Average and Marginal Cost

16/04/2020 0 By indiafreenotes

Marginal cost

The marginal cost is the increase in total cost as a consequence of an increase in a production unit, or in mathematical terms, it is the first differential quotient of the total cost function. This can be expressed as a partial derivative of change of total costs and variation in one unit of production.

It is useful using marginal cost to check the convenience of velocity of production of a firm into multiple levels of production:

The law of increasing returns implies that production is increasing more with impact of one additional unit of production, therefore the marginal cost gradient, as the second derivate of marginal cost is below 0 and firm is reducing marginal costs as result of production.

The second scenario is law of constant returns, where the total cost curve is regular and smooth and change in productions maintain the same marginal cost and marginal cost gradient is equal to 0.

The law of diminishing returns applies where total cost curve is convex and marginal cost increases monotonically, being marginal cost gradient positive when production increase.

Firm´s decision to maximize profit depend greatly if marginal cost are lower than price of product, expanding production until marginal cost is equal to price.

Average cost

Average costs represent the quotient of the ordinate and abscissa of a point on the total cost curve. Also it is named as cost of velocity of production, where it measures the cost per unit, taking in consideration fixed cost and variable costs, divided on total production.

The average cost can be explained in two components:

  • Variable cost: where it is included only costs related to velocity of production.
  • Fixed cost: related with investment required to produce the firm but it does not depend on velocity of production.

The average cost start declining as result of average fixed cost falls with velocity of production. However, it will rise, as impact of fixed factors constrains production, limiting the benefits of increase production and impact in total cost per unit. To move from a lower average cost, firm requires increase the fixed factors of production to move to a new lower point, developing scale economics. As result of behavior of fixed and variable cost, average cost shape is U form.

The usage of average cost is useful to know about total costs incurred by firm based on units of productions. Every velocity of production has a cost covering price and depending the amount of production with lowest cost covering prices is where enterprise can sell without generating losses. However, if firm is looking return investment, the respective price must be equal to average cost to recover fixed cost and variable costs.

Average Cost vs. Marginal Cost Comparison Table

Average Cost

Marginal Cost

Definition
It is per unit cost of goods or services manufactured.   It is the extra cost incurred for the manufactured of one extra unit of goods or services.
Purpose/Intention

The average cost is calculated to evaluate the effect on total unit cost due to the change in the output unit.

Marginal cost is calculated to check if it is beneficial to manufacture an extra unit of goods/services or not.

Component
The average cost is separated between Fixed cost and Variable cost.

Marginal cost considered all costs it cannot separate between Variable cost and Fixed cost. Fixed cost remains constant up to a certain level of production.

Formula
AC = TC (FC+VC) Divided by the Total number of units manufactured.        MC = Change TC Divided by change in the Total number of units manufactured.
Business decision               With the help of Average cost, an organization can take the decision to reduce cost at a production level With the help of Marginal cost, an organization can take a decision to increase profit at the production level.
Profitability If an organization is looking for a return on investment, in that case, the price of the product must be equal to the average cost to recover the fixed cost and variable cost.

If an organization is looking for increasing Profits in that case marginal cost must be lower than the price of the product and the organization may expand production until marginal cost equal to the price of the product.

 Average Cost vs. Marginal Cost

  1. Average cost is nothing but the Total cost divided by the number of units manufactured which shows the result as per unit cost of the product, whereas Marginal cost is extra cost generated while producing one or some extra unit of products and it is calculated by dividing the change in total cost with Chang in total manufactured unit.
  2. Marginal cost considered all cost which fluctuates during the level of production and fixed cost remain constant up to a certain level of production, whereas Average cost considered Fixed cost and Variable cost. In Average cost, both Fixed and Variable cost is product cost whereas in margin cost Fixed cost is considered as period costs and Variable cost is product cost.
  3. Average cost calculates the effect on total unit due to change in output level whereas marginal cost is calculated to find out if producing one extra unit of product is profitable or not.
  4. Average cost method also called a weighted average method and Marginal cost method is also called as variable costing.
  5. Both average cost vs marginal cost is measured under the same units and obtain the result from Total cost.
  6. If an objective is to increase profit during production level than the marginal cost technique is useful and when an objective is to reduce cost during production level, in that case, the Average cost technique is used.

Marginal cost vs. Average cost both are costing technique used to calculate the cost of the product which incurred while manufacturing. It helps an organization to set the final price of the product and cover all its expenses through it. Marginal cost method helps an organization to increase profitability at the production level and the Average cost method helps an organization to reduce cost at the production level. Average cost helps to understand how much expenses incurred while producing a single of product and Marginal cost helps to understand how much extra cost will incur while producing one extra unit of product.

Marginal cost does not depend on fixed cost because it does not change with output, or it remains constant up to a certain level of production whereas variable cost change with the output, so in short marginal cost is due to change in variable cost. The average cost considers both fixed cost and variable cost of the product which is called Total cost. The average cost and Marginal cost effect each other as the production varies. When average cost decreases in that case marginal cost is less than the average cost and vice versa and when the average cost is the same or constant in that case both are equals to each other. Marginal cost plays an important role in economics as it shows the costs at a very definite point in time. Even though the average and marginal cost is an important concept for an organization but some time pricing of products with this method leads to a significantly different result.