Concept Architecture
Concept
Theoretically, Average Cost (AC) is the mean cost incurred per unit of output, service or health outcome produced. It is a fundamental concept in microeconomics and cost analysis that describes how total costs are distributed across the quantity of goods or services delivered. In health economics, average cost is used to estimate the typical cost of providing healthcare interventions, treating patients or delivering healthcare services, supporting economic evaluation, budgeting and resource allocation decisions.
Mathematically, average cost is calculated by dividing total cost by the total quantity of output. Total cost generally comprises both fixed and variable costs, and the average cost changes as output varies because fixed costs are spread across different production volumes while variable costs increase with activity. The average cost curve therefore reflects the relationship between production scale and unit cost.
In practice, average cost is estimated using observed expenditure and activity data collected from healthcare providers, administrative databases, clinical trials or costing studies. It is commonly reported as the average cost per patient treated, hospital admission, outpatient visit or quality-adjusted life-year generated. Average cost estimates are frequently used in budget impact analyses, cost-effectiveness studies and health service planning.
Purpose
Used to estimate the typical cost of producing a healthcare service or intervention by expressing total expenditure on a per-unit basis, thereby supporting costing studies, economic evaluation and healthcare resource planning.
Mathematical Formulae
Primary Formula
AC = TC / Q
where:
- AC = average cost
- TC = total cost
- Q = quantity of output
Supporting Formulae
Total Cost:
TC = FC + VC
Average Fixed Cost:
AFC = FC / Q
Average Variable Cost:
AVC = VC / Q
Therefore:
AC = AFC + AVC
Related Mathematical Methods
- Cost Function
- Marginal Cost
- Micro-Costing
- Gross Costing
- Cost Analysis
- Cost Allocation
Example
A hospital spends �4,800,000 annually operating a chemotherapy service and treats 2,400 patients during the year.
Average Cost = �4,800,000 � 2,400
Average Cost = �2,000 per patient
This estimate can be used as the unit cost within a cost-effectiveness model evaluating alternative cancer treatments.
Excel Implementation
| Function | Example Formula | Health Economics Application |
|---|---|---|
| AVERAGE | =AVERAGE(B2:B101) | Calculates the average observed treatment cost across patients. |
| SUM | =SUM(B2:B101)/SUM(C2:C101) | Calculates average cost from total expenditure and total activity. |
| SUMPRODUCT | =SUMPRODUCT(CostRange,VolumeRange)/SUM(VolumeRange) | Calculates weighted average cost across multiple providers or services. |
| IFERROR | =IFERROR(B2/C2,0) | Prevents division-by-zero errors when calculating average cost. |
| ROUND | =ROUND(B2/C2,2) | Rounds average cost estimates for reporting. |
VBA (Optional)
VBA can automate calculation of average costs across healthcare providers, patient groups or intervention categories while generating summary costing reports.
Sources
- Drummond MF, Sculpher MJ, Claxton K, Stoddart GL, Torrance GW. Methods for the Economic Evaluation of Health Care Programmes. Oxford University Press.
- Briggs A, Claxton K, Sculpher M. Decision Modelling for Health Economic Evaluation. Oxford University Press.
- Gold MR, Siegel JE, Russell LB, Weinstein MC. Cost-Effectiveness in Health and Medicine. Oxford University Press.
- NICE. Health Technology Evaluation Manual.
- ISPOR Good Practices for Costing Methodology.
Related Concepts (2)
Library
Publications
1
Economic Analysis in Health Care — Morris, Devlin, Parkin & Spencer, 2nd Edition ed., 2012 (John Wiley & Sons)
A core textbook for advanced undergraduate and postgraduate health economics students, covering both the economics of health care systems and the evaluation of health care technologies, with international case studies and a strong balance of theory and application.
BookView source →
Frequently Asked Questions (6)
What is cost valuation?
The process of assigning a monetary value to identified units of resource use, such as bed-days multiplied by unit cost.
Source: Drummond MF, Sculpher MJ, Claxton K, Stoddart GL, Torrance GW. Methods for the Economic Evaluation of Health Care Programmes. 4th ed. Oxford University Press; 2015.
What value does cost valuation attach to a unit of resource?
In principle the value is what the resource would have produced in its best alternative use, since that is what is given up by committing it here. In practice a market price is used as an approximation, on the reasoning that in a competitive market the price reflects what buyers elsewhere were willing to pay and therefore what the alternative use was worth. The approximation is only as good as the market, which is why the substitution has to be examined rather than assumed.
Source: Drummond et al. 2015
When do observed prices fail as a basis for cost valuation?
They fail where prices are administratively set rather than market determined, which covers much of healthcare. Charges are a particular trap, since a charge reflects a pricing policy including cross-subsidy between services and has no reliable relation to the resources consumed. Internal transfer prices between departments are set for control purposes. Prices under monopoly or exclusive supply exceed the value of the resources used. Where any of these applies, the price paid and the cost to the system diverge.
Source: Finkler 1982
What is a shadow price, and when does cost valuation need one?
A shadow price is a value assigned to a resource that has no market price or whose price is distorted, constructed to reflect what the resource is actually worth in its alternative use. It is needed for volunteer time, informal care provided by family, donated goods, and facilities occupied at nil charge, all of which are genuinely consumed and would otherwise be recorded as costless. It is also used where an observed price is known to be distorted and a corrected value can be defended.
Source: Drummond et al. 2015
Where do the unit costs used in cost valuation come from?
National reference cost collections and published compendia of unit costs are the usual starting point, since they apply consistent definitions across organisations and are updated annually. Local ledgers provide organisation-specific figures where the national average would misdescribe the setting. Manufacturer list prices are used for medicines and devices and require adjustment where confidential discounts apply. Each source carries a different definition of what the figure includes, so mixing them without checking produces inconsistent totals.
Source: healtheconomics.wiki
Why does the price paid differ from the cost to the system in cost valuation?
Taxes on purchases move money within the public sector rather than consuming resources, so they are transfers and are excluded from a societal valuation while remaining real to the organisation paying them. Confidential discounts mean the published price of a medicine is not the price paid, and analyses using list prices systematically overstate cost. Charges levied between organisations include margins and overhead recovery that do not correspond to resources used. The perspective of the analysis determines which of these adjustments applies.
Source: Drummond et al. 2015
Trust Record
Verified by Dr Darrin Baines
British health economist
Professional identity: darrinbaines.org
Verification date: 25 Jul 2025
Content version: 1.0.0
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- Term code
- HE-EE-CA-027
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