Use Unit Costs Cautiously

Although unit costs are regularly used in financial reports and for making product mix and pricing decisions, for many decisions, managers should think in terms of total costs rather than unit costs. Consider the manager of the Memphis plant of Tennessee Products. Assume the $40,000,000 in costs incurred in 2020 to produce the 500,000 speaker systems consist of $10,000,000 of fixed costs and $30,000,000 of variable costs (at $60 variable cost per speaker system produced). Suppose the total fixed costs and the variable cost per speaker system in 2021 are expected to be unchanged from 2020. The budgeted costs for 2021 at different production levels, calculated on the basis of total variable costs, total fixed costs, and total costs, are as follows:

A table shows budgeted costs for 2021 for Tennessee Products at different production levels.

The table depicts the units produced, variable cost per unit, total variable costs (which equals units produced times variable cost per unit), total fixed costs, total costs (which equals total variable costs plus total fixed costs), and unit cost (which equals total costs divided by units produced. The details of the table are as follows:

  1. 100,000 units produced

    • Variable cost per unit: 60 dollars
    • Total variable costs: 6,000,000 dollars
    • Total fixed costs: 10,000,000 dollars
    • Total costs: 16,000,000 dollars
    • Unit cost: 160.00 dollars

  2. 200,000 units produced

    • Variable cost per unit: 60 dollars
    • Total variable costs: 12,000,000 dollars
    • Total fixed costs: 10,000,000 dollars
    • Total costs: 22,000,000 dollars
    • Unit cost: 110.00 dollars

  3. 500,000 units produced

    • Variable cost per unit: 60 dollars
    • Total variable costs: 30,000,000 dollars
    • Total fixed costs: 10,000,000 dollars
    • Total costs: 40,000,000 dollars
    • Unit cost: 80.00 dollars

  4. 800,000 units produced

    • Variable cost per unit: 60 dollars
    • Total variable costs: 48,000,000 dollars
    • Total fixed costs: 10,000,000 dollars
    • Total costs: 58,000,000 dollars
    • Unit cost: 72.50 dollars

  5. 1,000,000 units produced

    • Variable cost per unit: 60 dollars
    • Total variable costs: 60,000,000 dollars
    • Total fixed costs: 10,000,000 dollars
    • Total costs: 70,000,000 dollars
    • Unit cost: 70.00 dollars

A plant manager who uses the 2020 unit cost of $80 to arrive at the budgeted costs for 2021 at different production levels will underestimate the actual total costs in 2021 if the plant’s 2021 output is below the 2020 level of 500,000 units. If the volume produced falls to 200,000 units due to, say, the presence of a new competitor and less demand, actual costs would be $22,000,000. The unit cost of $80 times 200,000 units equals $16,000,000, which underestimates the actual total costs by $6,000,000 ($22,000,000 - $16,000,000). In other words, the unit cost of $80 applies only when the company produces 500,000 units.

An overreliance on the unit cost in this situation could lead to insufficient cash being available to pay the company’s costs if volume declines to 200,000 units. As the table indicates, to arrive at the budgeted costs for 2021, managers should think in terms of total variable costs, total fixed costs, and total costs rather than unit cost. As a general rule, first calculate total costs, then compute the unit cost, if it is needed for a particular decision.