How to Calculate Average Fixed Cost? Formula, Definition, and Example

Definition:

Average Fixed Cost (AFC) refers to the fixed costs of production divided by the quantity of output produced. Fixed costs are those that do not vary with the production level. 

These may include rent, salaries of permanent staff, and insurance. These costs remain constant whether the firm produces nothing, a little, or a lot.

Formula

AFC=Total Fixed Costs / Quantity of Output Produced

What is Total Fixed Costs?

Total Fixed Costs refer to the sum of all costs that do not change with variations in the level of production or sales over a specified period.

These costs remain constant, regardless of the volume of goods or services a company produces or sells.

Characteristics:

  1. Consistency: Fixed costs remain the same, even if the production level increases or decreases.
  2. Duration: They are typically consistent for a specific period, often contractual.
  3. Non-variable: Fixed costs don’t vary with the level of operational activity.

Examples:

  1. Rent: The monthly rental expense for a factory or office space is fixed as it doesn’t change based on production levels.
  2. Salaries: For salaried employees not paid on a production basis (e.g., administrative staff), their wages remain the same irrespective of output.
  3. Insurance: Premiums for insurance typically remain constant over the contract period, irrespective of production.
  4. Depreciation: This represents the spread-out cost of an asset over its useful life and remains consistent over time, regardless of how much the asset is used in production.
  5. Property Taxes: Annual property taxes on business premises are also an example of fixed costs.
  6. Interest Expenses: If a business has taken out loans, the interest expense may be fixed if the interest rate and principal amount remain unchanged.

What is the Quantity of Output Produced?

The Quantity of Output Produced refers to the total number of units of a particular product or service that a company manufactures or delivers in a given period. 

It measures a business’s productive capacity and efficiency in transforming inputs into finished goods or services.

Characteristics:

  1. Measurability: The quantity of output can be precisely measured, usually in units, batches, kilograms, liters, or any relevant measurement standard about the product.
  2. Variability: It can vary from one period to another based on factors like demand, production capacity, availability of raw materials, and operational efficiency.
  3. Direct Relation to Inputs: The quantity of output typically correlates directly to the inputs used. For example, the higher the potential output, the more raw materials and labor hours are used.
Related article  LIFO Reserve: Definition, Formula Example, And How Does it Work

Factors Affecting Quantity of Output Produced:

  1. Production Technology: Advanced machinery and techniques can enhance production capacity.
  2. Availability of Raw Materials: The supply of raw materials is essential for continuous production.
  3. Labor Skills and Efficiency: Well-trained and efficient labor can significantly increase the quantity and quality of output.
  4. Operational Strategy: Companies might adjust their production levels based on strategies like inventory management, demand forecasting, and market conditions.
  5. External Factors: Situations like strikes, natural disasters, or supply chain disruptions can affect production levels.

How and When Average Fixed Cost (AFC) Is Used

  1. Pricing Decisions: Businesses often use AFC to help determine product pricing. By understanding the fixed cost per unit, a company can better set a price that covers its costs and ensures profitability.
  2. Profitability Analysis: By comparing AFC with the selling price of a product, businesses can estimate the contribution of each unit towards covering variable costs and generating profit.
  3. Production Decisions: Companies can analyze how AFC changes at different production levels. This can guide decisions on scaling production up or down. As more units are produced, AFC diminishes, which might incentivize companies to produce more, provided there’s demand.
  4. Cost Control: Monitoring AFC can provide insights into how efficiently a company spreads its fixed costs over its production output. A rising AFC might indicate under-utilization of capacity.
  5. Break-even Analysis: AFC is a component in determining the break-even point of production—the point where total costs (fixed and variable) equal total revenue.
  6. Budgeting and Forecasting: Understanding AFC can help businesses in forecasting costs for future production levels, aiding in more accurate budgeting.
  7. Comparing Efficiency: Businesses can compare their AFC with competitors or industry benchmarks to gauge operational efficiency. If a company’s AFC is significantly higher than the industry average, it might indicate inefficiencies or under-utilization of resources.
  8. Investment Decisions: Potential investors or lenders might look at AFC as a part of their analysis to determine the viability of investing in or lending to a business. A consistently high or rising AFC can be a red flag.
  9. Evaluating Economies of Scale: AFC is instrumental in evaluating economies of scale. As production increases, the AFC decreases, indicating that the firm is achieving economies of scale.

