Long Run Incremental Cost (LRIC): What It Is, How It Works

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. It is a gradual cost that a company can predict and plan for over the long term.

Key Takeaways

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

Understanding Long Run Incremental Cost (LRIC)

LRIC refers to 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.

LRIC often refers to changes affiliated with making a product, such as the cost of raw materials. For example, if oil prices are expected to decline, the LRIC of producing the good is likely to decline. Calculating such costs helps a company make future investment decisions, although the exact amount of change is not guaranteed.

The impacts of LRIC can be seen on the income statement. If the action taken results in more revenue, revenues and cost of goods sold would both increase. These are areas that would increase or decrease depending on whether a company decided to produce more or fewer goods or services, which is what LRIC seeks to measure.

LRIC usually impacts the price of a good or service as well. If the cost per unit increases due to LRIC, a company would have to increase the price to maintain the same profit margin. Conversely, if the unit cost decreases, a company would reduce the price to maintain the same profit margin and perhaps increase demand or operate with a higher profit margin.

LRIC Evaluation

Accurate cost prediction and measurement is critical to properly pricing goods and services. Companies with the most accurate cost measurement can determine whether they are making a profit and how to gauge potential new products and investments. Incremental and marginal costs are two fundamental tools to evaluate future production and investment opportunities.

Sunk costs, such as the cost of a plot of land or building a factory, are not included in LRIC predictions. Incremental costs include direct or indirect costs that will change.

For example, if a factory production line is at full capacity and a company wants to add another line, the incremental costs might include new equipment, staffing, electricity, and additional human resources and benefits. These costs are considered long-term incremental costs as they are implemented as long-term aspects of the business and would not be eliminated within a year.

LRIC vs. Marginal Cost

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. Analyzing marginal cost helps determine at what point an organization can achieve economies of scale, which refers to reduced costs per unit that arise from increased total output of a product.