A common name for fixed cost is “overhead.”

Critical Thinking Questions

A common name for fixed cost is “overhead.” If you divide fixed cost by the quantity of output produced, you get average fixed cost. Supposed fixed cost is $1,000. What does the average fixed cost curve look like? Use your response to explain what “spreading the overhead” means.

The Answer

As we know, fixed costs are expenditures that do not change regardless of the level of production, which means whether you produce a lot or a little, the fixed costs are the same. Average fixed cost curves are typically U-shaped. Supposed fixed cost is $1,000, the average fixed cost curve will look like a downward slope curve in the first period. Because in the beginning, each unit of production tends to share and lower the total cost, or we can say that as output grows, fixed costs become relatively less important. After it meets at the lowest average cost point, the curve may start to upward since each extra production tends to pull up the total cost. Because diminishing marginal returns implies that additional units are more costly to produce. 

Suppose Bruce starts his own coffee business with a $1,000 fixed cost at first, for purchasing an espresso machine, decorating the shop, pay the rents, and POS system. If his average cost per cup of coffee, for the first 10 cups he sold, is $102 

( ($1,000 +$2 x 10) / 10 ) = $102 

*Notice that the $2 per cup is a variable that appears from per cups of coffee sold.

If he produce and sold 20 cups of coffee, the average cost per transaction are more like $52

( $1,000 + $2 x 20 ) / 20 = $52 

If he produce and sold 30 cups, the average cost is approximately $35

( $1,000 + $2 x 30 ) / 30 = approximately $35

As we can see in the beginning, his average cost per cup of coffee is pretty high. But as more and more cups of coffee be produced and sold, the fixed cost becomes less and less important and relatively small, as the variable cost grows. The growing number of denominator also tends to pull down the result. From 10, 20, to 30 as the total cost increased from 1,020 to 1,060. 

If we separate the $1,000 from the calculation, the results will be like this. For the first 10 cups, is $100 ( $1,000 / 10 )  

*Notice that the prior $2 per cup is a variable that appears from per cups of coffee sold, and now we removed it. 

For 20 cups are sold, the average fixed cost is $50 ( $1,000 / 20 )

If he produces and sold 30 cups, the average fixed cost is approximately $33 ( $1,000 / 30 ) 

As we can see in the calculations, his average fixed cost per cup of coffee is lower and lower as he produces and sold more and more cups of coffee. As the fixed cost does not change, they spread overhead to 10, 20, or 30 units.