As another example, ABC Company assumes that the cost of a green widget is $10.00 within a relevant range of no less than 5,000 units per year and no more than 15,000 units per year. If the actual unit volume is less than 5,000 units, the purchased cost of materials increases sufficiently to make the assumed cost of $10.00 per unit too low. Conversely, if the actual unit volume is higher than 15,000 units, the purchased cost of materials decreases sufficiently to make the assumed cost of $10.00 per unit too high. The relevant range refers to a specific activity level that is bounded by a minimum and maximum amount. Within the designated boundaries, certain revenue or expense levels can be expected to occur.
We will need to add to our space, thus increasing our fixed expenses. During the financial year 2015, sales dropped despite sustained production which resulted in increase in number of motorbikes to be parked in the warehouse. 125H was forced to rent out another warehouse that could accommodate 25,000 units at time for $120,000 per annum. When identifying a relevant range, there is a strong need to make use of factual information. While it is possible to develop some sort of range using all sorts of criteria, including hopes and dreams for the future of the company, those may or may not be grounded in reality. What sets a relevant range apart is that the process calls for remaining grounded in what has a reasonable chance of occurring during the upcoming budgetary period and making allowances for those events.
- As a third example, if ABC Company were to produce more than 20,000 of its yellow LED lights, it would need a third shift to produce them, which would require an additional $70,000 annual salary for a shift supervisor.
- Each salesperson’s increased revenue more than covers the cost of hiring them.
- As a fourth example, ABC Company constructs a manufacturing facility, which has a fixed cost of $10 million to operate and maintain every year.
- Above that amount, a new relevant range can be assumed for a different cost that assumes the inclusion of the cost of the shift supervisor in the cost of the product.
- It allows businesses to identify opportunities and threats within their environment that could affect their decision-making process.
- Managerial accountants like to assume that the relationship between a cost and an activity run in a straight line.
Alex is a manufacturer whose monthly production is consistently between 20,000 to 50,000 units of the product requiring between 30,000 to 35,000 machine hours. Within this relevant range of activities, the companyâ€™s manufacturing operations run smoothly with the same amount or quantity of monthly fixed costs. On average, a fixed cost is approximately $300,000 per month, covering the cost of supervisors, rent, depreciation, and other fixed expenses. Calculate the cost of doing business at your current rate to determine your relevant range. This requires considering both fixed costs and variable costs.
Calculate current costs
In order to do this, assumptions must be made regarding the pertinent gamut of activities they might engage in during the budgetary period. These presumptions enable businesses to calculate costs based on their fixed expenses. The anticipated profits and losses are likely to be realized as long as their operations are within the relevant range. A company’s assumption how to set up payroll for your small business in 9 steps may benefit from keeping the pertinent range close to the level of current activity. Let’s assume that a manufacturer’s monthly production volume is consistently between 10,000 to 13,000 units of product requiring between 20,000 to 25,000 machine hours. However, suppose Alexâ€™s manufacturing volume were to drop to 15,000 units of product or 20,000 machine hours.
Companies determine whether the amount of materials falls within their relevant range when calculating the value of buying in bulk at a specific price range. During the financial year 2014, sales dropped but they kept producing bikes so they ended up with too many bikes to store in the rented space. They had to rent another space for $50,000 to store the extra finished goods inventory. The difference between the high and low prices traded during a period of time;
with commodities, the high/low price limit established by the exchange for a specific commodity for any one day’s trading. Costs that do not change with increases or decreases in the volume of goods or services
produced, within the relevant range.
At Direct AC, a sales team grew from three to seven people in a year. Each salesperson’s increased revenue more than covers the cost of hiring them. But the teams manager, who earns $75,000 annually, is unable to effectively oversee more than 10 salespeople at once. In the upcoming year, Direct AC will need to hire another manager to keep up with the team’s expansion, which will raise its fixed costs by $75,000. To maintain a profit, you might need to reduce your fixed costs at some point. As a third example, if ABC Company were to produce more than 20,000 of its yellow LED lights, it would need a third shift to produce them, which would require an additional $70,000 annual salary for a shift supervisor.
