Question

Average fixed costs and average variable costs differ as a business expands. How? And why is this important?

12. Average fixed costs and average variable costs differ as a business expands. How? And why is this important?

Answer 1

The business incur cost for using the resources for production. The cost broadly can be divided into fixed cost or variable cost.
The fixed cost is the cost which is independent of the production or operation and it is the cost which either incurred or unavoidable. The rent of the land or interest of the debt is considered as examples of the fixed cost because even if there is no production, these costs are obligatory.
Variable cost on the other hand changes with the level of production and this cost is incurred only when there is production.
The company will not buy any raw material if there is no production at all. Similarly, there will be an increase in the contractual labor cost if there is a higher level of production.

The average fixed cost is dependent on level of production. Suppose the fixed cost of the company is $100000 if the company is producing only 100 units then average fixed cost is $1000. However, if the production is increased to 10000 then the average fixed cost is only $10. The lower the fixed the better it is for the company.

This is applicable to the variable cost also because if the total production is higher then the average variable cost will also decrease. However, the variable cost does not keep decreasing forever. The law of diminishing marginal utility means after some level of production, the marginal cost actually increases and it might go up surpassing the marginal revenue.
The company should actually produce until its marginal cost is equal to the marginal revenue.

As the business expands, its average cost decreases and average fixed cost fall but this can not be necessarily correct about the average variable cost. The company should take into account this and plan the production level which will minimize the cost and maximize revenue and profit.