Question

ABC Company is a producer of electronic furnace air filters. A significant jump in new housing starts in the region has triggered a 25 percent increase in orders for the filter units, especially the quality model that ABC sells for $270. Six weeks after increasing production to supply the increased orders, the production intern questions you about the following cost data:

Filter	This month	Last month	Change
Average total coast per unit	$167.20	$171.14	($3.96)
Average Variable cost per unit	$104.90	$101.22	$3.68
(i.e. marginal cost)

In the simplest terms possible and using what you have learned about cost behavior, provide a plausible explanation of how this might occur.

1) Why does Average total cost decrease while average variable cost increase?

2) What reasons make up why average variable cost increase?

Answer 1

1. The total cost include the Variable and Fixed costs. The fixed cost does not increase with the unit produced and some examples are Rent, Cost of Machinery etc. As the Fixed cost is fixed, the per unit fixed cost shall decrease for every additional unit produced. Thus, the total cost per unit will come down to that extend for every unit produced. This is the reason why the total cost per unit decreases when the average variable cost increase or remain the same.

2. The average variable cost increases when the total cost decreases in this current situations. This shall be due to a number of reasons. The variable cost for the additionally produced units shall be higher than that of the others. As it is stated that the additional demand is for the quality product, this would have a greater amount of variable cost including material cost and labor time.

Also, another reason shall be the overutilization of the resources. For example, when the labor force are used for a time which is more than the normal, they would require a higher pay which is considerably higher than that already paid. This would increase the average variable cost per unit.