Average Variable Cost (AVC): Definition, Function & Equation
Firms rely on several cost functions to make important production decisions. This lesson will explain the average variable cost function and what it is used for in business decisions.
Average Variable Cost Definition
The average variable cost (AVC) is the total variable cost per unit of output. This is found by dividing total variable cost (TVC) by total output (Q). Total variable cost (TVC) is all the costs that vary with output, such as materials and labor. The easiest way to determine if a cost is variable is if the output changes, the cost changes as well.
Profit-maximizing firms will use the AVC to determine at what point they should shut down production in the short run. If the price they are receiving for the good is more than the AVC given the output they are producing, then they are at least covering all variable costs and some fixed costs. Fixed costs are those costs incurred that do not vary with production; they are fixed at a certain price no matter how much is produced. The best example is rent on the space used to produce the good or provide the service. It doesn’t matter how many units you produce or customers you serve, the rent will always remain the same. Therefore even if you are producing zero, as would be the case if you shut down production, you will still have to pay the fixed costs.
As long as price is above the AVC and covering some of the fixed costs, you are better off continuing production. If the price falls below the AVC, then the firm may decide to shut down production in the short run because the price is no longer covering any portion of the fixed costs or all of the variable costs. Therefore the firm would rather not incur any variable costs and just pay the fixed costs.
AVC Function and Equation
This chart below shows the average variable cost function. It’s a U-shaped curve. Initially, the variable cost per unit of output decreases as output increases. At one point, it reaches a low. After the low, the variable cost per unit of output starts to increase. The increase in AVC after a certain point is indirectly related to the law of diminishing marginal returns. The law states that at some point, the additional cost incurred to produce one more unit is greater than the additional revenue (or returns) received. At that point, the AVC starts to increase.
Average Variable Cost Function
The average variable cost (AVC) can be determined with the following equation:
AVC = TVC / Q
Where AVC is the average variable cost
TVC is the total variable cost
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