Companies incur different types of costs during the regular course of their operations. These costs may differ based on various criteria. For example, they may come from several sources or have a specific nature.
Companies must identify these costs and separate them for better costing and decision-making. This process falls under the managerial accounting function within a company.
One of the most prevalent types of cost classification involves separating costs based on their nature. In this classification, companies consider how costs change according to activity levels.
Based on that, they can segregate various expenses into several categories. These include variable, fixed, semi-variable and stepped-fixed costs. Each of these differs from the others based on specific criteria.
However, companies must allocate these costs to a product for better understanding. With variable costs, this process is straightforward. However, the same does not apply to fixed costs.
Companies must use various techniques to derive the fixed cost for every product unit manufactured. One such method is calculating the average fixed cost. Before discussing that, it is crucial to understand fixed costs.
What are Fixed Costs?
Fixed costs are any expenses incurred by a company that remain the same regardless of the activity levels. It implies that these costs do not change as companies produce more or fewer goods.
Essentially, these costs are specific throughout the whole process. Usually, these costs do not vary due to their nature. In most cases, these costs relate to functions outside production.
However, fixed costs usually change for every unit produced. When companies manufacture more goods, the per-unit fixed cost lowers. It occurs since there are more units to absorb those costs. On the other hand, if companies produce fewer goods, the fixed cost per unit will increase. Due to the lesser products to absorb those costs, every product gets a higher fixed cost.
For example, factory rent is a fixed cost for most manufacturing companies. If a company incurs $10,000 annual rent, it is unlikely to change. Therefore, it represents a fixed cost for the company.
However, the per-unit fixed cost may differ based on how many products a company manufactures during a period. If it produces 1,000 goods, the per-unit cost will be $10. However, if it only manufactures 100 units, that cost will be $100 per unit.
Fixed costs are prevalent in all businesses and companies. They are the opposite of variable costs that differ based on the activity levels for a specific period. In most companies, variable costs are crucial in determining the product costs for a product unit. However, fixed costs also play a critical role in costing techniques. More specifically, these costs are a part of absorption costing.
Overall, fixed costs remain fixed regardless of the activity levels within a company. However, the fixed per-unit cost absorbed for every product may differ. Some of the most common examples of fixed costs include the following.
- Rent
- Insurance
- Utilities
- Salaries and wages
- Advertising
- Depreciation
What is the Average Fixed Cost?
One concept often associated with fixed costs is the average fixed cost. Essentially, it represents the per-unit fixed cost for a specific period. However, it is not as straightforward. The average fixed cost is the fixed cost spent to produce a single unit. Usually, companies determine a specific activity level to determine the figure for a period.
The average fixed cost is also a crucial concept in economics. There, it has a similar meaning. Average fixed costs in economics are the fixed production costs for a precise quantity of output. These costs occur regardless of how many units a company produces during a specific period. Essentially, it represents the fixed cost per unit for a determined level of output or activity.
However, the average fixed cost is usually a short-term measure of the per-unit fixed costs. Since the activity levels differ between periods, companies cannot use the same amount every period. As stated above, the average fixed costs will fluctuate based on how many units a company produces. If these are higher, those costs will be lower. If they are less, the average fixed costs will be higher.
Overall, the average fixed cost represents the per-unit fixed cost for a specific activity level. It shows the cost companies must incur to produce a single unit. The average fixed cost comes from the fixed costs for a particular period. Usually, companies calculate this cost periodically based on an output level. The average fixed cost becomes a part of various calculations and costing techniques.
How to calculate the Average Fixed Cost?
Companies calculate the average fixed cost for every period. However, they can use two methods to do so. These include the division and subtraction methods. Both of these produce the same results. However, companies can use both depending on the available information. An explanation of these methods and how to calculate the average fixed cost is below.
Division method
In the division method, companies calculate the amount through two metrics. These include the fixed costs and the activity levels for that period. Usually, companies use this method to determine how fixed costs impact their fixed per-unit cost. Companies can use the following steps to calculate the average fixed cost in the division method.
- Choose a period for which the average fixed cost is under consideration.
- Add all the fixed costs for that period to reach the total fixed costs.
- Determine the activity levels for that period.
- Divide the total fixed costs by the activity levels.
The formula for the average fixed cost under this method is below.
Average fixed cost = Total fixed costs / Activity levels
Subtraction method
The subtraction method of calculating the average fixed cost also provides the same result. However, it requires different metrics for calculation. Essentially, it requires the average total and variable costs to calculate the average fixed costs. This method is helpful to determine how fixed costs are variable costs compared with each other. Companies can use the following steps to calculate the average fixed cost in the subtraction method.
- Determine a period.
- Calculate the total cost for that period.
- Calculate the average total cost.
- Determine the average variable cost.
- Subtract the average variable cost from the average total cost.
The average fixed cost formula under the subtraction method will be as below.
Average fixed cost = Average total cost – Average variable cost
Example
A company, ABC Co., wants to calculate its average fixed costs for a period. The company has already determined the timeframe for the calculation. ABC Co. incurred fixed costs of $10,000 during the period. In that period, its activity levels were 1,000 units. ABC Co. can use the division method to calculate its average fixed cost.
The average fixed cost calculation for ABC Co. will be as follows.
Average fixed cost = Total fixed costs / Activity levels
Average fixed cost = $10,000 / 1,000 units
Average fixed cost = $10/unit
Conclusion
Fixed costs are expenses incurred by a company that remain the same regardless of activity levels. Companies can use these costs in various calculations. Consequently, they must calculate the average fixed cost. It represents the fixed costs incurred to produce a single product. Companies can calculate the average fixed cost using two different methods.
