Average cost

Divide total cost by the number of units and you get average cost, a simple figure that hides as much as it reveals.

Average cost is the total cost of production divided by the number of units produced, the cost per unit. It is one of the most quoted figures in business and one of the most misused, because it blends together costs that behave very differently and tempts decisions that should be made at the margin.

How it moves with output

Average cost typically falls and then rises as output increases, tracing the U-shaped cost curve. At low output, hefty fixed costs are spread over few units, so average cost is high; as output grows, those fixed costs are shared more widely and the average falls. Beyond an efficient scale, diseconomies set in and average cost climbs again. The lowest point of the curve is the most efficient scale of production.

The trap of pricing on average

The great danger of average cost is using it to make decisions that belong to marginal cost. Whether to accept one more order, produce one more unit, or take a special low-priced deal depends on the cost of that extra unit, the marginal cost, not on the average. A firm that refuses any sale below average cost can turn down business that would in fact add to profit, because the extra unit's true cost is far below the average dragged up by fixed costs.

A useful summary, a poor guide to action

Average cost is genuinely useful as a summary: it tells you whether, over a given output, revenue per unit covers cost per unit, and it underlies long-run questions of viability and scale. Its weakness is as a guide to marginal decisions, where it systematically misleads by attributing a share of unavoidable fixed cost to each new unit.

Average cost is the figure most people reach for and the one most likely to lead a marginal decision astray. Knowing when to use it, for judging overall viability, and when to ignore it, for deciding whether to do a little more, is a basic test of cost literacy.