The parameters of production or activity within which a company maintains the same fixed costs are the relevant range. Fixed costs are constant and independent of particular production rates in accounting. In today’s rapidly changing business environment, companies are looking for ways to remain competitive, and strategic planning is a key element of success. As businesses look to plan for the future, they must consider the concept of relevant range to ensure that their decisions are optimized for long-term success. Relevant range is a tool used to define the scope of a particular problem or decision that must be made, taking into account both the internal and external factors that will influence the outcome.
- If actual sales were to exceed that amount, then ABC would need to construct a new manufacturing facility.
- In fixed expenses, if our facility is designed to build 5,000 widgets per month, what will happen when we reach sales of 5,001 widgets?
- Managers can use this to assess whether business costs are legitimate.
The relevant range, in managerial accounting and cost accounting, refers to the range of activity within which certain assumptions about cost behavior are valid. In other words, it’s the range of production or sales volume where the total fixed costs remain constant, and the variable cost per unit stays the same. Outside this range, these assumptions may no longer hold, and costs may behave differently.
Calculate current costs
The company’s annual sales increase by 10 units once it becomes well-known. Given that ABCMotorcycles purchased 60 exhaust pipes and sold 60 motorcycles, this still falls within relevant range. The managerial staff uses cost accounting as a tool to determine the total cost of doing business and to plan for future expansion. Managers can use this to assess whether business costs are legitimate. The new warehouse will be big enough until they reach 55,000 bikes, so the total rent will remain at $150,000 until that time.
- At Direct AC, a sales team grew from three to seven people in a year.
- The warehouse rent per annum is $100,000 regardless of the number of bikes parked there, so it is a fixed cost.
- The restaurant still needs $200 to cover the other expenses, so the amount is no longer within the acceptable range to pay five servers.
- Afterward, Alexâ€™s companyâ€™s fixed costs are approximately $300,000 every month within a relevant activity range.
- Thus, the relevant range of this fixed cost is up to a maximum of 3 million units per year.
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. The idea behind identifying a relevant range is to allow businesses to effectively project expenses as well as revenue so that workable budgets for upcoming periods can be prepared. Calculate the cost of doing business at your current rate to determine your relevant range. Production materials are an example of a variable cost that changes depending on how much the business sells.
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. The relevant range is the range of activity where the assumption that cost behavior is a straight line (linear) is reasonably valid.
Relevant Range Details
Also, if you ignore relevant range, you may hit capacity issues where you don’t realize you physically cannot make all of the goods needed because you have hit your capacity for the time period. 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. 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. 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. 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. Relevant range is important because if you make the assumption that all of your costs will remain constant, whether they are fixed or variable, you may make errors on your projections.
Hopefully, they get manufacturing and sales aligned before that happens, but for now, that is the new relevant range. The increased warehouse rent will remain fixed until the maximum capacity indirect reference definition of that second warehouse is reached i.e. inventory balance exceeds 75,000 motorbikes. When identifying a relevant range, there is a strong need to make use of factual information.
Compare your costs and growth rate
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. If actual sales were to exceed that amount, then ABC would need to construct a new manufacturing facility. For ZenSpace, the relevant range is from 0 to 25 students per class.
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. 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. 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.
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.
A particular activity level bound by a minimum and maximum amount. My Accounting Course is a world-class educational resource developed by experts to simplify accounting, finance, & investment analysis topics, so students and professionals can learn and propel their careers. Two important assumptions must be considered when estimating costs using the methods described in this chapter.
It is a cost that does not increase or decrease in the number of goods and services produced or sold. Within the specified boundaries, particular revenue or expense levels are assumed to take place. 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. As a fourth example, ABC Company constructs a manufacturing facility, which has a fixed cost of $10 million to operate and maintain every year.