To make significant production decisions, businesses depend on multiple cost functions. In this article, we are going to discuss the average variable cost function, its uses for business decisions.
Average Variable Cost Definition
The TVC, total variable cost, per unit of output is known as the AVC, average variable cost. It can be found easily when the TVC, total variable cost, is divided by the total output (Q). TVC, total variable cost, is all the costs, such as materials and labor that vary with production. The best way to evaluate that variable cost is that if production increases so the cost increases as well.
The AVC would be used by profit-maximizing companies to decide whether to continue their production or shut down it in the short term. If given the products they make, the price they earn against the good is above the AVC, and then they at least cover some fixed costs as well as variable costs. Fixed costs (FC) are those expenses that do not change with scale of production; no matter how much is produced, they are fixed at a certain amount. Building/warehouse is the best example of fixed cost as it has not link with production. Regardless of how many units or clients you create or serve but its rent will remain the same. Consequently, even though you produce nothing, you would still have to pay the fixed costs even in the case of shut down the production.
You are better off continuing production, when the price is higher than the AVC and covers some of the fixed costs. If the price less than the AVC, the company can decide, in the short term, to shut down production as the price will no longer covers all of the variable costs or any part of the fixed costs. The company would decide to shut down the production for minimization of losses.
AVC Function and Equation
The average variable cost function is shown in this graph below. It’s a curve with a U shape. Initially, as output increases, the variable cost against per unit of production decreases. It hits a low at a given stage. The variable cost against per unit of production begins to rise after the low one. After a certain point, the rise in AVC is indirectly connected to the law of diminishing marginal returns. The law specifies that the extra expense occurred on production of one more unit is greater than the added profit (or return) earned at any point. The average variable cost is beginning to increase at that point.
The AVC, average variable cost, can be determined by using following equation.
AVC = TVC / Q
Where AVC shows average variable cost
TVC shows total variable cost
Q shows Quantity
Average Variable Cost and Firms
Average variable cost (AVC) is a key factor in the option of whether to continue operating for a given business. Specifically, for the company to continue running profitably over time, the total variable (TC) cost should be smaller than the marginal revenue (MR).
In other words, this suggests that a good’s average variable cost may be smaller than the good’s price, in this case the business can afford all the variable costs (VC) as well as a majority of the fixed costs (FC). And if a company sells its products for less than the AVC, a company trying to increase its profits (as businesses usually do) may stop manufacturing to avoid the creation of more variable costs.
Average Variable Cost and Marginal Cost Relationship
Marginal Cost (MC) is the cost of a given commodity for each added unit. The total variable cost (TVC) is equal to the accumulated marginal cost of Q units. It implies, then, that, when divided by Q, the average variable cost (AVC) is equal to the total marginal cost (MC) of Q units.
Average Variable Cost Calculator
In this calculator you just have to insert the values it will automatically give you desired results.