When to Use AFC:

  • Planning Production Levels: When a business plans its production levels, understanding how AFC changes at different production quantities can guide these decisions.
  • Launching New Products: Before launching a new product, a company will analyze the projected AFC to determine the feasibility and profitability of the product.
  • Capacity Decisions: If a firm is considering expanding its production capacity (e.g., by acquiring a new factory), understanding how this will affect AFC is crucial.
  • Evaluating Operational Efficiency: Regularly, as part of routine financial analysis, to check the efficiency of spreading fixed costs across production.
  • Strategic Planning: In long-term strategic planning, the company aims to see the impact of scaling operations on fixed costs.
Related article  Absorption Costing Vs. Variable Costing: What Are the Main Different

Example:

Imagine a company that produces toys.

The company’s total fixed costs, including the factory rent, salaries for permanent staff, and machinery maintenance, amount to $10,000 per month.

In a particular month, if the company produces 5,000 toys, the AFC can be calculated as:

AFC=Total Fixed Costs / Quantity of Output Produced

AFC =$10,000/5,000 toys= $2 per toy

This means the company incurs a fixed cost of $2 for each toy produced that month. 

As the company produces more toys, the AFC per toy will decrease, demonstrating economies of scale.

So, the Average Fixed Cost is a valuable metric for companies to understand their fixed cost burden per production unit. 

It helps in pricing decisions, gauging operational efficiency, and understanding economies of scale.

Advantages of Average Fixed Cost (AFC)

  1. Budgeting and Planning: AFC allows businesses to predict their fixed cost per output unit, making it easier to plan budgets and set pricing strategies.
  2. Economies of Scale Recognition: By monitoring AFC, firms can determine if they are achieving economies of scale. As production levels increase, AFC decreases, indicating that the firm is better at spreading its fixed costs over larger units.
  3. Cost Control: Understanding AFC can help a business control its fixed expenses. If the AFC begins to rise, it can indicate inefficiencies or underutilization of resources.
  4. Pricing Strategy: Businesses can use AFC to help determine the minimum price they need to charge for a product to cover their fixed costs.
  5. Performance Benchmarking: AFC can serve as a benchmark for performance comparison over time or against competitors. If a company can produce goods with a lower AFC than competitors, it may have a competitive advantage.
  6. Facilitates Decision Making: By understanding their AFC, businesses can make informed decisions about production levels, whether to invest in additional capital, or whether to continue or discontinue a product line.
  7. Helps in Break-even Analysis: AFC, when combined with variable costs, helps in determining the break-even point of production, i.e., the level at which total costs equal total revenue and the firm neither makes a profit nor a loss.
  8. Simplifies Financial Analysis: AFC is a straightforward metric, making it easier for managers to analyze and communicate about a firm’s cost structure, especially when explaining financial data to stakeholders not familiar with more complex cost accounting metrics.
Related article  Just-In-Time: History, Objective, Productions, and Purchasing

Disadvantages of Average Fixed Cost (AFC)

  1. Not Comprehensive: AFC only considers fixed costs and disregards variable costs. Businesses must consider Average Variable Costs (AVC) to understand per-unit costs fully.
  2. Misleading in Isolation: A declining AFC might give a misleading signal of overall cost efficiency if used in isolation. For instance, even if AFC decreases, the total costs might increase if the variable costs rise faster.
  3. Limited Relevance at High Production Levels: As production levels become very high, the AFC tends to become very small and thus might become less relevant in decision-making.
  4. Doesn’t Reflect Actual Cash Outflow: AFC is an average figure. It doesn’t necessarily show the actual cash outflows related to fixed costs in a given period.
  5. Risk of Overproduction: Relying heavily on reducing AFC might lead companies to produce more than the market demands, potentially leading to excess inventory or wastage.
  6. Can Lead to Complacency: A continuously declining AFC might make businesses complacent, thinking they are continually achieving cost efficiencies, even when other significant financial problems might be lurking.
  7. Might Not Reflect Economic Realities: In some cases, the categorization of costs into fixed and variable might need to be clarified. Some costs have fixed and variable components, making the calculation of AFC less precise.
  8. Potential Misuse: Without a clear understanding, managers might aim to dilute fixed costs over more units, leading to overproduction or other inefficient practices.
  9. Doesn’t Consider Opportunity Costs: Focusing on AFC doesn’t consider the opportunity costs of deploying resources in one area versus another, which might lead to sub-optimal resource allocation.
  10. External Factors Ignored: AFC calculations do not consider external market conditions or economic fluctuations, which can profoundly affect business profitability and performance.