When doing the production, firms are concerned about their costs. All payments made by a firm in the production of a good or service are called the cost of production. Cost of production is important for a firm because that determines how much profit the firm can make.
Fixed costs are called so because they remain fixed irrespective of the scale of production. Even with a low quantity of production, these fixed costs will still be the same. For example, rent of a retail shop will be the same even if the sales are high or low. Another example of a fixed cost is the salary of the sales person.
Variable cost varies with the scale of production. In a retail shop, the higher the sales the higher the cost of goods sold. More goods are needed to sell more goods. Therefore the stock of goods for sale is a variable cost. In a fish canning factory, the fish, and the cans are variable costs.
Total cost is all the payments made by the firm in the production process. Total cost includes both the fixed cost and the variable cost. Therefore we can come up with the formula:
Total cost = Fixed cost + Variable cost
Firms often need to measure how efficient it is in terms of the use of resources. Therefore it needs to calculate the average cost. Average cost is equal to the total cost divided by the number of goods produced. Calculation of average cost is important because it tells us how much resources are used to produce a single unit of goods. Therefore we can use the formula:
Average Cost = Total Cost / Total Output
If a farm has the following cost figures:
Fixed Cost = $200.
Variable Cost = $300
Output = 250 units,
Total Cost = $200 + $300 = $500.
Average Cost = Total Cost / Output = $500/250 = $2 per unit.