Determining the total cost and average total cost using the formula is an important part of your accounting process when pricing your products and services. This step ensures that your product prices are high enough to cover both your variable and fixed costs.
Calculating total costs is important for understanding your company’s profitability, which will help you avoid financial problems and improve your business planning. This is why we’ve put together this brief overview of the total cost and average total cost formula, examples, advantages and disadvantages of the total cost formula in economics and how to calculate the total loan cost.
What Is the Total Cost?
Total cost can be defined as the amount of money required to produce a product. The total cost includes both fixed and variable costs, such as production costs. This is the economic cost of manufacturing. Understanding the various types of costs that occur in your business and the impact they have on profitability is critical when maintaining finances, as cost is one of the most significant factors determining whether your business is successful or not.
What Is the Formula for Total Cost?
A total cost formula is an accounting tool that calculates the cost per unit of any products that a company produces over time. It’s an important tool for ensuring that product pricing properly covers the total costs of production. In economics, understanding the total cost formula is critical for making informed decisions.
The formula for determining the total cost is as follows:
Total Cost of Production = Total Fixed Cost + Total Variable Cost
It is critical to consider how the formula for total cost may need to be modified to fit your company’s needs.
What is a Business’s Average Total Cost And its Formula?
The average total cost formula calculates the per-unit cost of producing a given number of units. It includes both fixed and variable costs. A company must price their products above the average total cost to generate a profit. The average total cost formula is as follows:
(total fixed costs + total variable costs) / number of units produced = average total cost.
The Total Cost and Average Total Cost Calculation Process Using the Formula
You can use the following steps to calculate the total cost and average total cost:
#1. Determine the Fixed Costs
A fixed cost does not change in response to business activities. Regardless of its activity, a business pays it regularly. Rent, salaries, insurance bills, equipment costs, and utilities are all included. Examine your profit and loss statement to identify fixed costs.
#2. Determine the Variable Costs
Variable costs are those that rise or fall in response to production output or business activity; as production rises, so do variable costs. This includes raw material costs, direct labour costs, delivery or shipping charges, and sales commissions. You can find these again by reviewing your profit and loss statement.
#3. Determine the Total Cost of Production
The total cost of production in your company can then be calculated. Identifying your company’s total and variable costs is the first step in accomplishing this. The two are then added together. This can be represented mathematically as:
Total production costs = total fixed costs + total variable costs
#4. Determine the Number of Units Manufactured
This is the final piece of information needed for the formula. This is the total number of items produced. Make sure you’re calculating production costs based on the number of products manufactured during the same period.
#5. Determine the Average Total Cost
The average total cost for the period in question is calculated by dividing the total cost of production (calculated in step 3) by the total number of products manufactured. This can be represented mathematically as:
Total average cost = total production cost divided by the number of units produced
Examples of How to Calculate Total and Average Total Cost Using Formula
Example 1 – Calculating total cost using the formula
A small sandwich shop pays £10,000 per year in rent on their premises. They spend £15,000 on bread and £20,000 on sandwich fillings each year. Their insurance cost £3,000, and their packaging materials cost £5,000 each. Calculate:
The total of the sandwich shop’s cost is calculated using the total cost formula
Rent (£10,000) and insurance (£3,000) are fixed costs. Total fixed costs are therefore as follows: Fixed costs = £10,000 + £3,000 = £13,000
Bread (£15,000), sandwich fillings (£20,000), and packaging (£5,000) are all variable costs. So the total variable costs are as follows: Variable costs = £15,000 + £20,000 + £5,000 = £40,000
Total costs = fixed costs + variable costs = £13,000 + £40,000 = £53,000
Example 2 – calculating the average total cost using the formula
Assume you’re about to open a small coffee shop in central London and you’re trying to figure out the average total cost to figure out how much you can charge per cup of coffee to make a profit.
To begin calculating the average total cost, you must first determine your fixed and variable costs. Assume you anticipate selling 3,000 cups of coffee in your first month. After adding your fixed and variable costs together, you can calculate the total cost of producing 3,000 cups.
Calculating fixed costs
Rent and utilities, which typically total £3,000 per month, are fixed costs. A coffee machine to make your coffee costs an additional £500 per month. When you add these two costs together, your total fixed cost per month is £3,500.
Calculating variable costs
Your variable costs are the materials used to make the coffee cups you’re selling, which could include the recyclable coffee cup, the coffee grind, milk, and water. When you make a total of 3,000 cups of coffee, you determine that these variable costs are £0.80 per cup. As a result, your total variable cost for producing 3,000 cups of coffee is £2,400.
Calculating the average total cost
Your total cost to produce 3,000 cups of coffee is £5,900, based on your fixed and variable costs. You can use the following formula to calculate the average total cost:
Average total cost = total cost divided by the number of coffee cups produced
£5,900/3,000 is the average total cost.
The average total cost per cup of coffee is £1.97.
Because it may cost you £1.97 to produce one cup of coffee, you can sell one cup of coffee for more than £1.97 to make a profit. So, to compete in the market, you decide to charge £2.50 for each cup of coffee. This means you can make £0.53 profit on each cup of coffee sold.
When Should the Total Cost Calculation Formula Be Used?
The total cost calculation formula can also be used for the following purposes:
#1. To Improve Production Comprehension
Understanding the total cost of production allows a company to gain a better understanding of its profitability and efficiency. This can help a company decide whether to rethink its pricing strategy, cut costs, or take other steps to increase profitability.
