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. Doing so means the chances of being overwhelmed by shifts in the economy are lessened, which in turn means the business what is the interest coverage ratio and how do you calculate it has a better chance of surviving whatever chain of events should come to pass. Relevant range helps organizations or companies deal with mistakes in their projections. If an organization or company assumes that all their cost will remain constant, it might lead to errors in their projection. If they ignore their relevant range, unanticipated capacity issues might arise, preventing them from producing all the needed goods simply because they have hit their capacity for a particular time.
Outside this expected relevant range, revenues and expenses will most likely be different from the expected amount. We define fixed costs as costs which do not change with increase or decrease in the number of units produced. However, this proposition is not valid indefinitely, i.e. fixed costs remain fixed only when production remains within certain minimum and maximum limit. A relevant range is a range or span of behavior in which certain activities related to a business operation are anticipated to remain within certain boundaries. This applies to fixed costs as well as variable costs that may be averaged for the period of time under consideration.
Example of Relevant Range
It’s pretty major but it does not get the attention it deserves. Most professors and authors blow by it pretty quickly but it is a foundational concept that most other assumptions rely on. Arrangement whereby the shareholders of a project receive output free of
charge but agree to pay all operating and financing charges of the project. Harold Averkamp (CPA, MBA) has worked as a university accounting instructor, accountant, and consultant for more than 25 years. He is the sole author of all the materials on AccountingCoach.com. A monetary system under which countries pledge to maintain their exchange rates
within a specific margin around agreed-upon, fixed central exchange rates.
- If you want to make more than that, you are outside the relevant range and will incur additional costs.
- However, suppose Alexâ€™s manufacturing volume were to drop to 15,000 units of product or 20,000 machine hours.
- The retail outlet pays $15 and sells them to the consumer for $19.99.
- The concept of the relevant range is particularly useful in two forms of analysis, which are noted below.
- A step cost occurs when a variable or fixed cost crosses the boundary of the relevant range, making it jump up suddenly.
Perhaps, there is a discount on additional direct material at a given point. So from a relevant range standpoint, we need to determine at what point that number will change. Perhaps we get a discount after we purchase 100 components, at which time the cost of direct material will drop to .80 per widget. With variable costs then, the relevant range will be the range where the cost of adding one more, will be the same as the last.
What is a Relevant Range?
We often state that fixed costs will not change as volume changes. However, if volume were to triple, there would likely be more fixed costs as the company will need more space and managers. Accordingly, we state that costs are fixed only in a relevant or reasonable range of activity. They store the finished inventory in a rented warehouse which is designed to accommodate 25,000 bikes at one time. The warehouse rent per annum is $100,000 regardless of the number of bikes parked there, so it is a fixed cost. The assumed cost of a product, service, or activity is likely to be valid within a relevant range, and less valid outside of that range.
relevant range definition
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. Identification of relevant range is important because knowing the production level at which costs will change is critical for cost accounting, budgeting and financial planning.
Fixed costs remain the same in terms of their total dollar amount, regardless of the number of units manufactured or sold. These are general expenditures that cannot be traced to any one item sold and may include electricity, insurance, depreciation, salary, and rent expenses. When identifying a relevant range, there is a strong need to make use of factual information.
In this example, although the
total cost line increases in production, it does not pass through the origin
because there is a fixed cost component. A fixed amount of electricity is required to run
the factory air conditioning, computers and lights. There is also a variable
cost component related to running the machines on the factory floor. Hence, at a production level of 500 units, the total
electric cost is $8,000 [$3,000 + ($10 x 500)].
10: Relevant Range
In this example, from widgets, each additional widget will add $1 in cost to our direct materials. As a fourth example, ABC Company constructs a manufacturing facility, which has a fixed cost of $10 million to operate and maintain every year. However, if production levels exceed 3 million units per year, then this fixed cost will increase, because of additional wear and tear on the facility. Thus, the relevant range of this fixed cost is up to a maximum of 3 million units per year.
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The following table illustrates fixed and variable cost behaviors using the book example and assuming that the number of units manufactured all fit within our current existing operating capacity. The mixed cost illustrated in the
above chart is called a step function. An example of such cost behavior would
be the total salary expense for shift supervisors. If the factory runs one
shift, only one shift supervisor is required. In order for the factory to
produce above the maximum capacity of a single shift, the factory must add a
second shift and hire a second shift supervisor, so that total shift supervisor
salary expense doubles.
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. Thus, the initial cost of the LED light is only valid for a relevant range that stops at 20,000 units. 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. 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.
In that case, fixed costs will probably jump dramatically because expenditures like rent and additional salaries don’t increase incrementally. For instance, leasing a second factory to double output from 1,500 units to 3,000 units doubles the monthly rent, even if it only produces ten more units—or even zero units. Variable costs vary in a linear
fashion with the production level. However, when stated on a per unit basis,
variable costs remain constant across all production levels within the relevant range.
If the relevant range is fairly narrow, it could be called a “step-variable” cost (see video below). In any case, like mixed costs, a step cost is a variation of the basic behavior categories of fixed or variable. In cost behavior analysis, relevant range represents the production bracket expressed in terms of units within which fixed costs are indeed fixed. Therefore, using the high-low method, we estimate the variable cost per unit is $12 and fixed costs are $35,000.