How does fixed cost affect marginal cost?

How does fixed cost affect marginal cost? Why is this relationship important?

The Answer

A fixed cost is a cost that does not change with an increase or decrease while the amounts of goods or services produced or sold, and companies have the obligation to pay those fixed bills. In general, companies have to pay for two types of costs, fixed costs or variable costs. 

Marginal cost, on the other hand, is the change in total production cost that comes from making or producing one additional unit. Marginal cost of production includes all of the costs that vary with that level of production. For instance, if Apple needs to build a new factory in order to produce more iPad, the cost of building the factory is a marginal cost. The amount of marginal cost varies according to how many iPhone are being produced.

The marginal cost measures the change in the total cost with respect to the change in output, so a change in fixed costs does not affect the marginal cost. Suppose the fixed cost is $1,000, the variable cost is $200, and the quantity is 100 units. Then, the variable cost increase to $300, and the quantity is 200 units. The calculation for the marginal cost is:

Marginal cost = Total cost change / Quantity increased = ( $300 - $200 ) / (200 - 100 ) = $1 per unit.

As the calculation shows, the fixed cost does not affect the result since it remains unchanged. Moreover, if there are only fixed costs associated with producing goods, the marginal cost of production is zero. Because there is no change at all. However, the marginal cost of production is affected by variable costs associated with production. Just like the example shows, when the variable cost increase to $300, and the quantity is 200 units, the marginal cost starts increasing.

In the long term, while the fixed cost becomes less and less important, the marginal cost is the key to long term profitability. Focus on the marginal and slight changes that actually affect the operating, is more efficient while in the long term that fixed cost is relatively less important. We can focus on every marginal change in global warming not always compare the events to the beginning of the earth. 

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.