#2. Including Fixed Costs
The fact that the total cost formula includes fixed costs is a huge advantage. By determining a product’s pricing, you ensure that you cover all variable manufacturing costs. This calculation may not take into account fixed costs associated with business operations, such as administrative costs, marketing costs, or insurance. These costs may have increased since you implemented the pricing strategy, and the company is now losing money despite appearing to cover its manufacturing costs.
Advantages of the Total Cost Formula
One significant advantage is that this formula can influence strategic business decisions such as pricing and marketing. Keeping track of total production costs can also be a useful benchmarking tool. You can assess your company’s performance and determine its market position among competitors.
For example, if a company discovers that it needs to lower its prices to remain competitive, it can use total cost data to determine whether it needs to reduce variable costs to do so. In economics, the total cost formula can also be used as an internal profitability tracking tool. This can provide you with a snapshot of the performance of specific product lines or ranges. You can then use this information to make business decisions.
This information can also be useful when negotiating with suppliers or seeking to outsource certain aspects of production, as making their margins clear provides a high level of transparency in dealings with external suppliers. The formula for calculating total cost is critical to business strategies in economics.
Disadvantages of Total Cost Formula
Businesses with a small product portfolio frequently use the formula because it is relatively simple. This enables you to differentiate between the suppliers needed and the manufacturing methods used for specific products. Calculating total costs for larger businesses with a more diverse and complex portfolio of products and services can be more difficult.
It becomes more difficult to allocate resources properly and effectively calculate the total cost as more costs are considered and included and as a company produces a greater number of items. Companies may also struggle to include variable costs that are subject to seasonal fluctuations or other unanticipated price changes. As a result, using the full-cost formula as a forecasting tool can be difficult.
Forecasting using total cost is heavily reliant on predictable increases and decreases in costs. When costs and utilities fluctuate in unpredictable ways, the value of forecasting is diminished. Also, there may be volume-based variations in raw material purchasing costs that they should consider, as purchasing more in total may lower the variable cost per unit.
Calculating Total Loan Costs using the Formula
To figure out how much a loan will cost you, you can use the formula by adding up the total interest charges over the life of the loan and multiplying that amount by any loan fees you paid. If you did not pay any loan fees, such as an origination fee, your total loan cost using the formula is made up of interest charges.
Of course, the principal amount you borrowed is included in your total loan costs. Fortunately, there is a quick and simple formula you can use to calculate total loan costs on a fixed-rate loan. All you have to do is multiply your monthly payment by the number of months you have to make it.
You could borrow £10,000 for 48 months with £237.16 in monthly instalments. The total amount repayable is £11,383.68. Representative 6.7% APR, 6.5% annual interest rate (fixed): £25,000.
This representative APR applies to loans ranging from £7,500 to £25,000, with terms ranging from 1 to 5 years. Other loan lengths and loan amounts are available at varying interest rates. You could be offered a maximum APR of 29.9%. The representative APR is the rate that at least 51% of people are projected to receive when taking out a loan for the amount and duration range specified.
Total Fixed Cost vs. Total Variable Cost
Variable costs are costs that vary depending on a variety of factors. This could be how many items you sell or how much of a service you use. It is analogous to a household gas bill fluctuating depending on how much heating is used.
Fixed costs, on the other hand, are costs that do not vary from month to month, for example, based on factors such as the number of products sold. Fixed costs, on the other hand, are consistent. This could include, for example, the rent for your company’s property or the salaries of your employees.
What Is an Illustration of a Total Cost Function?
Total costs = fixed costs + (number of units of A * variable cost per unit of A) + (number of units of B * variable cost per unit of B)
What Is the Total Variable Cost Formula With an Example?
Calculate the total variable cost by multiplying the cost to produce one unit of your product by the quantity of products you have developed. For example, if one unit of your product costs £60 and you make 20 units, your total variable cost is £60 x 20, or £1,200.
How Should the Total Cost Function Be Interpreted?
Consider the total cost function, TC: For a given value of Q, say Q = 10, we can interpret this function as saying that when we produce 10 units of this good, the total cost is 190.
Is It Possible to Apply the Total Cost Formula to Service Industries?
Yes, the total cost formula applies to the service industry. Rent and salaries are examples of fixed costs, while supplies and hourly labour wages are examples of variable costs. It’s important to note, however, that the formula may need to be tweaked depending on the specifics of the service.
What if I’m having Trouble Identifying my Variable Costs?
It is not uncommon for variable costs to be difficult to identify, especially in complex businesses. If you are unsure, utilise an accounting programme that can assist you in classifying and monitoring these expenses, or speak with a financial advisor.
Conclusion
Lastly, it is essential to comprehend the total cost formula in economics when analysing the financial effects of a loan. Understanding a company’s financial performance is essential to determining how well it is doing. In economics, the total cost of production can be calculated using a formula.
Understanding and applying the total cost formula effectively is critical for business strategy, budgeting, pricing concepts, and profitability evaluation. Applying this formula, whether you are a business owner, a financial analyst, or a student of economics, will greatly enhance the capacity you have to make profitable choices while achieving your goals.
Related Articles
- Net Revenue: Definition Formula and All You Need To Know
- What Is Profit? Levels, Formular and All You Need To Know
- Cost of Sales: Definition, Formula, and Examples
- What Is Net Income? Meaning, Formula & How to Calculate
- EBITDA Margin: What It Is, Formula & All You Need
References
