What Is Long Run Incremental Cost (LRIC)?

A long run incremental cost (LRIC) is a forward-looking cost that a company needs to include in its accounting. Long run incremental costs are gradual costs a company is able to predict and plan for over the long term.

Key Takeaways

  • A long run incremental cost (LRIC) is a cost that a company incurs gradually over the long term and is able to predict.
  • Long run incremental costs (LRIC) can include changes to the cost of raw materials, increases in rent, and maintenance costs.
  • Estimating long run incremental costs (LRIC) helps a company to make future investment and operational decisions.
  • Sunk costs are not included in long run incremental cost predictions.
  • Marginal costs are similar but different to long run incremental costs and refer to the cost of producing one more unit of a service or good.

Understanding Long Run Incremental Cost (LRIC)

A long run incremental cost (LRIC) refers to the changing costs that a company can somewhat foresee. Examples of long-run incremental costs include energy and oil price increases, rent increases, expansion costs, and maintenance expenses.

Long run incremental costs often refer to the changes affiliated with making a product, such as the cost of raw materials. For example, say production for a certain manufactured good requires a significant amount of oil. If oil prices are expected to decline, then the long run incremental cost of producing the good is also likely to decline. There is no guarantee that long run incremental costs will change in the exact amount predicted, but attempting to calculate such costs helps a company make future investment decisions.

The impacts of long run incremental costs can be seen on the income statement. For example, if the action taken resulted in more revenue, revenues would increase. In addition, cost of goods sold would increase as would operating expenses. These are the areas that would increase or decrease depending on whether a company decided to produce more or fewer goods or services, which is what long run incremental cost (LRIC) seeks to measure.

Long run incremental costs (LRIC) usually impact the price of a good or service as well. If the cost per unit of a good increases due to an increase in long run incremental costs (LRICs) then a company would have to increase the price of its product to maintain the same profit margin. If the unit cost decreased then a company would reduce the price of its product to maintain the same profit margin and perhaps increase demand or it could operate with a higher profit margin.

Long Run Incremental Cost (LRIC) Evaluation

Accurate cost prediction and measurement is critical to properly pricing goods and services. Companies with the most accurate cost measurement can adequately define whether or not they are making a profit, and know how to gauge potential new products and investments. Using an accurate method to determine costs is a primary focus of cost accounting and financial control. Incremental and marginal costs are two fundamental tools to evaluate future production and investment opportunities.

Previously made purchases or investments, such as the cost of a plot of land or the cost of building a factory, are referred to as sunk costs and are not included in long run incremental cost predictions. Incremental costs can include several different direct or indirect costs, however only costs that will change are to be included.

For example, say a factory production line is at full capacity and therefore the company would like to add another production line. Incremental costs might include the cost of new equipment, the people to staff the line, electricity to run the line, and additional human resources and benefits. All these costs would be considered long term incremental costs because they would be implemented as long-term aspects of the business. These are not short-term costs that would be eliminated within a year.

Marginal Cost

Conversely, marginal costs refer to the cost of producing one more unit of a service or product. Goods or services with high marginal costs tend to be unique and labor-intensive, whereas low marginal cost items are usually very price competitive.

The marginal cost is the change in total cost that comes from making or producing one additional item. The purpose of analyzing marginal cost is to determine at what point an organization can achieve economies of scale, which refers to the reduced costs per unit that arise from an increased total output of a product.