06 Jun Average Fixed Cost
What is Average Fixed Cost?
Definition: Average fixed costs can be calculated by dividing total fixed costs by the number of units produced. As production volumes rise, average fixed costs fall.
What does Average Fixed Cost mean?
The total cost of production can be calculated by adding fixed costs and variable costs. Fixed costs remain the same regardless of the number of units that are manufactured. Variable costs, on the other hand, rise with an increase in production volumes.
Which costs would remain the same if the quantity of goods that is manufactured increases? Fixed costs include:
⇨ Interest paid on loans
⇨ Insurance expenses
These costs would not increase if production volumes were stepped up. Even if the quantity manufactures falls, fixed costs would remain the same.
Consequently, a firm could find it profitable to increase production. By doing this, they could spread their fixed costs over a larger number of units. The following table will illustrate this point. It has been prepared for a factory that incurs a total fixed cost of $1,000,000.
|Number of units||Average Fixed Cost $|
When 1,000 units of a good are produced, the average fixed cost is equal to $1,000 per unit. However, it is seen that an increase in production leads to a fall in the average fixed cost.
Capital-intensive businesses will have a high fixed cost. For these firms, it is important to ramp up production volumes. If they are able to produce more, they will be able to lower their average fixed costs. Conversely, if output falls, average fixed costs would rise and this could result in a situation where the firm would have to raise prices in order to make a profit.
Example of Average Fixed Cost
Glover Industries manufactures office chairs. Its fixed costs consist of salaries, rent, insurance, and the interest that it pays on its long-term loan from the bank. The total yearly fixed costs are $700,000.
The company manufactures 5,600 chairs per year. Its average fixed costs are $125 per chair ($700,000 divided by 5,600). In the next year, the company gets orders for a total of 7,000 chairs.
The average fixed costs fall to $100 ($700,000 divided by 7,000). Glover Industries sees an increase in profitability due to its higher production volumes.
An increase in output leads to a fall in average fixed costs. When a company steps up production volumes, its profits can rise as its fixed costs are spread over a greater number of units.