Average Total Cost

For any commerce or economics student, accounting is the core subject of study. Concepts like cost, revenue, taxes, assets, margins, etc., are significant to make them understand the cost and pricing structure of a company as also the larger picture in the financial field. For any company, the concept of average total cost (ATC) helps in determining its profit and loss structure, the variables affected, distribution and marketing strategies, and hence the money to be spent on them. Any change in the ATC has a bearing on all these factors.

What is Average Total Cost?

Average total cost (ATC) is the total cost per quantity produced. For instance, if the total cost of producing 1000 units for an XYZ company is $10,000, then average total cost is $10 per unit. ATC is made up of two quantities, namely, average fixed cost (AFC) and average variable cost (AVC). Also, there's another major cost concept called marginal cost (MC), which we'll see in the later part of the article. Average fixed cost is fixed cost per unit quantity, which is the total of money spent on fixed entities like rent, salaries, electricity, water, insurance, etc. AFC never changes even if there is a rise or fall in production depending on the demand and supply. On the other hand, average variable cost is variable cost per unit quantity, which is the dynamic spending on overtime pays, marketing, advertisements, maintenance of machinery, cost of tools and labor, indirect materials, payroll taxes, etc. This cost undergoes a change every day, and hence it can have a major bearing on the profit margin. ATC is, basically, the addition of AFC and AVC.

The best way of knowing the profit is calculating the difference between the average total cost and the price of the product. For instance, if a company manufactures a shirt at the ATC of $50 and sells it to a garment store for $70, it makes a profit of $20 per shirt. If the ATC goes up, the profit will lower and vice-versa. Thus, ATC has a lasting effect on the entire revenue structure of the company.

Average Total Cost Formula

For determining the ATC, first we'll need to find out the total fixed cost and total variable cost. Then, the AFC and AVC, and hence ATC are calculated with the following formulas.

AFC = Total fixed cost Quantity of output produced.

AVC = Total variable cost Quantity of output produced.

ATC = AFC + AVC.

Or, ATC is simply calculated as, ATC = Total cost Quantity of output produced. Now, when we plot the ATC curve on a graph with the quantity of output produced on the x-axis and average total cost on the y-axis, we get a U-shaped curve. It decreases exponentially as the quantity produced increases until it achieves a lowest point and intersects the marginal cost curve. Marginal cost is the cost required to produce one more unit of output and calculated as dTC/dQ, where TC is the total cost of production and Q denotes the quantity. It tells us the required cost to produce the next unit and the point where the MC curve and ATC curve intersect denotes the 'capacity', which is the quantity which minimizes average total cost. At this point, the ATC is minimum and hence the profit is maximum, with the company being at the most efficient level of production. After this point in the graph, the law of diminishing returns takes over and each quantity produced after that has a higher per unit cost, hence increasing the average total cost. Thus, the negatively sloped portion denotes the decreasing ATC and increasing marginal returns, and the positively sloped curve denotes the exact opposite.

Average total cost and marginal cost curves, thus, help a company in deriving the entire profit-loss arrangement once they have a detailed idea of demand and supply structure. ATC calculation paves a way to ascertain a future strategy to maximize the profits and optimize the company's work-fabric and efficiency. Also, if you are an economics student, this concept will come up every now and then in the accounting problems. I hope this article thoroughly clarified this concept. All the best!