What is Average Fixed Cost?
The Average Fixed Cost (AFC) is the fixed costs incurred by a company that remain constant irrespective of output, expressed on a per-unit basis.
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How to Calculate Average Fixed Cost
The average fixed cost is an estimate of the costs incurred to manufacture one production unit.
The average fixed cost is a financial metric used to analyze the fixed cost component of the cost structure of a given company.
The average fixed cost is an estimate of the cost incurred to manufacture one production unit.
Broadly put, the costs incurred by companies can be designated as fixed or variable costs.
- Fixed Costs (FC) → Fixed costs, as implied by the name, remain relatively the same under different levels of output (i.e. production volume).
- Variable Costs (VC) → In contrast, variable costs fluctuate directly based on the level of output in a given period.
Unlike variable costs, fixed costs remain constant, regardless of the number of goods and services produced in a given period.
In a nutshell, the average fixed cost is the fixed cost per unit of a company, calculated by dividing its total fixed cost burden by the total unit output.
A company must strategically manage its cost structure to understand where its revenue is allocated and what directly impacts its profit margins.
Fixed costs are independent of factors such as revenue, production volume, market demand, etc.
The following list contains the most common types of fixed costs incurred by companies in their day-to-day operations.
- Rental or Lease Payments
- Employee Salaries (Base Salary, Excluding Bonuses)
- Property Taxes
- Utilities (Internet Wi-Fi, Gas, A/C, Water)
- Insurance Premiums
The step-by-step process to calculate the average fixed cost is as follows.
- Separate Total Costs (TC) into Fixed Costs or Variable Costs
- Calculate the Sum of Fixed Costs
- Divide the Total Fixed Costs by the Number of Units Produced (Output)
Semi-Variable Costs
The distinction between fixed and variable costs is a broad generalization.
For instance, there is validity to the counterpoint that electricity and water bills could be classified as variable costs, as increased usage causes the bill to rise.
Hence, certain practitioners designate costs that share traits of fixed and variable costs as “semi-variable costs”.
How to Analyze Fixed Cost Per Unit?
Performing cost structure analysis is mandatory to understand where the capital (and revenue) of a company is spent, including ensuring that there is sufficient “cushion” for underperformance.
Given the insights derived from the analysis, a company’s management team must then set pricing rates appropriately, establish budget constraints, and optimize its business model to improve the operating efficiency of the company.
The proportion of fixed costs in a company’s cost structure varies widely based on industry and business model.
- Capital Intensive Business Model → The fixed costs incurred by a manufacturer that builds heavy machinery for their customer base will be outsized compared to a service-based company, such as a consulting firm.
- Labor Intensive Business Model → The cost of labor is the most significant expense for consulting firms, as the number of clients who hire the firm for their consulting services (i.e. output) is their source of revenue. But if client demand underwent a steep decline due to unforeseeable circumstances, the firm’s total costs would decline in proportion, since the consultants are no longer working in that case.
With that said, the average fixed cost per unit is only informative if the comparisons are between that of similar companies (i.e. industry peers, competitors).
Average Fixed Cost Formula
The formula to calculate the average fixed cost is as follows.
Where:
- Total Fixed Cost → The sum of all fixed costs incurred by the company over a set period.
- Production Output → The total quantity or volume of units produced in the coinciding period (i.e. “output”)
For example, suppose an industrials manufacturer produced 50 product units in 2023 while incurring $10k in fixed costs.
The average fixed cost per unit is approximately $200.00.
- Average Fixed Cost (AFC) = 10,000.00 ÷ $50.00 = $200.00
With that said, the manufacturer must quantify its average variable cost per unit to use in conjunction with the average fixed cost per unit to determine its break-even point (BEP) in order to determine the necessary pricing to ensure a profit is generated.