What is Average Variable Cost?
Definition: Average variable cost refers to the total variable cost divided by the number of units that are produced. Variable costs rise with the level of output. The average variable cost of a production batch tells you the per unit variable cost.
What does Average Variable Cost mean?
To understand what average variable cost means, it’s important to know that production costs consist of two components. These are variable costs and fixed costs.
Fixed costs remain the same regardless of the level of production. But variable costs increase with each extra unit that is produced.
Examples of fixed costs: insurance, property taxes, rent, depreciation.
Examples of variable costs: direct material costs, production supplies, piece rate labor.
The average variable cost calculation provides very important information to a firm’s management. Consider a situation where a manufacturing company is incurring losses. Its per unit production costs exceed the revenues that it gets from the sale of each unit.
Should this company continue its manufacturing activity or should it stop operations? Calculating the average variable cost of production will help it to make a decision.
If the sales price of one unit is more than the average variable cost of production, the company should continue producing goods at its factory. That’s because each sale that it makes covers its variable cost and contributes some amount to fixed costs.
However, if the average variable cost exceeds the sales price, the firm should suspend operations. If it continues production in this situation, each unit that it makes will increase its loss.
Example of Average Variable Cost
Boxit, a manufacturer of corrugated boxes, makes standard-sized containers for sale to various clients. However, costs have been rising and selling prices have remained stagnant. Consequently, Boxit is making losses.
Boxit’s selling price is $7.50 per corrugated box. It needs to decide whether to continue operations or to suspend its manufacturing activity till it can raise selling prices. It prepares the following table on the basis of its accounting data and its sales projections:
The company decides to maintain production at 30,000 boxes per month. At that level, it can maximize the contribution to fixed costs.
The average variable cost of production is the variable cost incurred in producing a single unit of output.