Average Total Cost: Definition & Formula

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  • 0:01 Definition of Average…
  • 1:03 Average Total Cost Formula
  • 2:38 Implications of…
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Lesson Transcript
Instructor: Dr. Douglas Hawks

Douglas has two master's degrees (MPA & MBA) and a PhD in Higher Education Administration.

Knowing and understanding cost structure is an important part of budgeting, production planning, and pricing decisions. In this lesson, you'll learn the definition and calculation of average total cost.

Definition of Average Total Cost

When economists, production managers, or others refer to average total cost, they are referring to the per unit cost that includes all fixed costs and all variable costs. Knowing average total cost is critical in making pricing decisions, as any price below average total cost will result in a financial loss.

Total costs are made up of fixed costs, those costs that are required for production but do not change based on output, and variable costs, those costs that increase or decrease as output increases or decreases. For example, if an organization manufactures desktop computer screens, the glass screens, plastic casings, electrical boards and wires, and screws are all variable costs. The cost of the facility they are made in and the equipment used to assemble the monitors are fixed costs. It doesn't matter if one monitor is made or 100, the cost of the facility and equipment will remain fixed.

Average Total Cost Formula

The average total cost is sometimes referred to as the per unit total cost since it is calculated by taking the total cost of production and dividing that by the number of units produced (quantity). In variable form, it looks like this:

TC / Q = ATC

Where fixed costs + variable costs (quantity) = TC

In the computer monitor example, let's set our fixed costs of the monthly lease payment for the equipment and building at $50,000. We can set our variable costs at $100. For purposes of comparing how average total cost can change based on production, let's set output (Q) at 4,000 in July and 6,000 in August.

In July, our total cost is $50,000 + $100(4,000) = $450,000. Once we have total cost, we can divide that by our quantity produced to get average total cost. For July, $450,000 / 4,000 = $112.50. In July, each monitor produced cost $112.50.

Using the same formula for August, but increasing production, results in an average total cost of $108.33. Why did the average total cost go down? While total variable costs increased as production increased, there were more units to share the fixed costs, resulting in a lower average total cost.

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