Question

Why does average variable cost increase as volume goes up?

Answer 1

Fixed cost is the cost which does not change with the level of production. e.g Factory Rent, salary of permanent staff etc. Variable cost varies directly with the level of production. Variable cost, however, remains unchanged per unit of output. For example - Direct material cost, say, is $ 10 per unit. So for 100 units, it will be $ 1000; for 250 units, it will be $ 2500 and so on… but the per unit variable cost will remain constant.

One use of Variable cost and Fixed cost is to determine how many units you need to produce as a minimum so that the business breaks even ; i.e. it does not gets into loss but does not make any profits either.

The Break-even point = Fixed Cost / (Selling Price per unit - Variable Cost per unit)

So if there is a change in these costs, then the BEP will also change and you need to see how you can produce more than BEP to actually earn profits.

Another essential applicability comes in management decision making , where variable costs and avoidable fixed costs are considered relevant in making decisions such as whether to produce in-house or outsource the manufacturing activity, whether to shutdown the plant or continue if a labour strike happens, whether to expand the production activity to meet up new demand for the product or not and so on…