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How to Understand and Calculate Cost Measures

Using Cost Data From a Chart

Adam Gault/ OJO Images/ Getty Images
[Q:] I have an assignment and it is asking for a lot of figures relating to cost. Average Fixed Cost, Total Variable Cost, etc. Can you help me make sense of all these definitions of cost and help me figure out how to calculate them?

[A:] I sure can. There are quite a few definitions relating to cost. We will consider the following seven terms: Marginal Cost, Total Cost, Fixed Cost, Total Variable Cost, Average Total Cost, Average Fixed Cost, and Average Variable Cost. When asked to compute these seven figures on an assignment or on a test, the data you need is likely to come in one of three forms.

1. In a table which gives you total cost and quantity produced.

2. A linear equation relating total cost (TC) and quantity produced (Q). This would be an equation like TC = 400Q + 20, or TC = 50 + 6Q.

3. A non-linear equation relating total cost (TC) and quantity produced (Q). This would be an equation like TC = 34Q3 – 24Q + 9 or TC = Q – log(Q).

Each of these situations has to be dealt with differently. In section 1 we will consider the first situation. Section 2 will look at the linear equation example, and section 3 will deal with non-linear equations.

We will look at all seven of these terms using the data on the bottom of this article. You may want to print this page out as a reference so you don't have to keep scrolling back and forth. Lets get started!

Marginal Cost

Marginal Cost is the cost a company incurs when producing one more good. Suppose we're producing two goods, and we would like to know how much costs would increase if we increase production to three goods. This difference is the marginal cost of going from two to three. It can be calculated by:

Marginal Cost(2 to 3) = Total Cost of Producing 3 – Total Cost of Producing 2.

Looking at our data, it costs 600 to produce three goods and 390 to produce two goods. The difference between the two figures is 210, so that is our marginal cost.

Sometimes your chart will give you the marginal cost, and you'll need to figure out the total cost. We might have that the cost of producing one good is 250, and the marginal cost of producing another good is 140. Then we can figure out the total cost of producing two goods by:

Total Cost of Producing 2 = Total Cost of Producing 1 + Marginal Cost(1 to 2)

In our case the total cost would be 250 + 140 = 390. So the total cost of producing two goods is 390.

Total Cost

The total cost is simply all the costs incurred in producing a certain number of goods. That question is easy to answer here, as we can just read it off of our chart. So the total cost of producing three goods is 600 and the total cost of producing five goods is 1200. If you're given marginal cost data instead of total cost data, you can compute the total by the example given in the marginal cost section.

Fixed Cost

Fixed costs are the costs that are independent of the number of goods you produce, or more simply the costs you incur when you do not produce any goods. We see from our chart that when we produce zero goods our costs are 130. So our fixed cost of production is 130.

Total Variable Costs

These are just the opposite of fixed costs; these are the costs that do change when we produce more. We calculate the total variable cost of producing 4 units by:

Total Variable Cost of Producing 4 units = Total Cost of Producing 4 Units – Total Cost of Producing 0 units.

In our case it costs us 840 to produce 4 units and 130 to produce 0. Then our total variable costs when we produce 4 units is 710 since 810-130=710. Similarly our total variable costs when we produce 5 units is 1070.

Average Total Costs

Our average total cost is our fixed costs over the number of units we produce. So if we produce five units our formula is:

Average Total Cost of Producing 5 = Total Cost of Producing 5 units / Number of Units

With our data we have an average total cost of producing five units of 200, as the total cost of producing five units is 1200 and 1200/5 = 240. The average total cost of producing four units is 210 as 840/4 = 210.

Average Fixed Costs

Our average fixed cost is our fixed costs over the number of units we produce, given by the formula:

Average Fixed Cost = Fixed Costs / Number of Units

So our average fixed cost of producing five units is our total fixed costs (130), divided by the number of units (5), which gives us an average fixed cost of producing five units of 26 (26 = 130/5). Similarly the average fixed cost of producing two units is 65 as 130/2 = 65.

Average Variable Costs

As you might have guessed, our formula for average variable costs is:

Average Variable Cost = Total Variable Costs / Number of Units

We saw that the total variable cost of producing four units is 710 and 870 for six units. Then the average variable cost of producing four units is 177.5 (710/4) and the AVC of producing five units is 214 (1070/5).

Be sure to continue to section 2 where we look at calculating all seven cost measures when given a linear equation.

Total Cost and Quantity Data

 Q TC 0 130 1 250 2 390 3 600 4 840 5 1200
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