Average total cost (i.e. ATC) is defined as the sum of all production costs divided by the quantity of output produced. That is, it measures how much a firm has to spend on each unit of output it produces. This concept is extremely important to understand how firms set prices and how they compete with each other. Thus, if you are studying economics, chances are you’ll have to calculate ATC sooner than later. Fortunately, that’s a pretty straightforward process. We can calculate the average total cost by following three simple steps: (1) find total quantity, (2) calculate total cost, and (3) divide total cost by total quantity.
1) Find Total Quantity
First of all, we need to find the quantity of output (Q). Q represents how much of a good or service a company is producing and attempting to sell on the market. In many cases, the correct value for Q will be provided as part of the problem you are trying to solve. If not, then you may have to obtain Q by carrying out profit maximization first. For now, we’ll assume that Q is provided.
To give an example, let’s say you own an Italian restaurant, called Best Pizza. Next month, you plan to sell exactly 1,000 pizzas. Thus, the quantity of output Q is equal to 1,000. No complicated calculations needed here.
Note that while total quantity usually has the abbreviation of a capital Q, it sometimes appears as a lowercase q. This might happen in problems or models where the goal is to emphasize the fact that the company is small.
2) Calculate Total Cost
The next step is to find the total cost of production. Total cost (TC) is made up of two parts: fixed cost and variable cost. Fixed cost (FC) is fixed and constant just as the name suggests. It remains the same no matter what quantity of output is being produced. Meanwhile, variable costs (VC) increase as quantity rises. That means, higher output results in higher variable costs. To compute total cost, we simply need to add up fixed costs and variable costs, i.e. TC = FC + VC.
With that being said, let’s revisit our Best Pizza case. To run this restaurant you have to pay rent. This is an example of a fixed cost (at least in the short run). Assume your monthly rent is USD 2,500. You’ll have to pay that amount regardless of the number of pizzas you sell. Meanwhile, you also have to buy ingredients to make pizza (flour, water, cheese, etc.). These are variable costs. For the sake of this example, we’ll assume that the ingredients needed for one pizza cost exactly USD 2.00 and there are no other fixed costs than the rent you pay. Thus, if you plan to sell 1,000 pizzas, your variable costs will add up to USD 2,000 and total cost is USD 4,500 (i.e. 2,500 + 2,000).
3) Divide Total Cost by Total Quantity
Finally, we can calculate the average total cost by dividing total costs by total quantity (i.e. ATC = TC/Q). This step is necessary because we are looking for the average total cost, i.e. the cost per unit. As mentioned above, this value is critical for companies when it comes to pricing decisions. If they sell their products at a price below ATC they will incur a financial loss.
To illustrate this, let’s calculate ATC for Best Pizza. By now we know that Q = 1,000 and TC = USD 4,500. If we plug these numbers into the formula above we find that ATC = USD 4.50 (i.e. 4,500/1,000). That means, for your target level of output the average cost of one pizza will be USD 4.50. So to make a profit, you will need to sell your pizzas at a price higher than USD 4.50. If you sell it for less than that, you will essentially lose money.
Please note that ATC may vary as the level of output changes. This has to do with increasing or decreasing marginal costs. This is explained in more detail in our post on how to calculate marginal cost.
In a Nutshell
Average total cost (i.e. ATC) is defined as the sum of all production costs divided by the quantity of output produced. It describes the cost per unit of output. To calculate ATC, we can follow a three-step process: (1) Start by finding the quantity Q, which is the number of units the company is producing. (2) Calculate total cost by adding fixed cost and variable cost together. (3) Divide total cost by total quantity to obtain ATC.