What Does Understanding Long-Run Average Total Cost (LRATC) Do for the Investor?

by Investing School on January 25, 2012

There are many metrics used to analyze the market and financial trends; the Long-Run Average Total Cost (LRATC) is one of these tools. As the name implies, the LRATC displays the average cost of a particular unit of product over a long period of time. All the inputs into the analysis are deemed variable.

Since long term costs are taken over a long time frame, companies are afforded more flexibility in the way they operate. This allows them to be more efficient, a situation which presents the appearance of greater efficiency. One example cited is that of a company building a bigger plant. The belief is that the LRATC per unit would become lower over time as the company can make use of decreased prices resulting from economies of scale.

It is important to note that the LRATC evaluates the average cost, not the specific cost at a particular point in time. For that the Short-run Average Total Cost is used. It is the combination of many SRATCs that create the LRATC – typically generating a U-shaped curve. There are certain factors which can be anticipated in production costs – for example wages – while others are random and beyond the producer’s control. Costs of water, power and materials vary, sometimes dramatically, from month to month.

By viewing the Long-Run Average Total Cost (LRATC) the investor receives a better picture of the company’s stability and overall costs. For example, while a company may have a monopoly on a particular product initially, as competitors enter the market, the LRATC becomes more of an indicator of long term stability.

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