Production materials are an example of a variable cost that changes depending on how much the business sells. It is not necessary for the rate of change for variable costs and production to be proportional. You might, for instance, see a 20% increase in production while only a 10% increase in variable costs. Budget projections are created by businesses to plan for future growth and to update shareholders.
If actual sales were to exceed that amount, then ABC would need to construct a new manufacturing facility. A monetary system under which countries pledge to maintain their exchange rates
within a specific margin around agreed-upon, fixed central exchange rates. For instance, a clothing company plans to make 100 shirts and sell them for $10 each, bringing in $1,000. However, the business would spend $1,000 and lose money if it attempted to purchase 10,000 metal snaps at the same unit price of $10 per snap. A particular activity level bound by a minimum and maximum amount. A forward exchange rate contract that places upper and lower bounds on the cost of foreign exchange.
In particular, a “fixed” cost is likely to remain fixed only within a relevant range of activity. Also, volume discounts from suppliers are only valid for certain purchasing volume quantities. It stores ready-to-sell motorbikes in a rented warehouse which is designed to accommodate 50,000 units at one time. The warehouse rent per annum is $200,000 regardless of the number of bikes parked there; hence, it is a fixed cost. We often state that fixed costs will not change as volume changes.
The Relevant Range of Operating Capacity
Outside of that relevant range, revenues and expenses will likely differ from the expected amount. The concept of the relevant range is particularly useful in two forms of analysis, which are noted below. Although this is probably a more accurate description of how variable costs actually behave for most companies, it is much simpler to describe and estimate costs if you assume they are linear.
Examples of the relevant range
The goal is to determine if any of those fixed costs are likely to increase during the new budget period, and if so what allowances must be made for that change. At the same time, variable costs will be evaluated and a range of possible movement with those expenses created to accommodate any expectations of increase or decrease in those average costs. For instance, if manufacturing or production is increased, there might be a need for additional space or additional working supervisors, resulting in higher fixed costs. Afterward, Alexâ€™s companyâ€™s fixed costs are approximately $300,000 every month within a relevant activity range. In the following year, it sells 70 motorcycles, prompting the purchase of an additional 60 green exhaust pipes.
Relevant Range: What It Is and How To Use It
This is the “relevant range,” and it’s a critical qualifier when budgeting and allocating fixed costs. As defined earlier, the relevant range is a term used to describe the range of activity (units of production in this example) for which cost behavior patterns are likely to be accurate. The relevant range for total production costs at Bikes Unlimited is shown in Figure 5.8.
If sales were expected to increase in the future, the company would have to increase capacity, and cost estimates would have to be revised. One way to understand a relevant range is to consider the task of preparing a budget for the upcoming year. As part of the process, review of each fixed cost currently incurred by the company is evaluated.
Doing so means the chances of being overwhelmed by shifts in the economy are lessened, which in turn means the business has a better chance of surviving whatever chain of events should come to pass. When looking at costs and how costs behave, relevant range is the range of output or production in which our assumptions are true. If you move outside the relevant range, your cost assumptions are no longer valid. Because making the assumption that all of your costs will remain constant, whether they are fixed or variable, could lead to inaccurate projections, relevant range is crucial. Relevant range helps organizations or companies deal with mistakes in their projections.
However, this proposition is not valid indefinitely, i.e. fixed costs remain fixed only when production remains within certain minimum and maximum limit. These costs don’t change unless your company expands or contracts more than what your relevant range permits. For instance, you might produce more units one month than the previous month, but your fixed costs will typically not change. However, if you increase production to the point where you need to relocate or hire more staff, you have now outgrown your appropriate market. This implies that your fixed costs are adjusted to reflect the new rent and the new salaries. As a result, you can calculate costs when creating your budget because this establishes your new relevant range.
Both assumptions are reasonable as long as the relevant range is clearly identified, and the linearity assumption does not significantly distort the resulting cost estimate. You start to panic a bit, but you hire more workers and start running three shifts per day. By reconfiguring your machinery to add more capacity, you are now able to make 40,000 mugs per month. Even with the excess capacity, you still can’t keep up with the orders. For example, ABC Company constructs a budget within a relevant revenue range of no more than $20 million.