Costs

There are three kinds of total cost:
1. Total fixed cost is the sum of those costs that are fixed in total – no matter how much is produced. Among these fixed costs are rent, depreciation, managers’ salaries, property taxes, and insurance. Such costs stay the same even if production stops temporarily.
2. Total variable cost, on the other hand, is the sum of those changing expenses that are closely related to output – expenses for parts, wages, packaging materials, outgoing freight, and sales commissions. At zero output, total variable cost is zero. As output increases, so do variable costs. If Wrangler doubles its output of jeans in a year, its total cost for denim cloth also (roughly) doubles.
3. Total cost is the sum of total fixed and total variable costs. Changes in total cost depend on variations in total variable cost – since total fixed cost stays the same. And there are three kinds of average cost:
1. Average cost (per unit) is obtained by dividing total cost by the related quantity (that is, the total quantity that causes the total cost).
2. Average fixed cost (per unit) is obtained by dividing total fixed cost by the related quantity.
3. Average variable cost (per unit) is obtained by dividing total variable cost by the related quantity.

Cost-oriented pricing requires an estimate of the total number of units to be sold. That estimate determines the average fixed cost per unit and thus the average total cost. Hen the firm adds the desired profit per unit to the average total cost to get the cost-oriented selling price. How customers react to that price determines the actual quantity the firm will be able to sell. Further, the quantity the firm actually sells (times price) determines total revenue (and total profit or loss). A decision made in one area affects each of the others – directly or indirectly. Average-cost pricing does not consider these effects. A manager who forgets this can make serious mistakes.