Average Fixed Cost Declines Continually as Output Increases

Average Fixed Cost Definition

Average Fixed Cost is fixed production expenses of the company concerning per unit of goods produced by it. With an increase in the quantity of output produced, this average cost reduces because the fixed cost remains the same while the number of output increases.

Examples of the fixed cost includes the rent paid, salaries paid to the permanent employees, mortgage payments on the plant and machinery, etc. This cost remains the same, but as the total units of the produced increases, then the average fixed cost of the company decreases because the same amount of the fixed costs incurred by the company is getting spread over the more significant number of the units of output. It is different from the average variable cost, which remains the same, even when there is a change in the quantity of the goods produced by the company.

Table of contents

• Average Fixed Cost Definition
  • Average Fixed Cost Formula
  • Examples
    • Example #1
    • Example #2
  • Advantages
  • Disadvantages
  • Important Points
  • Conclusion
  • Recommended Articles

Average Fixed Cost Formula

Average Fixed Cost formula = Total Fixed Cost / Output

It can also be calculated by subtracting the average variable cost Average Variable Cost refers to the cost that directly varies with the output incurred on each unit of goods or services. It is evaluated by dividing the total variable cost incurred during the period by the number of units produced. read more of the company from the average total cost, as the total cost of the firm can either be fixed or variable. If variable one is deducted from the total cost, it will give the fixed cost as the resultant. Mathematically:

AFC formula = Average Total Cost (ATC) – Average Variable Cost (AVC)

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Examples

The following are examples to understand the concept in a better manner.

Example #1

Company A ltd. is in the business of providing telecom services to the customer. During the month of June-2019, the total fixed cost of the company was $ 100,000, and the output during the same period was $5,000. First, calculate the average fixed cost of the company.

Solution:

Calculation of the AFC

• = $ 100,000 / $5,000
• = $ 20 per unit

Thus the AFC of the company A ltd. is $ 20 per unit.

Example #2

George Inc. is a factory manufacturing chocolates. It produces 2,500 units of chocolates. It incurs the following fixed costs annually:

• Annual rent of factory premises: $2,500
• Fixed annual salary of contract worker (per person): $1,500
• Annual property taxes: $2,000
• Other Fixed Costs: $1,000

Three contract workers are hired. Calculate the average fixed cost from the above information. Suppose 5,000 units are manufactured with the same total fixed costs. Will the AFC change?

Solution:

Scenario 1:

2,500 units are produced

Salary of 3 contract workers = 3*$1,500 = $4,500

Calculation of Fixed Cost will be –

Total Fixed Costs = $2,500 + $4,500 + $2,000 + $1,000

Total Fixed Costs = $10,000

Calculation of AFC can be done as follows:

AFC = 10000 / 2500

AFC = $4

Scenario 2:

5,000 units are manufactured

Calculation of average fixed cost can be done as follows:

AFC = 10000 / 5000

AFC = $2

Advantages

• It is simple to calculate, as the fixed cost for the enterprise, when divided by the total output produced by the company; the results will be the AFC.
• When there is an increase in the company's production, then the AFC of the company falls. So, there is the advantage of the increase in the output, and the profit of the company, in that case, will be more.
• The number of average fixed costs will help the company determine the minimum amount of profit that it must earn per quantity of goods produced so that at least all the company's expenses can be paid off.

Disadvantages

• When there is a decrease in the company's production, then the company's AFC increases. So, there is a disadvantage to the reduction of the output.
• Sometimes the fixed cost is confused with the average fixed cost by the user of the value, which may not fulfill the purpose of the analysis.

Important Points

• There are two ways to calculate the average fixed cost in the company, i.e., either by dividing the total fixed cost by the total output or by subtracting the company's average variable cost from the company's average total cost.
• With the increase in the company's production, the AFC of the company falls, and the curve of the AFC will slope downwards continuously, from left to right.
• It is different from the average variable cost, as AFC changes whenever there is a change in the quantity of the goods produced by the company. Still, in the case of the average variable cost, it remains the same even when there is a change in the quantity of the goods produced by the company.

Conclusion

Thus, the fixed cost refers to the company's fixed expenses per unit of production. The curve of the AFC will slope downwards continuously, from left to right. When there is an increase in the company's production, then the company's average fixed cost falls. So, there is the advantage of the rise in the output, and the profit of the company, in that case, will be more. However, when there is a decrease in the company's production, then the company's average fixed cost increases, leading to a reduction in the profits of the company.

Recommended Articles

This has been a guide to Average Fixed Cost and its definition. Here we discuss how to calculate the average fixed cost using its formula and examples, advantages, and disadvantages. You may learn more about finance from the following articles –

• Depreciation Unit of Production
• Incremental Costs Examples
• Average Total Cost Calculation
• Budgetary Slack

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Source: https://www.wallstreetmojo.com/average-fixed-cost/

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