Difference Between Average Cost and Marginal Cost

Key Difference – Average Cost vs Marginal Cost
 

The key difference between average cost and marginal cost is that average cost is the total cost divided by the number of goods produced whereas marginal cost is the rise in cost as a result of a marginal (small) change in the production of goods or an additional unit of output. Both average cost and marginal cost are two key concepts in management accounting that are widely considered in decision making by considering the revenues earned and resulting costs of a given scenario. A positive relationship exists between these two types of costs since marginal cost remains less than the average cost when the average cost decreases and the marginal cost is greater than the average cost when the average cost increases. When the average cost is constant, marginal cost equals the average cost.

CONTENTS
1. Overview and Key Difference
2. What is Average Cost
3. What is Marginal Cost
4. Side by Side Comparison – Average Cost vs Marginal Cost
5. Summary

What is Average Cost?

Average cost is the total cost divided by the number of goods produced. It consists of the sum of average variable costs and average fixed costs. Average cost is also termed as ‘unit cost’. Average cost can be calculated using the below formula.

Average cost = Total cost/Number of units produced

Average cost is directly affected by the level of output; when the number of units produced increases, the average cost per unit reduces as the total cost will be divided among a higher number of units (assuming the variable cost per unit remains constant). Total fixed cost remains constant irrespective of the rise in the number of units produced; thus, the total variable cost is the main contributor towards the total average cost.

E.g., ABC Company is an ice cream manufacturing company who manufactured 85,000 ice creams during the previous financial year incurring the following costs.

Total variable cost (cost per unit is $15* 85,000)       = $1,275,000

Total fixed cost                                                           = $ 925,000

Total cost                                                                    = $2,200,000

The above resulted in an average cost per unit of $ 25.88 ($2,200,000/85,000)

For the upcoming financial year, the company expects to increase the number of units to 100,000. Assuming the per unit variable cost remains constant, the cost structure will be as follows.

Total variable cost (cost per unit is $15* 100,000)       = $1,500, 000

Total fixed cost                                                             = $ 925,000

Total cost                                                                      = $2,425,000

The resulting average cost per unit based on the above is $ 24.25 ($2,425,000/100,000).

Figure 01: Average total cost graph

What is Marginal Cost?

Marginal cost is the rise in cost as a result of a marginal (small) change in the production of goods or an additional unit of output. The concept of marginal cost is an important decision-making tool businesses can use to decide how to allocate scarce resources in order to minimize costs and maximize earnings. Marginal cost is calculated as,

Marginal cost = Change in total cost/Change in output

In order to make effective decisions, marginal cost has to be  compared with the marginal revenue (increase in revenue from additional units)

E.g., BNH is an electronic device manufacturer who produces 500 units at a cost of $135,000. Cost per pair of shoes is $270. Sales price of a pair of shoes is $ 510; thus, the total revenue is $255,000. If GNL produces an additional pair of shoes, the revenue will be $255,510 and the total cost will be $ 135,290.

Marginal revenue                                         = $255,510 – $255,000 = $510

Marginal cost                                               = $135,290 – $135,000 = $290

The above results in a change in net benefit of $220 ($510-$290)

Marginal cost helps businesses decide whether it is beneficial or not to produce additional units. Increasing the output alone is not advantageous if the selling prices cannot be maintained. Therefore, marginal cost supports the business to identify the optimal level of production.

Figure 02: Marginal cost graph

What is the difference between Average Cost and Marginal Cost?

Summary – Average Cost vs Marginal Cost

The difference between average cost and marginal cost is that average cost is used to calculate the impact on total unit cost due to changes in the output level while marginal cost is the rise in cost as a result of a marginal change in the production of goods or an additional unit of output. These two concepts are used for better decision-making by efficiently allocating scarce resources and to identify and practice optimum production levels.

Reference:
1. Boundless. “Average and Marginal Cost – Boundless Open Textbook.” Boundless. Boundless, 08 Aug. 2016. Web. 09 May 2017. <https://www.boundless.com/economics/textbooks/boundless-economics-textbook/production-9/production-cost-64/average-and-marginal-cost-241-12339/>.
2. “Marginal Cost Of Production.” Investopedia. N.p., 03 Apr. 2015. Web. 09 May 2017. <http://www.investopedia.com/terms/m/marginalcostofproduction.asp>.
3.”Marginal Cost: Definition, Equation & Formula”. Study.com. Study.com, n.d. Web. 09 May 2017. <http://study.com/academy/lesson/marginal-cost-definition-equation-formula.html>.

Image Courtesy:
1. “Costcurve – Av Total Cost” By Costcurve_-_Av_Total_Cost.PNG: User:Trampledderivative work: Jarry1250 (talk) – Costcurve_-_Av_Total_Cost.PNG (CC BY-SA 3.0) via Commons Wikimedia
2. “Marginalcost” By Dupz (talk) – en.wikipedia (Public Domain) via Commons Wikimedia

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