What is Average Variable Cost?
The Average Variable Cost (AVC) is the variable cost per unit incurred by a business across a given period.
The average variable cost is calculated by dividing a company’s total variable cost by the quantity of output (i.e. the number of units produced).
Table of Contents
How to Calculate Average Variable Cost
The average variable cost is an integral component in performing break-even analysis and estimating production capacity.
The average variable cost, often used interchangeably with the term “variable cost per unit,” measures the total variable cost incurred by a company relative to the quantity of output (i.e. production output).
By analyzing the average variable cost (AVC) metric, including its connection to the total cost (TC), management can optimize the company’s margin profile and improve its operating efficiency.
In practice, cost structure analysis refers to the disaggregation of a specific company’s cost composition into fixed costs and variable costs.
- Fixed Costs (FC) → Fixed costs remain constant under different levels of production output.
- Variable Costs (VC) → Variable costs fluctuate based on the levels of production output.
The following list contains the most common types of variable costs:
- Direct Labor
- Direct Material
- Sales Commission (and Bonuses)
- Shipping and Delivery Fees
Generally put, production should continue only if the monetary benefits received from customers (i.e. the price) exceed the fixed costs and variable costs.
Otherwise, the company must adjust its business model (e.g. increase pricing) because its profit margins will inevitably compress, which is not sustainable over the long run.
Quantifying the average variable cost, assuming the average fixed cost was determined beforehand, is enough to estimate a company’s break-even point (BEP).
The process of calculating the average variable cost (AVC) consists of three steps:
- Identify the Variable Costs Embedded in Total Cost
- Calculate the Sum of the Variable Costs
- Divide the Total Variable Cost by the Production Output (Quantity)
How to Analyze Average Variable Cost
Analyzing the variable cost per unit starts with grasping the internal and external factors that the company faces, which impacts its cost structure.
Understanding the cost structure of a company is necessary to set prices appropriately to ensure the break-even point is met (or exceeded, to generate a profit), as well as setting limitations on production capacity.
With that said, the cost structure concept is industry-specific, so companies operating in different industries cannot always be compared to each other.
- Capital-Intensive Industries (Asset-Heavy) → The cost structure of companies operating in capital-intensive industries, such as manufacturing and industrials, will have substantially more fixed costs, as the reliance on capital expenditures (Capex) is an inherent part of their business models.
- Service-Oriented Industries (Asset-Lite) → On the other hand, the cost structure of service-oriented industries like consulting and related professional services is composed mostly of variable costs, since labor is the most significant expense. For that reason, service-oriented industries tend to fare better in periods of economic contractions – not with regard to performance, but in terms of better avoiding financial distress and insolvency.
Cost Structure Analysis by Industry
To reiterate, the percent mix of fixed and variable costs in the cost structure of companies is contingent on the industry.
Certain manufacturing companies can continue to perform well amid periods of economic slowdown, especially if there are long-term B2B customer contracts, and the product is “mission-critical” to the end markets served (i.e. represent non-discretionary spending).
However, there is still significant risk for capital-intensive companies, especially if clients file for bankruptcy or there is substantial debt on the company’s balance sheet (i.e. high credit risk).
Conversely, labor-intensive industries can opt to reduce headcount to uphold margins and wait for the unfavorable economic conditions to pass, because such firms have more flexibility and levers to pull to ensure their “survival” (and service-oriented companies rarely carry much debt).
