Total Cost: Definition and Formula
By Indeed Editorial Team
Updated February 22, 2021 | Published February 4, 2020
Updated February 22, 2021
Published February 4, 2020
For businesses to be successful, they need to have a clear understanding of their profitability. To do this, there are several elements to their accounts that they need to calculate. One of these is total cost, and this is calculated using the total cost formula, which requires inputting a variety of metrics to calculate a specific figure. This figure can be used to determine the profitability of the business.
In this article, we will explore what total cost formula is and how it works, as well as its advantages and disadvantages.
What is total cost formula?
The total cost formula is used to combine the variable and fixed costs of providing goods to determine a total. The formula is:
Total cost = (Average fixed cost x average variable cost) x Number of units produced
To use this formula, you must know the figures for your fixed and variable costs.
Fixed costs are the business expenses that stay the same regardless of the number of units produced. These include costs that do not vary from one month to the next such as rent, insurance, payroll taxes, office supplies and wages for members of staff that are not directly involved in delivering the service or producing or manufacturing the items sold.
Variable costs are those which will increase or decrease depending on the number of items produced or customers requiring the service. They can also change according to other factors, such as a rise in the price of materials or an increase in heating costs over the winter. Variable costs may include materials used in manufacture, packaging and delivery costs of the products, purchase, hire and maintenance of the equipment used in production, cost of labor for staff working directly on delivering the service or goods and the utilities used in the production or work area.
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How total cost formula works
The total cost formula works by allocating all the costs of doing business to the goods or services for sale. By calculating everything that the business spends and dividing it by the organization's unit output, it is possible to determine how profitable the business is and whether there is a need to adjust pricing, reduce costs or identify diversification opportunities that may increase profits.
Knowing the total cost of producing an item is vital to a business's pricing policy. While the unit price may cover the variable costs of actually making the items, if the profit margin does not also allow for the fixed costs of marketing the products and dealing with the administration, then the business is not viable. When fixed or variable costs increase, the total cost rises as well. This either needs to be passed on to the consumer or mitigated by making savings.
Businesses also use their total cost calculations to measure their efficiency and identify areas where they could make savings to bring both their variable and fixed costs down. This could mean sourcing materials from a cheaper supplier for variable costs or moving into a factory with cheaper rent to lower variable costs. Understanding how the total costs are calculated is an important aspect of ensuring that a business is profitable.
The total cost can also be used to inform price-setting and marketing strategies. By understanding how many of each item needs to be sold to make a profit, it can help with setting sales and marketing targets. The total cost can also be used as a tool to identify the lines that are performing poorly enough to be dropped or redesigned to make them more profitable.
Advantages of total cost formula
The main advantage of using the total cost formula is that it gives a clear and easily understood metric that can be measured and tracked to assess the profitability of a business. It can be compared over time to determine whether there is a need to review pricing or generate more sales to increase profits.
Keeping track of the total cost of each product line can also be a useful benchmarking tool to evaluate the performance of a business and to determine its market position compared to competitors. If an organization finds that its total cost per product is lower than a competitor's consumer price, then they can review their processes to identify ways to bring the total cost down to stay in line with a unit price that the market will bear.
As an internal tool for tracking profitability, the total cost can also give an overview of the performance of any given product line or range. This can be useful when negotiating with suppliers or outsourcing elements of the production, as it gives transparency to external suppliers by making their margin clear.
Disadvantages of total cost formula
Businesses that have a limited number of products or services, particularly where there is a clear distinction between manufacturing methods or supplies required, should find the total cost calculation relatively simple.
For businesses with several different products or services available, calculating the total cost can be very complex. The more costs that need to be included and the higher the number of items produced, the more difficult it becomes to allocate the costs effectively to calculate the total.
The fact that the fixed cost is derived from a formula requiring the variable costs to be calculated adds another layer of complexity. In a business where the cost of supplies can vary constantly or where prices change seasonally, the variable cost element of the total cost formula needs to be constantly adjusted.
Using total cost as a forecasting tool relies on predictable increases and decreases in the costs of each element of the process, but the cost of materials and utilities can vary in unpredictable ways. This also means that pricing strategies based on total costs rely on being able to adjust prices constantly which is not always possible for organizations where a dynamic pricing structure cannot be implemented.
The larger the organization and the broader the product range, the more figures there are involved in calculating the total cost. If one of those elements changes, then the calculations need to be done again. This may be a less effective way to ensure the viability of a business than focusing on a particular aspect and trying to bring those costs down.
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