What it means
In the short run, some costs are stuck: a lease runs for five years, a production line cannot be rebuilt overnight. In the long run, everything can be adjusted, so the business can choose the best possible set-up for any volume it wants to produce.
LRATC traces the cheapest cost per unit at each of those volumes. The curve usually falls at first, because larger operations spread fixed costs over more units, allow specialised staff and secure bulk-buying discounts.
Economists call this economies of scale. The curve may then flatten, and eventually rise again if the business becomes so large that coordination, bureaucracy and communication problems push unit costs up, which is known as diseconomies of scale.
For a manager, LRATC is the thinking tool behind questions such as whether to build a bigger plant, merge with a competitor or outsource production. If unit costs are still falling at your current volume, growth makes you more competitive.
If they have started rising, adding more scale makes things worse. The lowest point on the curve is called the minimum efficient scale, the smallest volume at which a firm can produce at the lowest available unit cost.
Industries where that point is very large, such as car manufacturing or telecoms, tend to be dominated by a few big players. Industries where it is small, such as hairdressing, support many small firms.
A practical caution is that LRATC is partly a theoretical construct. Real businesses seldom know the exact cost of a plant they have never built, so managers estimate it using quotes, benchmarks and the experience of competitors.
Treat the numbers as informed estimates and test them against the cost of being wrong.
In practice
Real-world examples.
Example
A bakery chain compares opening a fourth small shop with building one central kitchen that supplies all stores. The central kitchen would cost more in total but lower the cost per loaf from $0.90 to $0.70 at the expected volume. The owners choose the kitchen because the long-run unit cost is clearly lower.
Example
A software company finds that supporting 5,000 customers costs about $60 per customer each year, while supporting 50,000 costs about $25 because the same servers and tools are shared. Management uses this to justify investing heavily in sales, since each extra customer lowers the average cost of serving everyone.
Example
A regional logistics firm merges with a rival and discovers that its cost per delivery rises rather than falls. The extra layers of managers and the clash of two different systems add overhead faster than the larger fleet saves money, so the board sets a target to reduce complexity.
Formula
Calculation
LRATC = Total long-run cost / Quantity produced
Suppose a manufacturer is comparing three possible factory sizes, each designed to be efficient for its output level. The small plant makes 10,000 units at a total cost of $500,000, so LRATC = 500,000 / 10,000 = $50 per unit. The medium plant makes 40,000 units at $1,600,000, so LRATC = 1,600,000 / 40,000 = $40 per unit. The large plant makes 100,000 units at $4,500,000, so LRATC = 4,500,000 / 100,000 = $45 per unit. The medium plant has the lowest unit cost, and the rise at the large size is a sign of diseconomies of scale.Case study
Seen in the real world.
Harbourlight Plastics is an illustrative, fictional company that moulds food containers for supermarkets. Its finance manager built a simple LRATC table for three possible plant sizes ahead of a major investment decision. The mid-sized option had the lowest cost per container, while the biggest plant looked cheaper on paper but needed far more managers and warehouse space than anyone had planned for.
The leadership team chose the mid-sized plant and negotiated an option to expand the site later. In the illustrative story, the decision saved around $0.03 per container compared with the largest design, which across 80 million containers a year came to $2,400,000. The lesson was that the lowest total cost bid was not the same as the lowest cost per unit.
Watch out
Common mistakes.
- Confusing LRATC with short-run average total cost, which only applies when some inputs such as the factory are fixed.
- Assuming that bigger always means cheaper, when many businesses hit diseconomies of scale beyond a certain size.
- Using today's accounting cost per unit as the LRATC, even though the long-run figure assumes every input can be re-optimised.
Questions
People also ask.
Is LRATC the same as the long-run average cost curve?
Yes, in most textbooks the two names describe the same curve, which shows the lowest unit cost at each level of output when all inputs can be changed.
What shape does the LRATC curve usually have?
It is typically U-shaped, falling while economies of scale dominate, flat around the efficient scale, and rising when diseconomies of scale take over.
How can a manager use LRATC without perfect data?
Build a few scenarios using supplier quotes and benchmark costs, calculate the cost per unit for each, and choose the scale where the unit cost is lowest while staying within the risk the business can bear.
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