These critical business decisions will be made with the help of Average Cost Curves. These graphs will convey information about optimum production levels and the most beneficial expansion scheme. Total Average Cost is the average fixed cost plus the average variable cost. The Short Run Average Cost (SRAC) is the average cost of the product when at least one input variable remains fixed. This is usually the building or the plant used in manufacturing. The Long Run Average Cost (LRAC) is the average cost over a longer time period when all input variables have changed. It takes into account new plants, buildings, and large capital investments. Though these curves will vary depending on the individual product and situation, for a successful business they will almost always assume the same general shape. The shape of the SRAC curve and the LRAC curve are influenced by the changing input variables plotted against differing production levels. As Acme begins production, the cost of the first few units is heavily influenced by the fixed costs such as the lease on the building. The graph will start at a high average cost per unit. As they increase production levels, the fixed costs become spread out over more units and the SRAC begins to fall. At this point, the graph will begin to slope downward as the quantity rises. The SRAC will continue to decrease as production increases toward full capacity, as both fixed and variable (due to material volume) cost per unit declines. This period of declining SRAC is known as the economy of scale. When the factory has reached full capacity, its resources are being optimised and the total average cost per unit has reached a minimum. Manufacturing beyond this point will begin to increase the average cost as variable costs rise, and the process will enter a period of diseconomy of scale. Added expenses such as temporary labour, overtime, and additional management are a few of the factors that can contribute to the rising variable cost. Here, the graph turns upward reflecting the higher average cost. As more units are produced, the average cost continues to rise dramatically reflecting the inefficiencies involved with over capacity production. This is known as the law of diminishing returns.
A key component and indicator on the graph of the SRAC is the Marginal Cost (MC). This is the total cost of producing the next unit. With an efficient factory running near capacity, this will be at a minimum, and less than the average. However, going beyond this point will cause the marginal cost to spike upward on a steeper slope than the average. When the marginal cost line crosses the average, production is at its most efficient. As marginal costs rise, it pulls the SRAC curve up with it, though at a less responsive rate. Acme could remain profitable in this area of increasing costs and diminishing returns as long as MC is below the selling price. However, to maximise resources it is desirable to keep the SRAC at a minimum. The point at which the marginal cost begins to rise and cross the SRAC is the point at which Acme must consider expanding their production capabilities.
Acme has already planned for this expansion. They are no where near market saturation and the product design has a long life ahead of it. Their sales are increasing and they have studied various plans on the