When pricing your products and services, determining the average total cost is an essential part of your accounting process. This step ensures you are pricing your products high enough to recover both your variable and fixed costs. The total cost formula helps businesses determine the total amount of expenses it takes to run the business.
The total cost formula is an accounting equation that shows the cost per unit of the quantity that has been produced. It is calculated using two figures: the first figure represents the total production cost, whereas the second figure represents the quantity produced. The total cost of production is divided by the total amount paid in numbers, forming the average total cost formula. A straightforward and easy-to-use procedure, the total cost formula is calculated by dividing the total production cost by the number of products manufactured. Here is everything you need to know about the total cost formula, how it works, the advantages of using it for your business, and the setbacks that may come with it.
In this guide, we’ll help you understand:
What is the Total Cost Formula?
For the ultimate production planning and budgeting purposes, understanding the total cost structure of your business is quite important. Coming up with the total cost formula is quite simple, as long as you can identify your variable and fixed costs accurately and can thoroughly name the number of goods you have produced.
So What is the formula for total cost? The total cost formula helps derive the combined fixed and variable costs a batch of products creates. This formula can be summarized as follows: Average fixed price per unit plus the average variable price per unit, multiplied by the number of units. In other words, the total cost formula looks like this:
Total Cost = (Fixed Cost + Variable Cost) / Number of Units Produced
How Does the Total Cost Formula Work?
The total cost formula allocates all the costs your business has endured throughout a specific period for the goods or services you have put on sale. The formula allows you to determine your profitability rate by calculating your business’s entire expenses and dividing them by the organization’s unit output. The total cost formula also lets you know whether you need an adjustment in your pricing policy, reduced costs, or diversification to increase your profits.
Once you are familiar with the total cost to produce an item within your inventory, it becomes easier to plan your pricing strategies in light of this information. The unit price may sometimes recover for the variable costs of manufacturing the items. However, suppose the profit margins do not compensate for the fixed cost of marketing and other administrative expenses. In that case, it is safe to say that the business will not be viable for long. The total cost rises as fixed and variable costs increase, leading the company to decide whether to pass this extra cost to the customer or start trimming the sails.
Most businesses benefit from the total cost formula to calculate their overall efficiency and detect areas that could potentially bring savings on both fixed and variable costs. After measuring the company’s efficiency and profitability with the help of the total cost formula, businesses lean towards lowering variable costs by either moving into a factory with cheaper rent or buying materials from a cheaper vendor.
Getting a full grasp of how the total cost is calculated is an essential part of the profitability process. It can also use the total cost formula to set prices and fulfill various marketing strategies. Businesses can develop their sales and marketing targets by comprehending how many items need to be sold to profit. This formula is a useful tool in identifying performing aspects of the business, as well.
Example of a Total Cost Formula Explained: A Step-by-Step Calculation
You can follow these five easy steps to answer the question of “What is the total cost formula?” and calculate your initial average total cost.1. Identify your fixed costs.
Use your profit and loss account for this and identify your total fixed costs. Rent expenses, salaries, insurance bills, equipment costs, and other business-related utilities are considered fixed costs.2. Determine your variable costs.
Like you did with the fixed costs, use your profit and loss account, to sum up, your variable expenses. These costs could include direct labor, delivery and shipping cost, raw material costs, and sales commissions.3.Calculate your total cost of production.
It calculates the total cost of production by adding up the total fixed and variable costs. This part is represented in the total cost formula as follows: (Total fixed cost + Total variable cost)4.Identify the number of units produced.
It is the number representing the units manufactured throughout the specific period.5.Calculate your average total cost.
By dividing the total cost of production (step 3) by the number of units you have manufactured (step 4), you will be able to achieve the average total cost.
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Advantages of the Total Cost Formula
Using the total cost formula bears many advantages for businesses of any size. The most important benefit that the total cost formula provides is that it allows for a simple and clear understanding of the profitability of a business. It can be easily recognized, and the calculations necessary in determining the profitability margins can be quickly measured and tracked.
It can also compare the total cost formula over time to define whether the business needs a review of its pricing or sales strategies. It is important to keep track of the total cost in every single product line a company owns. The total cost formula evolves into a handy benchmarking tool and helps evaluate the performance of the business, therefore designate its position in the market. This formula comes in handy when conducting competitor analyses by determining its place in the market compared to its rivals and whether or not it needs to lower or increase its prices accordingly.
When used as an internal tool, the total cost formula acts as a profitability tracking method, giving a quick overview of a specific product line’s performance. It especially becomes useful when outsourcing certain elements of the manufacturing process or negotiating with suppliers. By making the margins clear, the total cost formula provides transparency to external vendors and similar third parties.
Disadvantages of the Total Cost Formula
The total cost calculation is a relatively simple formula to understand, especially for businesses with limited products and can clearly distinguish between their suppliers and manufacturing methods. However, an estimated total cost can turn into a rather cumbersome process for companies with various product lines. As the costs that need to be included in the formularise, the more complex it becomes to allocate these costs efficiently to come up with a total.
Businesses with constantly changing supplies find it harder to develop their fixed prices derived from a formula requiring the variable fees to be calculated first. The variable cost element of this equation then needs to be regularly adjusted to keep up with seasonal and unexpected price changes.
Since utilities and material costs can vary in unforeseeable ways, using the total cost formula as a forecasting tool may not always serve the most accurate predictions. Using the total cost formula as a predictor relies mostly on reasonably foreseeable increases and decreases in the costs of each element within the process. The same goes for pricing strategies as well, where the total cost-based pricing planning depends on being able to adapt to price changes constantly, which is not always possible.
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Things to Consider When Using the Total Cost Formula
It is important to be aware of the numerous issues that may arise with the use of the total cost formula, such as:
- Variable purchasing costs are volume-based. When purchasing raw material for the manufacturing process, the price per unit will change following the volume discounts. Therefore, the more units you order, the lower your variable per-unit cost will be.
- The total cost formula offers a limited range for average fixed costs. Fixed costs entail expenses that only apply within a narrow volume range. Since the same fixed charges apply across a wide range of unit volumes, the average static cost figure will not be as “fixed” as you would presume.
- Direct labor is considered a fixed cost. Since usually a fixed number of people are needed to work on a production line, the direct labor costs are considered a fixed cost. It should integrate them into the total cost formula accordingly. There are only a few cases in which direct labor varies directly by the production volume.
Written by Erhan Musaoglu
Erhan Musaoglu is the CEO and Co-Founder of Logiwa.