AVERAGE COST: CALCULATION, ADVANTAGES AND DISADVANTAGES, EXAMPLES - DUDAS - 2025

The average cost is the cost of production per unit of production, calculated dividing the total fixed costs and variable costs by the total number of units produced, which would total production. It is a cost accounting term also called unit cost.

It may depend on the period of time considered. For example, increasing production may be costly or impossible in the short term. They affect the supply curve and are a fundamental component of supply and demand. Lower average costs are a powerful competitive advantage.

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Average cost can also refer to the average cost of inventory, as well as the average cost of units produced.

These two categories are similar in nature. Retail stores generally do not produce any of their inventory, but rather purchase it from manufacturers or wholesalers.

On the other hand, manufacturers do produce their own inventory. Retail stores need to know the cost of what they paid for inventory, while manufacturers need to know how much it costs them to produce inventory.

How is the average cost calculated?

In economics, the average cost (CP) or unit cost is equal to the total cost (TC) divided by the number of goods produced, which would be the production of a quantity C.

Also the average cost is equal to the sum of the average variable costs (total variable costs divided by C) plus the average fixed costs (total fixed costs divided by C). Symbolically, the average cost is expressed as:

CP = CT / C, or also, CP = average variable cost (CVP) + average fixed cost (CFP), where, Average variable cost = Total variable cost (CVT) / Total production (C)

Average fixed cost = Total fixed cost (CFT) / Total production (C)

Average cost is extremely easy to calculate for a retail store. The average cost of inventory is calculated using the weighted average inventory method.

In other words, the total dollar amount paid for inventory is divided by the total number of inventory units available. Obviously, the total inventory must be made up of the same type of units.

Short-term and long-term average cost

Average cost is highly influenced by the production time period, as increasing or expanding production in the short term can be quite expensive or impossible.

Thus, economists study both short-run average costs and long-run average costs to decide production for a given period.

The short-run average cost is the cost that varies with the production of the goods, provided that the fixed costs are zero and the variable costs are constant.

On the other hand, the long-term average cost includes all the cost involved in varying the quantities of all the inputs used for production.

The long term is the period of time in which the amounts of all inputs to be used, including capital, can vary.

Therefore, average cost is an important factor in determining supply and demand within the market.

Advantages and disadvantages

Advantage

The biggest advantage of using average cost as a rate to evaluate new production projects is its simplicity. The calculation does not involve too much complication, since it is very easy to operate. This greatly reduces office work.

A single average cost rate saves managers a lot of time when evaluating new projects. If the projects have the same risk profile and there is no change in the proposed cost structure, the current average cost can be applied and used effectively.

Also, this method requires little manpower. Therefore, it is one of the least expensive cost accounting methodologies to maintain.

On the other hand, profitability will be more directly related to the quantity produced, although this could also be a disadvantage.

When it works well

The average cost method works well when you have the following situations in your business:

- When it is difficult to track the cost associated with the units individually. For example, it can be applied where individual units are indistinguishable from each other.

- When raw material costs move around an average cost point in an unpredictable manner, so that average cost is useful for long-term planning purposes, such as in developing a budget.

- When there are large volumes of similar items moving through inventory, which would otherwise require considerable staff time to be able to track individually. The average cost method is very suitable when materials are received in uniform batch quantities.

- Average cost sets the price of products at a level that allows monopolies to make normal profits, rather than economic profits. This benefits consumers, with higher production and lower prices.

- Society benefits because consumers do not have prices outside the market.

Disadvantages

The average cost method does not work well in the following situations within the company:

- When the units in a lot are not identical, but vary widely. Therefore they cannot be treated identically for costing purposes, because the average price will lead to wrong costs.

- When the inventory items are unique and / or expensive. In these situations it is more accurate to track costs per unit.

- When there is a clear upward or downward trend in product costs, the average cost does not provide a clear indication of the most recent cost in the cost of merchandise sold. Being an average, it presents a cost that can be more closely related to a period in the past.

Examples

If a retail store averaged $ 20 worth of shirts with $ 100 worth of shoes, the average inventory per unit would be slightly skewed. Each type of inventory must be averaged separately.

Average costing is the application of the average cost of a group of assets to each of the assets within that group.

For example, if there are three items in the same category that have individual costs of $ 10, $ 12, and $ 14, the average cost would dictate that the cost of the three items be treated as $ 12 each, this being the average cost of the items. three items.

References

1. Wikipedia, the free encyclopedia (2019). Average Cost. Taken from: en.wikipedia.org.
2. Business Dictionary (2019). Average cost. Taken from: businessdictionary.com.
3. Business Jargons (2019). Average Cost. Taken from: businessjargons.com.
4. My Accounting Course (2019). What is an Average Cost? Taken from: myaccountingcourse.com.
5. Coursehero (2019). Advantages and Disadvantages of Variable Cost. Taken from: coursehero.com.
6. Steven Bragg (2017). Average cost method. Accounting Tools. Taken from: accountingtools.com.