4. Calculate the average variable cost (AVC) by dividing the total variable costs by the number of units produced. So, for our total variable cost of $15,000 when 10,000 units are produced, the AVC would be $1.50 per unit.
5. Calculate average fixed cost. Subtract the average variable cost from the average total cost. The answer will be the average fixed cost. In the example, the average variable cost of $1.50 per unit would be subtracted from the average total cost of $3.50 per unit in order to reach an average fixed cost amount of $2 per unit. Note that this matches the average fixed cost calculated in method 1.

Analyzing Production Using Average Fixed Cost

1. Use AFC to check product profitability. Calculating a realistic AFC can be helpful to understanding your product's potential profitability. Before beginning a new project, try doing a break-even analysis to better understand how AFC, AVC, and price affect your timeline to profitability. In general, the most important thing is that your product's price is always set above your AVC (average variable cost). The excess is then used to cover fixed costs.
   • AFC goes down as production goes up and thus it's easy to be misled into thinking that producing as much product as possible (while maintaining total fixed costs) is a way to profitability.
2. Analyze expenses with AFC. You can also use average fixed costs in determining where to cut expenses. Cutting expenses may be necessary due to market conditions or may be simply used to increase profitability. If fixed costs make up a large part of your total cost, more so than variable costs, it may be a good idea to consider places where you could cut back. For example, you might think about cutting down on electricity usage with more efficient lighting or manufacturing equipment. Using AFC would allow you to see how this change could affect your profit per product.
   • Reducing fixed costs provides you with more "operating leverage" (more benefits from greater production numbers). Doing this will also lower the sales needed to reach your break-even point.
3. Use AFC to realize economies of scale. Economies of scale is a benefit that comes from large amounts of production. Essentially, by producing more, you are able to lower your fixed cost per item and increase your profit margin. By finding AFC at various levels of production, you are able to price out how much more profitable you could be by producing more. You can then compare this to the price of reaching this level of production (maybe in addition manufacturing space or machine purchases) to determine whether or not an expansion would be profitable.

Tips

• Average fixed cost will never be zero or negative, because the total fixed cost amount will always be a positive number.

Warnings

• You cannot get an accurate perspective of a product's economic feasibility by taking only the average fixed cost into account. Total costs (fixed costs and variable costs) must be considered for a complete understanding of the cost of production.

Related Articles

• Calculate Fixed Cost
• Calculate Variable Costs
• Find Marginal Cost
• Calculate Contribution Margin
• Do Break Even Analysis

Sources and Citations

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