Fixed costs are those associated with the invariable production of a given product, regardless of the number of units developed. For example, if a company produces curtains, the list of fixed costs will include items such as property rent, sewing machines, warehouses, lighting objects, and chairs for sewing. Average fixed cost (CFM) represents the total cost divided by the quantity of products made. There are two methods of calculating CFM, depending on the type of information you have been working with. Follow the instructions below to learn how to calculate and use the average fixed cost.
Method 1 of 3: Using the Division Method
Step 1. Select a period to take the measurement
You must choose a specific period to perform the calculations. Thus, it is possible to align costs to production and, finally, to calculate the fixed cost. It is generally easier to use a month or a certain number of months as it is easy to determine fixed costs over that period of time. You can also take another approach, using the amount of time it takes to produce a certain number of units.
For example, you might recognize that you produce 10,000 units every two months and use that period to calculate fixed costs
Step 2. Add up the total fixed costs
Fixed costs are those that do not change according to the quantity of products made. These include costs such as renting the property used in the production or sale of the good, the purchase or maintenance of manufacturing equipment, real estate taxes and insurance. It is also possible to include the payroll cost of employees who are not directly involved in the manufacturing process. To determine the total fixed costs, add these amounts together.
- Starting from the previous example, with 10,000 units being manufactured in two months, suppose you spend BRL 4,000 per month on rent for manufacturing space, BRL 800 per month on real estate taxes, BRL 200 on insurance, BRL 5,000 on administrative expenses and R$1,000 in machine depreciation. This would total $11,000 per month in fixed costs. Since the measurement is based on the two-month period, double this amount to get an amount of $22,000 in total fixed costs.
- For more information, see the article Calculate-Fixed-Costs
- Keep in mind that the calculation does not include any variable costs, or those based on the quantity of products made. Variable costs can be materials used to maintain production and pay bills, labor costs of salaried employees and packaging expenses.
Step 3. Determine the quantity of units produced
For this, it is enough to use the values related to goods produced within the evaluated period. It is important that the production period is equivalent to that from which the fixed cost information was collected.
In our example, we will use the value of 10,000 units produced in the two months being evaluated
Step 4. Divide the total fixed costs by the number of units produced
Doing so will result in the average fixed cost. To complete the example, we will divide the $22,000 of total fixed costs over the two-month period by the 10,000 units produced in that time. Finally, we will obtain an average fixed cost of R$ 2.20 per unit.
Method 2 of 3: Using the Subtraction Method
Step 1. Calculate the total cost
The value represents the total amount of money needed to make a product, equaling the total fixed cost plus the total variable cost. Each element of production must be factored into the total cost, including salaries, commissions, bills, advertising, administrative costs, office supplies, transport and handling, raw materials, interest, and any other cost specifically pertaining to the product. It is the sum of total fixed costs and total variable costs.
Step 2. Find out what the average total cost (CTM) is
This value represents the total cost divided by the number of units produced.
Starting from our previous example, in Method 1, if the total cost equals $35,000 in two months, with 10,000 units produced, the CTM will equal $3.50 per unit
Step 3. Determine the total variable costs
The value changes according to the quantity of products made, increasing as production goes up and decreasing as production goes down. For example, the most prevalent variable costs are manufacturing wages and raw materials. They also include bills that vary by production, such as electricity and gas or fuel used in manufacturing, for example.
- Continuing from the same example, imagine that the total variable cost is made up of BRL 2,000 in materials, BRL 3,000 in accounts (BRL 1,500 per month for two months) and BRL 10,000 (BRL 5,000 per month for two months) in salaries for employees. Add these amounts together to get the total variable cost of $15,000 for the two-month period.
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Step 4. Calculate the average variable cost (CVM) by dividing the total variable costs by the number of units produced
Thus, for the total variable cost of R$15,000 related to the production of 10,000 units, the CVM would be equivalent to R$1.50 per unit.
Step 5. Calculate the average fixed cost
Subtract the average variable cost from the average total cost and you get the average fixed cost. In the example, the average variable cost of BRL 1.50 per unit must be subtracted from the average total cost of BRL 3.50 per unit to obtain the average fixed cost of BRL 2.00 per unit. Note that this value corresponds to the average fixed cost calculated in Method 1.
Method 3 of 3: Analyzing Production with Average Fixed Cost
Step 1. Use CFM to check a product's profit margin
Calculating a realistic CFM can be helpful in understanding your product's profit potential. Before starting a new project, try to do a break-even analysis to better understand how your potential profit is influenced by CFM and CVM. Generally, the most important thing is to always keep the price above the CVM (average variable cost). The surplus is then used to cover fixed costs.
CFM goes down as production goes up, so it's easy to fool yourself into thinking that producing as much as possible (while maintaining a fixed total cost) is a surefire way to make more money
Step 2. Analyze CFM spending
You can also use average fixed costs to determine where to eliminate expenses. This cut may be necessary due to market conditions or it may simply be used to increase the profit margin. If fixed costs make up a large part of the total cost, higher than variable costs, it might be a good idea to consider places where savings could be made. For example, you can reduce electricity costs by using more efficient lighting equipment or manufacturing equipment. Using CFM would allow you to see how this change would affect profit per product.
Lowering fixed costs gives you greater "operational leverage" (more benefits from the increased amount of production). This also lowers the amount of sales needed to break even
Step 3. Use CFM to examine economies of scale
Economies of scale enjoy the benefit that comes from producing large amounts. Essentially, by producing more, it is possible to lower the fixed cost per product and increase the profit margin. By calculating CFM at various production levels, you can calculate to what extent you will be more profitable if you increase production. Then, it will be possible to make comparisons with the price that would be charged when reaching this productive level (perhaps after increasing the manufacturing space or the number of machines) to determine if the expansion would be profitable.