The total cost formula is used to derive the combined variable and fixed costs of a batch of goods or services. The formula is the average fixed cost per unit plus the average variable cost per unit, multiplied by the number of units. The calculation is:
(Average fixed cost + Average variable cost) x Number of units = Total cost
For example, a company is incurring $10,000 of fixed costs to produce 1,000 units (for an average fixed cost per unit of $10), and its variable cost per unit is $3. At the 1,000-unit production level, the total cost of the production is:
($10 Average fixed cost + $3 Average variable cost) x 1,000 units = $13,000 Total cost
There are several problems with the total cost formula, which are as follows:
- Limited range for average fixed cost. The definition of a fixed cost is a cost that does not vary with volume, so the average fixed cost part of the formula only applies within a very narrow volume range. Actually, the same fixed cost will apply across a broad range of unit volumes, so the average fixed cost figure could vary wildly.
- Variable purchasing costs are volume-based. When buying raw materials and sub assemblies for the production process, the per-unit cost will vary based on volume discounts. Thus, the more units ordered, the lower the variable cost per unit will be.
- Direct labor is actually fixed. There are few cases in which direct labor actually varies directly with production volume. Instead, a fixed number of people are needed to staff a production line, and that group can handle a fairly wide range of unit volumes. Thus, direct labor should usually be considered a fixed cost.
To correct for these issues, it is necessary to recalculate the total cost whenever the unit volume changes by a material amount.